Using the Rasch model to rank firms by managerial ability

Abstract

Purpose

The purpose of this paper is to evaluate firm financial success across a broad range of performance measures and identify areas of the performance spectrum for which positive results were most difficult to achieve. Simultaneously, the authors identify the firms that most frequently ranked among the top five in terms of composite financial performance.

Design/methodology/approach

The dichotomous Rasch model was applied to 13 financial ratios for two industries for the years 2002‐2011. Of these ratios, the authors identify those that are consistent with the requirements of the Rasch model and suitable for ranking composite firm financial performance in each industry during the sample years. Ratio difficulty rankings are obtained, along with firm rankings reflecting managers' ability to achieve broad‐based financial success.

Findings

For the Foods and Aerospace/Defense industries during 2002‐2011, above average performance was most difficult to achieve in the areas of liquidity, financial leverage, and market valuation. Above average profitability and returns on investment seem to have been easier performance targets during this sample period. The authors also list the ticker symbols of firms with managers who consistently achieved top overall financial performance.

Research limitations/implications

The performance data for each industry and time period have to fit the requirements of the Rasch model. In addition, it must be possible to translate continuous metric readings into binary measures without losing relevant information. Future research might explore the use of more sophisticated Rasch models, measures of non‐financial firm performance dimensions, additional industries and time periods.

Practical implications

This research offers managers, investors and regulators a fresh perspective on the evaluation of firm financial performance and managerial ability.

Social implications

Rasch models are widely used in the human sciences. Application of this methodology to firms offers a more comprehensive view of firm performance and may reveal factors relevant to firm valuation that have previously been ignored, thus possibly impacting the allocation of capital across firms and industries.

Originality/value

To the authors' knowledge, this research represents a first attempt to apply the Rasch approach to an evaluation of managerial ability as reflected in a firm's overall financial performance.

Citation

Schellhorn, C. and Sharma, R. (2013), "Using the Rasch model to rank firms by managerial ability", Managerial Finance, Vol. 39 No. 3, pp. 306-319. https://doi.org/10.1108/03074351311302818