OMEGA Int. J. of MgmtSci..Vol. 18. No. 2. pp. 131-138.1990 0305-0483/90 $3.00+0.00 Printedin Great Britain.All rightsreserved Copyright~ 1990 Pergamon Pressplc Data Envelopment Analysis Applied to Financial Statements P SMITH University of York, UK (Receit'ed December 1988; in revised form October 1989) Ratio analysis has been a tool of analysts for as long as financial statements have been prepared. Yet its limitation to considering only one numerator and one denominator severely limits its usefulness. This paper extends the traditional ratio analysis to permit the incorporation of any number of dimensions of performance, using data envelopment analysis. The method produces measures of corporate efficiency, together with a wealth of supporting information. The strengths and weaknesses of the method applied to financial statements are appraised. Key words--financial statements, data envelopment analysis, performance measurement, ratio analysis INTRODUCTION THE APPEARANCE OF a historical survey is sometimes a signal that advances in a subject have come to an end. Thus recent historical reviews [12, 19] might have been construed as signals that there were few new developments to be found in the application of ratio analysis to the interpretation of financial statements. How- ever, a recent survey [4] suggests that there is still a great deal of research activity on the subject. Two principal uses of financial ratios are usually identified (see for example [29]). The traditional approach, dating from the nine- teenth century, has been to use ratios as a basis for inter-firm comparisons. More recently, the development of econometric techniques has facilitated the use of financial ratios for predic- tive purpose, in particular with regard to bankruptcy risk [1, 5, 6, 26]. This paper is pri- marily concerned with the first of these uses. Using recent developments in economic models of productive efficiency, it explores whether financial statements contain adequate infor- mation to make secure judgements about cor- porate efficiency. Foster [17, p. 60] describes the comparison of ratios across firms as the most "widely discussed" cross-sectional technique of financial ratio analysis. Typically, two numbers are taken from the financial statement, and the compu- tation of the associated quotient permits com- parison between firms, usually by adjusting for differences in the size of firms. There is therefore an assumption of constant returns to scale implicit in most financial ratio analysis. Although some ratios (such as return on equity) explore the overall profitability of the firm, many look at more specialized phenomena, such as cash flow, capital structure, and debt service coverage. One of the fundamental limitations of tra- ditional univariate ratio analysis is that only two dimensions of activity, represented by numer- ator and denominator, can be examined in any one indicator. For example, a typical per- formance ratio might examine some output in relation to an input. Yet the complexity of firms means that inputs and outputs, both physical and financial, are multidimensional. In yielding a single scalar measure of performance, tra- ditional ratios either examine only a part of the enterprise's activity, or collapse these multiple dimensions into a single unsatisfactory account- ing number. In the past there have been attempts to com- bine ratios by various weighting systems, some 131