The Application of Principal Component Analysis in the Selection of Industry Specific Financial Ratios

Abstract

Aims: This paper investigates the application of principal component analysis in the selection of financial ratios that are significant and representative for two industry sectors in Malaysia. Companies in different industries, even in the same country, have different operational, market and capital structures. Therefore, to use ratios that are found to be useful for one industry sector may not be valid for companies in another industry sector. Study Design:  Research paper. Place and Duration of Study: Malaysia. Secondary data from 2006 to 2010. Methodology: 70 companies each from the consumer and trading and services sector respectively are randomly selected and analysed over a period of five years. An initial set of 28 financial ratios were factor analysed to obtain a smaller set of significant and useful ratios. Results: The results showed that only seven and nine ratios out of 28 for each sector respectively were identified as representative ratios. It is found that three ratios, cash flow to total assets, long-term debts to shareholders’ funds and current assets turnover, are the only ratios that were selected for both industries indicating that these three ratios are considered equally useful for these two industries while the others are more specific to their industry sector. Conclusion: This study showed that, for the present data, for the sample period taken and for an emerging economy like Malaysia, it is not necessary to use the many ratios that are found in the literature for assessing financial performances or the financial conditions of companies and a smaller set of representative ratios are sufficient and that financial ratios are industry specific and cannot be applied across industries.