how chartered financial analysts view financial ratios

CFA Institute

How Chartered Financial Analysts View Financial RatiosAuthor(s): Charles GibsonSource: Financial Analysts Journal, Vol. 43, No. 3 (May - Jun., 1987), pp. 74-76Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4479035 .

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How Chartered Financial Analysts View Financial Ratios

by Charles Gibson, Professor of Accounting, The Univer- sity of Toledo*

Financial analysts in the United States, United Kingdom and New Zealand have consistently given the corporate annual report the highest ranking as the most important source of information. Of 10 items included in annual reports, these analysts selected the income statement as the most important and the balance sheet as the second most important.+

Financial statements obviously play a major role in a fundamental approach to security analysis. Among the items of potential interest to analysts are financial ratios relating key parts of the financial statements. This note reviews the results of a survey of Chartered Financial Analysts (CFAs) regarding their views of specific financial ratios.

The Survey We sent a questionnaire to 400 CFAs randomly

selected from the membership directory of the Finan- cial Analysts Federation. A total of 52 usable responses (13.9 per cent) were received. Typical titles of the respondents were partner, vice president-invest- ments, vice president-research, president and in- vestment analyst. Thus the usable responses came from individuals holding high-level positions.

The questionnaire aimed to determine the follow- ing:

* What specific financial ratios do CFAs view primarily as measures of liquidity, long-term debt- paying ability, profitability or other?

* What are the relative importances of specific financial ratios?

The survey listed 60 financial ratios drawn from the finance literature; we hoped that the list included all the ratios of interest to CFAs, other than industry- specific ratios. Specifically, we asked the analysts how they perceived each ratio-as a primary measure of liquidity, long-term debt-paying ability, profitability or some "other" aspect of the firm's financial health. We also asked the analysts to rate the significance of each ratio, using a scale of 0 to 2 for low importance, 3 to 6 for average importance and 7 to 9 for high importance.

Table I lists the 60 ratios and gives the analysts' views of their primary role and their significance.

Primary Importance A single ratio may measure more than one aspect

of a firm's financial health. For example, many CFAs viewed the ratio of days' sales in inventory as a primary measure of liquidity, while others viewed it as a primary measure of profitability. In most cases, however, the majority of the CFAs agreed about the primary measure.

Liquidity ratios measure the firm's current ability to meet obligations to short-term creditors, hence indicate short-term financial risk. Table II lists the ratios identified by the responding analysts as primarily measuring liquidity.

Debt ratios can be effective in indicating the risk of not meeting long-term obligations to outsiders. They represent an indication of long-term financial risk. Table III lists the ratios identified as primarily measuring long-term debt-paying ability.

Profitability is the ability of the firm to generate earnings, and profitability ratios measure perform- ance. The ratios identified as primarily measuring profitability are listed in Table IV.

The ratios identified as indicating something other than liquidity, long-term debt-paying ability or profitability are listed in Table V. There were a few ratios that the majority of CFAs did not categorize as primary measures of liquidity, long-term debt-paying ability, profitability or "other." Table VI lists these ratios. Because a ratio can indicate more than one thing, it does not necessarily follow that these ratios are less important than the ratios that were categorized by the analysts. It did turn out, however, that these ratios were awarded relatively low significance ratings.

Significance Ratings The significance of a particular ratio may be influ-

enced by the circumstances of a particular company. For example, an analyst looking at a company with very high debt may place more significance on debt ratios. The survey outlined no particular circumstances; the CFAs were merely requested to give a significance rating in the general case. Their ratings therefore indicate the significance analysts would typically place on a ratio.

The surveyed analysts gave the highest significance ratings to profitability ratios. Return on equity after tax was given the highest significance by a wide margin. Four of the next five most significant ratios were also profitability ratios-earnings per share, net profit margin after tax, return on equity before tax and net profit margin before tax.

The price-earnings ratio-categorized by the analysts as an "other" measure-received the second- highest significance rating. CFAs apparently view profitability and what is being paid for those profits before turning to liquidity and debt.

* The anuthor thanks Raj Aggarwal of The University, of Toledo for his helpful comminents. t See L. S. Chang, K. S. Most and C. W. Brain, "The Utility of Annual Reports: An International Study," Jouirnal of International Business Studies, Spring/Summer 1983, pp. 63- 84.

FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1987 E 74



Table I CFAs Views of Financial Ratios

Primary Measure (% of Responses) Significance Ratio Liquidity Debt Profitability Other (0-9)

1. Cash Ratio 97.87 0.00 0.00 2.13 5.510 Accounts Receivable Turnover:

2. Days 74.00 0.00 8.00 18.00 5.154 3. Times 69.39 0.00 14.29 16.33 5.308 4. Days' Sales in Receivables 68.89 0.00 15.56 15.56 5.021 5. Quick Ratio 95.74 4.26 0.00 0.00 7.098

Inventory Turnover: 6. Days 57.78 0.00 33.33 8.89 5.143 7. Times 54.35 0.00 39.13 6.52 5.462 8. Days' Sales in Inventory 54.35 2.17 23.91 19.57 5.816 9. Current Debt/Inventory 66.66 16.67 0.00 16.67 3.561

10. Inventory/Current Assets 88.10 0.00 4.76 7.14 2.891 11. Inventory/Working Capital 84.09 2.27 6.82 6.82 4.021 12. Current Ratio 100.00 0.00 0.00 0.00 6.340 13. Net Fixed Assets/Tangible Net Worth 6.82 47.73 6.82 38.64 4.404 14. Cash/Total Assets 80.00 8.89 0.00 11.11 4.735 15. Quick Assets/Total Assets 90.70 6.98 0.00 2.33 4.560 16. Current Assets/Total Assets 81.82 9.09 0.00 9.09 4.740 17. Retained Earnings/Total Assets 9.30 44.19 25.58 20.93 4.820 18. Debt/Equity Ratio 6.52 84.78 2.17 6.52 7.000 19. Total Debt as a % of Net Working Capital 14.29 80.95 0.00 4.76 5.176 20. Total Debt/Total Assets 0.00 95.65 0.00 4.35 6.500 21. S-T Debt as a % of Total Invested Capital 20.00 62.22 0.00 17.78 5.083 22. L-T Debt as a % of Total Invested Capital 6.38 85.11 2.13 6.38 6.520 23. Funded Debt/Working Capital 21.95 60.98 0.00 17.07 4.174 24. Total Equity/Total Assets 4.17 62.50 12.50 20.83 6.420 25. Fixed Assets/Equity 4.35 45.65 17.39 32.61 4.143 26. Common Equity as a % of Total Invested Capital 2.17 58.70 15.22 23.91 5.620 27. Current Debt/Net Worth 34.04 55.32 4.26 6.38 4.551 28. Net Worth at Market Value/Total Liabilities 8.70 52.17 6.52 32.61 4.857 29. Total Asset Turnover 8.70 2.17 60.87 28.26 5.500 30. Sales/Operating Assets 6.52 2.17 65.22 26.09 4.958 31. Sales/Fixed Assets 9.09 0.00 63.64 27.27 4.245 32. Sales/Working Capital 22.92 2.08 50.00 25.00 4.633 33. Sales/Net Worth 6.38 4.26 53.19 36.17 4.040 34. Cash/Sales 38.30 2.13 14.89 44.68 3.500 35. Quick Assets/Sales 30.43 2.17 17.39 50.00 3.408 36. Current Assets/Sales 29.55 2.27 18.18 50.00 3.320

Return on Assets: 37. Before Int. and Tax 6.12 0.00 89.80 4.08 6.039 38. Before Tax 4.17 0.00 91.66 4.17 6.000 39. After Tax 2.08 0.00 93.75 4.17 70059 40. Return on Operating Assets 2.13 0.00 91.49 6.38 5.959 41. Return on Working Capital 6.25 0.00 81.25 12.50 4.020

Return on Total Invested Capital: 42. Before Tax 4.08 0.00 91.84 4.08 6.400 43. After Tax 4.08 0.00 93.88 2.04 6.882 44. Return on Equity Before Tax 2.08 0.00 95.83 2.08 7.412 45. Return on Equity After Tax 2.00 0.00 96.00 2.00 8.212 46. Net Profit Margin Before Tax 0.00 0.00 100.00 0.00 7.320 47. Net Profit Margin After Tax 0.00 0.00 100.00 0.00 7.520 48. Retained Earnings/Net Income 0.00 6.98 58.14 34.88 4.490 49. Cash Flow/Current Maturities of L-T Debt 34.04 59.57 0.00 6.38 5.420 50. Cash Flow/Total Debt 13.04 80.43 0.00 6.53 5.840 51. Times Interest Earned 4.26 91.49 2.13 2.13 7.060 52. Fixed Charge Coverage 4.26 91.49 2.13 2.13 7.220 53. Degree of Operating Leverage 2.13 21.28 57.45 19.15 6.360 54. Degree of Financial Leverage 0.00 57.14 24.49 18.37 6.608 55. Earnings Per Share 0.00 0.00 68.75 31.25 7.577 56. Book Value Per Share 0.00 4.35 17.39 78.26 6.314 57. Dividend Payout Ratio 4.17 6.25 14.58 75.00 6.120 58. Dividend Yield 2.13 0.00 14.89 82.98 5.765 59. Price/Earnings Ratio 0.00 0.00 14.58 85.42 7.647 60. Stock Price as a % of Book Value 0.00 2.13 8.51 89.36 6.750

FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1987 O 75



Table II Liquidity Ratios

Ratio Significance

Quick Ratio 7.10 Current Ratio 6.34 Days' Sales in Inventory 5.82 Cash Ratio 5.51 Inventory Turnover (times) 5.46 Accounts Receivable Turnover (times) 5.31 Accounts Receivable Turnover (days) 5.15 Inventory Turnover (days) 5.14 Days' Sales in Receivables 5.02 Cash/Total Assets 4.74 Current Assets/Total Assets 4.74 Quick Assets/Total Assets 4.56 Inventory/Working Capital 4.02 Current Debt/Inventory 3.56 Inventory/Current Assets 2.89

Table III Debt Ratios

Ratio Significance

Fixed Charge Coverage 7.22 Times Interest Earned 7.06 Debt/Equity Ratio 7.00 Degree of Financial Leverage 6.61 L-T Debt as a % of Total Invested Capital 6.52 Total Debt/Total Assets 6.50 Total Equity/Total Assets 6.42 Cash Flow/Total Debt 5.84 Common Equity as a % of Total Invested 5.62

Capital Cash Flow/Current Maturities of L-T 5.42

Debt Total Debt as a % of Net Working 5.18

Capital S-T Debt as a % of Total Invested Capital 5.08 Net Worth at Market Value/Total L-T 4.86

Liabilities Current Debt/Net Worth 4.55 Funded Debt/Working Capital 4.17

Table IV Profitability Ratios

Ratio Significance

Return on Equity After Tax 8.21 Earnings Per Share 7.58 Net Profit Margin After Tax 7.52 Return on Equity Before Tax 7.41 Net Profit Margin Before Tax 7.32 Return on Assets After Tax 7.06 Return on Total Invested Capital After Tax 6.88 Return on Total Invested Capital Before Tax 6.40 Degree of Operating Leverage 6.36 Return on Assets, Before Interest and Tax 6.04 Return on Assets Before Tax 6.00 Return on Operating Assets 5.96 Total Asset Turnover 5.50 Sales/Operating Assets 4.96 Sales/Working Capital 4.63 Retained Earnings/Net Income 4.49 Sales/Fixed Assets 4.25 Sales/Net Worth 4.04 Return on Working Capital 4.02

Table V "Other" Ratios

Ratio Significance

Price/Earnings Ratio 7.65 Stock Price as a % of Book Value 6.75 Book Value Per Share 6.31 Dividend Payout Ratio 6.12 Dividend Yield 5.76

Table VI Uncategorized Ratios

Ratio Significance

Retained Earnings/Total Assets 4.82 Net Fixed Assets/Tangible Net Worth 4.40 Fixed Assets/Equity 4.14 Cash/Sales 3.50 Quick Assets/Sales 3.41 Current Assets/Sales 3.32

The two highest rated debt ratios were fixed charge coverage and times interest earned, rated seventh and ninth, respectively. Both these ratios indicate a firm's ability to carry debt. The highest rated debt ratio relating to the balance sheet was the debt/equity ratio, rated as the 11th most significant. Surprisingly, more significance was placed on debt ratios relating to the ability to carry debt than on those relating to ability to meet debt obligations.

The highest rated liquidity ratio was the quick ratio, rated eighth. The second-highest liquidity ratio was the current ratio, rated 20th. In general, liquidity ratios were not given high significance ratings.

The relative ratings of profitability, debt and liquidity by the CFAs appear to be logical. Apparently, the analyst first wants to know about profitability and what is being paid for these profits before turning to debt and liquidity. He likely places more emphasis on debt than on liquidity because debt represents a longer-term position than liquidity.

FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1987 C 76



how chartered financial analysts view financial ratios

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