The Debatable Distance between Theory and Practice: An Analysis of Financial Ratios Theory

Essay, 2014

18 Pages


Table of Content

Is There a Gap between Theory and Practice?

Literature Review
Relationship between Theory and Application
Short-term Liquidity Measurement Theory
Application of the Liquidity Measurement Theory

Discussion and Findings

Integration between Theory and Practice

The Application of the Short-term Liquidity Measurement Theory




Is There a Gap between Theory and Practice?

The subject of the relationship between theory and practice has long been focused by psychologists as to what extent theories can be used as the principles that guide practice. A theory has a fundamental role in providing researchers with frameworks and in guiding practitioners to formulate a problem in actual practice settings. This paper is divided into four sections. The first section explores the literature review of the relationship between theory and practice. The second section illustrates the short-term liquidity measurement theory in the context of how the theory can be translated into practice. In the third section of this paper, the researcher discusses the connections between the theory described and related applications. The fourth and concluding section outlines some recommendations.

Literature Review

Relationship between Theory and Application

Scientific knowledge is encoded in theories to predict events, explain phenomena or solve problems (Kilduff, Mehra & Dunn, 2011). During the scientific work cycle researchers ought to invoke various theories and theoretical frameworks to explain and test the occurrence of a phenomenon under consideration (Harlow, 2009; Gelso, 2006). In turn, theories are useful instruments in helping the researchers to determine why one or more variables or constructs, that characterize a particular problem, cause or affect one or more outcome variables (Gelso, 2006). In contrast, Kilduff et al. (2011) identified pragmatic philosophical views in which application is the primary focus of using theory in psychology. Kilduff et al. suggested a set of action logics derived from ontological and epistemological philosophies of science, including the logic of problem solving, which emphasizes on discovering the theory that involves the highest likelihood to solving a particular problem, collaboration between cross-discipline scientists, and practically oriented researchers. In addition, realism and instrumentalism views of psychological science focus on how theory is used for both discovery and validation. According to Kilduff et al., some versions of realism involve putative terms such as practical utility function that is seen when theory can be directly applied to real-life phenomena. From this perspective, theories should be judged according to how well they depict a theoretical orientation, and where scientific theories replace each other over time so that science moves closer to the truth about a phenomenon. The counterpoint to the realism view is instrumentalism that can be viewed as an opposite dimension of realism on the grounds that scientific theories involve practical instruments, each of which in its own nature is quite helping practitioners to predict events and to solve problems by providing a theoretical orientation that focus mainly on facilitating empirical prediction or providing theories as devices for discovery (Kilduff et al. 2011; Thompson, 2011). Moreover, the relationship concerning theory and practice can also be explained by the integration that exists between the philosophy of science and psychological theory, in which reductionism and determinism concepts play a crucial role in the understanding of applied theory (Shepherd & Sutcliffe, 2011; Stem, 2007). According to Stem (2007), reductionism is a process that tends to reduce statements of a phenomenon or practice in a certain setting into a small set of statements to test, such as hypothesis that convey specific variables founded in an experiment. The utility of this deduction has a tendency to translate the phenomenon of interest to more practical pattern. While reductionism is narrowly addressing a problem down to lesser statements, determinism, on the other hand, aims to identify and assess the causes that may influence effects or outcomes (Shepherd & Sutcliffe, 2011). Notwithstanding reductionism and determinism are emanated as two dogmas of post-positivist worldview assumptions, both approaches can provide reasonable inferences about phenomena based upon scientific reasoning. However, while determinism permits practitioners to develop predictions of a phenomenon, reductionism could provide mathematical relationships whereby the theory becomes a device for implementation (Stem, 2007).

Furthermore, the burgeoning body of literature spawns a reciprocal relationship between theory and practice (Midgley, 2008; VanMaanen, Sorensen & Mithchell, 2007). Theories can guide practice by providing direction for action and rationale for decision-making, in particular when researchers employ multiple theoretical perspectives as a source for the explanation of the phenomenon of concern (Midgley, 2008). In addition, the interplay between theory and practice may also occur within a text defined by evoking various theories to formulate interconnected research questions in qualitative and quantitative research, and to predict hypotheses in quantitative inquiry method, that infer principles (Corley & Gioia, 2011). The results, in turn, become practical by serving as a base-line used to guide practice (VanMaanen et al. 2007). For example, in research settings, the answers to research questions constitute the direction in which the research translates the underlying problem (Ellis & Levy, 2008). Midgley (2008) points out, the scientific researcher, who also acts as an observer, is an integral part of a phenomenon he or she observes, not detached from the phenomenon. Consequently, theory has a central role to solving a practical problem so that science can be seen as intervention that could be made by the researcher rather than the inherent characteristics of the phenomenon being observed. Similarly, practice can inform theory on the grounds that practitioners and researchers are usually called upon to utilize theory in term of dealing with real-life problems. However, many of the arguments used to describe the theory building as a process that determines the degree to which an intrinsic problem clarifies existing theories or introduces constructs and variables that serve as the foundation for new theory. That being said, a good theory comes from engagement with an intrinsic problem, not gaps in literature (Kilduff, 2006).

Furthermore, management practitioner journals are often ought to lament the dogma that what have been theorized is not being applied in different contexts (Saari, 2007). Williamson and Snow (2013) shed light on this gap and argue that there are significant gaps between theory and practice. The issues involved in translating theory into practice can be described from different schools of thought. The topics pursued by scientific researchers need to be appropriate to practitioners, the questions of a research should sound true to those who are working in the field, and the language and assumed prior knowledge of scientific research should be accessible by practitioners (Andersen, 2004). To exemplify this state of affairs, Meyer (2013) conducted an explanatory research to explore the gap between science and practice in the area of employee engagement by utilizing the findings reported in meta-analysis reviews of employee engagement, including employee empowerment, work design and leadership, and by modeling the engagement process and underlying principles. Meyer (2013) targeted organizations that seek their employees to demonstrate higher level of engagement, and sampled the meta-analysis reviews that encompassed sound evidence on external validity. From the standpoint of employee engagement concept, the study findings indicate that there is a set of theories attainable to shape and guide organizations’ leaders who sustain their workforces to provide the highest level of engagement in their work. The theories most commonly cited in the sampled meta-analysis reviews include principles, lens and guidelines through which practitioners understand a certain phenomenon but do not reflect an understanding of the need to drive employee engagement and to improve this leadership behavior. One important conclusion drawn from Meyer’s (2013) study is that theory practitioners may disregard one or more constructs, variables, or boundary conditions embedded in the theory being applied. Consequently, the generalizability virtue (Wacker, 1999) that is underlying the theory does not embrace its domain to dispread broader reach of the theory across different settings. In turn, practitioners may claim that a theory has a one-way knowledge and involves problematic implementation impacts.

Annan, Bowler, Mentis and Somerville’s (2011) quantitative study for practitioners’ reflection on the chasm between espoused theories and theories-in- use demonstrates another school of thought in translating theory into practice. The fundamental proposition of the study reflects the gap that exists between practitioners who adopt a theory in a particular discipline and find it inconsistent in their practice; hence, the purpose of the study was to develop a model that facilitates educators who are enrolled in a postgraduate course at Massey university, Newzeland to convey their beliefs in a practical manner. Annan et al. (2011) sampled and surveyed 15 educators using the developed model that named Learning Theories Profile (LTP). The study finding indicates that participates’ espoused theory and their application to theory –in-use was at a 42 percent accuracy rate before completing the “LTP”. Whereas this ratio elevated to 66 percent after the post activity survey “LTP” was applied. However, the sample size employed in the study reveals a threat to the external validity, because it was very limited to generalize the results and to reduce the dissonance between theory and practice.

Furthermore, the debatable distance between theory and practice can be justified on the ground that theory provides claims and sometimes their applications go beyond these claims. In the next section, the researcher of the present paper explores the debate from an entirely different angle by discussing the theory of short-term liquidity measurement and evaluates the suitability of its applications in which the theory could be applied.

Short-term Liquidity Measurement Theory

Short-term liquidity measurement of non-financial corporations is ingrained in the financial analysis theory. In majority of the literature, researchers have venerated liquidity ratios theory as the most prominent financial technique of measuring the short-term liquidity position of business organizations (Ammons & Gosman, 2012; Bardia & Kastiya, 2010; Malíková & Brabec, 2012; Singh, 2008). In addition, financial analysts, suppliers of goods and other short-term creditors commonly use the liquidity ratios to evaluate a firm’s liquidity and ability to pay its short-term debts (Bardia & Kastiya, 2010; Manisha, 2012). The fundamental rationale behind liquidity ratios method stipulates that if the current assets of a firm increase over its current liabilities, the liquidity position of the firm will increase, and vice versa ( Doina & Mircea, 2008; Manisha, 2012 ). For example, a current ratio of 2.00 indicates that the firm has $2.00 in current assets for every $1.00 in current liabilities. Consequently, liquidity ratios theory indicate that the cash that is required to pay current liabilities is included only within the current assets. In turn, the liquidity ratios theory is used to compare the size of current assets to the size of current liabilities. As a result, a firm’s liquidity position depends primarily on the cash that will flow exclusively from current assets and on the assumption stipulated that all current assets and current liabilities have an equal degree of liquidity albeit they are varying in terms of their maturity time (Tibor & Veronika, 2011).

The importance of short-term liquidity measurement theory stems from three reasons. First, the short-term liquidity position reflects a firm’s working capital that forms the spine used to fund the firm primary operations (Ammons & Gosman, 2012). Second, at many lending institutions, credit analysts require that business customers should maintain a specific minimum cash balance to provide a loan or to extend credit facilities, and the absolute amount of the working capital should not plummet below a certain balance; however, this balance is labeled as a compensating balance (Sagner, 2009).

Third, The Security and Exchange Commission promulgated the disclosure of a firm’s liquidity position when filling form 10-K (Emery & Cogger, 1982). However, while the liquidity ratios theory stated above are important; it is insufficient on its own to gauge a firm’s liquidity position. Liquidity ratios derived from the statement of cash flows, rather than the income statement and balance sheet data that are reported using the traditional accrual-based accounting principle, provide unique meaningful insights based on information spawned from cash receipts and payment (Ibarra, 2009; Manisha, 2012). According to Hodge, Hopkins, & Wood (2010), in 1987 the Financial Accounting Standards Board (FASB) has promulgated the Statement of Financial Accounting Standard (SFAS) 95 that mandated the Statement of Cash Flows (SCF) as required in financial statements. The statement of cash flows allows researchers and practitioners to measure the extent to which cash flow ratios are significantly better in gauging a firm’s sustainable financial performance (Arinović-Barac, 2011; Mazouz, Crane & Gambrel, 2012) and helps the researchers and practitioners to incorporate operating-cash-flow- related data with working capital, as a prime creation to measure a firm's liquidity position. This combination between the cash basis and accrual basis of accounting, as main sources of liquidity data, may bridge the information gap between traditional balance-sheet-based data and the amount and timing of operating cash flows (Mills & Yamamura, 1998; Zeller & Stanko, 1994).

Application of the Liquidity Measurement Theory

Financial analysts, business leaders, bankers, and auditors consider short-term liquidity measurement theory from different perspectives. For example, financial analysts and business leaders use the theory to gauge firms’ ability to meet their short-term obligations. In this trajectory, Bardia and Kastiya (2010) studied the efficiency of liquidity management by measuring the liquidity position of manufacturing companies using different liquidity ratios, including current ratio, quick ratio, inventory turnover ratio and working capital turnover ratio. The authors designed a sample of two leading pharmaceutical companies in India and used their annual reports of nine years from 2000 to 2009 to collect relevant data. Data was analyzed using mean, standard deviation, t-test and correlation of variance as statistical techniques. The authors also employed parametric and non-parametric tests for hypotheses testing purpose. The study findings show that the current and quick liquidity ratios of both sampled companies were almost equal to the ideal ratio of 2:1 and 1:1 respectively. However, the researcher of the present paper identifies that even though the sample size employed in Bardia and Kastiya’s (2010) study was not large enough to detect differences and so limited to draw generalizations, the results of this study reveals that the liquidity ratios technique seems useful when measuring the liquidity position of firms that operate in a similar industry sector. In addition, the primary claim of the short-term liquidity measurement theory falls in the extent to which financial analysts and business leaders apply the theory to measure organizations’ ability to pay their short-term obligations, but the applications of the liquidity theory cross away from the theory’s primary claims, in which the theory could be used by auditors and lenders to measure liquidity for different purposes. First, lenders employ the traditional liquidity ratios to delineate a specific liquidity level in loan contracts in which borrowers should maintain during the loan duration. One of the most notable examples that demonstrate this function is Sagner’s (2009) research who conducted a descriptive study to determine the extent to which bank loan covenants depend on traditional liquidity ratios to stipulate a certain level of liquidity. The study has been conducted during the recent economic recession and liquidity crises. The purpose of the study was also intended to propose an alternative liquidity measure named receipts -to- cash flow ratio. The study finding indicates that balance sheet ratios, including the traditional liquidity ratios, have little predictive power toward a loan default. To illustrate this conclusion, Sagner (2009) explains that lenders who rely primarily on balance sheet ratios to evaluate the viability of borrowers face significant obstacles in application, including the use of accrual accounting convention, embedded components of the composition of current assets and current liabilities that involve aggregated data and may cause an increase or a decrease in actual liquidity ratios outcome, and off-balance sheet obligations such as the unexercised portion of bank credit facilities that is not reported in the balance sheet. In addition, Doina and Mircea (2008) argue that liquidity ratios approach involves some important disadvantages including (a) the permanent portion that is usually embedded in current assets, and can be termed as non-monetary items, could not be convertible into cash to pay a firm’s current liabilities when they are due, (b) Doina and Mircea (2008) also assert that albeit the maturity dates between current assets and current liabilities are different, liquidity ratios constructed from balance sheets may record a sustainable liquidity position, but indeed a company is actually suffering a lack of liquidity, and (c) the ratios are based on accrued data and are calculated at a particular point in time that precludes the interpretation of balances in terms of events and activities during the entire date (Doina & Mircea, 2008). Second, auditors ought to use liquidity and cash ratios approaches either to detect fraudulent financial reporting (Greg Burton, Jeffrey Wilks & Zimbelman, 2013) or to construct their conclusions about a firm’s ability to continue as a going concern (Davis, 2010). Furthermore, researchers have conducted several attempts to examine the predictive power of liquidity ratios in rising early signals about business failure (Coyne & Singh, 2008; Nwezeaku, 2010; Kaminski, Wetzel, Guan, 2004). Singh (2008) conducted a quantitative study to present a set of financial failure predictors and determine which financial measures are more sensitive in predicting business failure. The authors conducted a seven-year longitudinal analysis with 13 hospital organizations before they filed for bankruptcy and collected comparative data from five other organizations for the same seven-year period. Financial data were collected from annual financial statements filed with the Securities and Exchange Commission. The study went to analyze balance-sheet-oriented measures, such as debt to equity and debt services coverage ratios, and operating cash flow measures, including operating cash flow total liabilities and operating cash flow to net income ratios. The study finding indicates that traditional balance-sheet-oriented and income statement measures did not provide clear early warning signals for bankruptcy. The authors also pointed out that firms' management should use cash- flow-based measures to assess the financial condition of their organizations.


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The Debatable Distance between Theory and Practice: An Analysis of Financial Ratios Theory
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Dr. Alaa Eldin Moustafa (Author), 2014, The Debatable Distance between Theory and Practice: An Analysis of Financial Ratios Theory, Munich, GRIN Verlag,


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