DECOMPOSITION ANALYSIS OF FINANCIAL STATEMENTS MICHAEL C. WALKER, JOHN D. STOWE AND SHANE MORIARITY” INTRODUCTION zyxwv DCBA Over the past decade there has been a resurgence of interest in financial s analysis and a number of new techniques have been developed.’ One promising new technique, which is neither widely zyxw DCB known among practitioners nor has been extensively investigated by academicians, is decomposition analysis. With s notable exceptions, decomposition analysis zyxw CBA has been largely absent from the finance and accounting literature. The purpose of this paper is to reevaluate one of the suggested uses for decomposition analysis and to suggest a new app of the technique. The first section of the paper briefly outlines the nature of decomposition analysis and summarizes the applications of the technique which have been reported in previous empirical studies. The next section reconsiders the us decomposition analysis as a predictor of corporate bankruptcy using a diff sample from those previously employed. In the final section, decomposition proposed as a technique for monitoring the financial condition of firms. Decomposition analysis is logically suited as a monitoring device and could augment or replace traditional monitoring procedures. PROPERTIES OF DECOMPOSITION MEASURES Decomposition analysis is a tool normally associated with information theo However, its use in business and economics has generally focused on the s of structural change, particularly changes over time in the relative proport of dollar amounts in accounts or subsets of accounts. For example, the first application of decomposition analysis to financial statements was by Theil [ 121. Theil argued that decomposition could be used as a “summarizing descript device for changes” in the composition of firm balance sheets. Further dev of the use of decomposition analysis for analyzing financial statements was undertaken by Lev zyxwv JIHGF [6,7,8]. Lev offered an economic rationale for the usefulne of decomposition analysis. The essence of the argument was that business organizations are homeostatic in that they seek to maintain equilibrium relationships. Any structural changes, whether planned or unplanned, are of interest to the financial analyst for identifying changes in management str or signaling an inability by management to maintain a desired structure. Lev [7] z L *The authors are Associate Professor of Finance at North Texas State Assistant Professor of Finance and Associate Professor of Accounting at the University of Oklahoma. (Paper received June 1978) Journal of Business Finance & Accounting, 6,2(1979) 173