Financial Statement Analysis: The Piotroski Model

It is obvious that the quality and persistence of earnings, are related and judged by the corresponding attributes of accruals. The later are measured by certain models widely used among the practitioners. The oldest one is that is used by Jones (1991). It is measuring nondiscretionary accruals and as a result also discretionary accruals that depend on the flexibility of management. As it is expected the lower the amount of nondiscretionary accruals, the higher the amount of discretionary accruals. It is also important to take in to consideration the fluctuation of discretionary accruals from year to year. High discretionary accruals coupled with fluctuations (that are not attributed to growth), are considered as signals of possible managements’

Stock prices are viewed as encompassing the information in realized cash flows and earnings concerning firm performance. Now, we review briefly the literature of financial statement analysis with the use of ratios that led to the development of Piotroski model.

Financial ratios contribute to the classification of the most important data contained in financial statements. Ratios help us to identify the crucial relations among data that transform them into information and through analysis to valuation.

The approach based on financial statement analysis was exploited in Ou and Penman (1989,) who show that ratios calculated using financial statement data can predict future earnings changes. Ou and Penman perform a financial statement analysis that uses an extensive number of 68 ratios coming from financial statements and produce one summary which indicates the direction of one-year-ahead earnings changes. They don’t specify the criteria they used to pick out the massive group of ratios they used. They accept the study of Ball and Brown (1968), which indicates that accounting earnings carry information that are reflected in stock

Lev and Thiagarajan applied specific financial signals that financial analysts use and show that these signals are correlated with contemporaneous returns. So, Lev and Thiagarajan took a different approach and identify a group of financial ratios, used in practice by ‘‘experts’’,mostly analysts and market financial media, and examine their association with stock returns. They ultimately identified twelve such fundamental signals. The most important of the signals chosen were relative change in sales compare to changes in inventories, changes in accounts receivables, in capital expenditures, in gross margins, in selling and administrative expenses etc. A relative increase in sales to accounts receivable ratio for instance, were interpreted as a predictor of a rise in future earnings. On the other hand, a decreases in sales to accounts receivable ratio, may signal weakness in producing more sales that dictate credit extensions or/and may mean that receivables cannot be collected. Both explanations represent signs of a problematic situation. Analogously interpreted the increase in inventory that come about through decrease in sales. Favorable sign was considered the increase in gross margin to sales that increases competitiveness and pave the way to increase