Unveiling the directional network behind the financial statements data using volatility constraint correlation

TL;DR

This paper introduces a novel volatility constrained correlation method to uncover directional relationships among financial statement variables, revealing influential and susceptible factors across numerous firms over decades.

Contribution

It applies the VC correlation technique to financial data, providing new insights into causal influences among key financial variables, which differ from traditional investment indicators.

Findings

Operating income is the most influential variable.

Market capitalization and revenue are the most susceptible variables.

Results challenge conventional understanding based on P/E and P/B ratios.

Abstract

Financial data, such as financial statements, contain valuable and critical information that may assist stakeholders and investors in optimizing their capital to maximize overall economic growth. Since there are many variables in financial statements, it is crucial to determine the causal relationships, that is, the directional influence between them in a structural way, as well as to understand the associated accounting mechanisms. However, the analysis of variable-to-variable relationships in financial information using standard correlation functions is not sufficient to unveil directionality. Here, we use the volatility constrained correlation (VC correlation) method to predict the directional relationship between two arbitrary variables. We apply the VC correlation method to five significant financial information variables (revenue, net income, operating income, own capital, and market capitalization) of 2321 firms listed on the Tokyo Stock Exchange over 28 years from 1990 to 2018. This study identifies which accounting variables are influential and which are susceptible. Our findings show that operating income is the most influential variable while market capitalization and revenue are the most susceptible variables. Surprisingly, the results differ from the existing intuitive understanding suggested by widely used investment strategy indicators, the price--earnings ratio and the price-to-book ratio, which report that net income and own capital are the most influential variables affecting market capitalization. This analysis may assist managers, stakeholders, and investors to improve financial management performance and optimize firms' financial strategies in future operations.