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CFA Institute

How Chartered Financial Analysts View Financial Ratios


Author(s): Charles Gibson
Source: Financial Analysts Journal, Vol. 43, No. 3 (May - Jun., 1987), pp. 74-76
Published by: CFA Institute
Stable URL: http://www.jstor.org/stable/4479035 .
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How Chartered Financial Primary Importance
A single ratio may measure more than one aspect
Analysts View Financial Ratios of a firm's financialhealth. For example, many CFAs
ofAccounting,TheUniver-
byCharlesGibson,Professor viewed the ratio of days' sales in inventory as a
sity of Toledo*
primarymeasure of liquidity, while others viewed it
as a primarymeasure of profitability.In most cases,
Financial analysts in the United States, United
however, the majorityof the CFAs agreed about the
Kingdom and New Zealand have consistently given
primarymeasure.
the corporate annual report the highest ranking as
Liquidityratiosmeasure the firm'scurrentabilityto
the most important source of information. Of 10
meet obligations to short-termcreditors, hence indi-
items included in annual reports, these analysts se-
cate short-termfinancial risk. Table II lists the ratios
lected the income statement as the most important
identified by the responding analysts as primarily
and the balance sheet as the second most important.+
measuring liquidity.
Financial statements obviously play a major role in
Debt ratios can be effective in indicatingthe risk of
a fundamental approach to security analysis. Among
not meeting long-term obligations to outsiders. They
the items of potential interest to analysts are financial
represent an indication of long-term financial risk.
ratios relating key parts of the financial statements.
Table III lists the ratios identified as primarilymea-
This note reviews the results of a survey of Chartered
suring long-term debt-paying ability.
Financial Analysts (CFAs) regarding their views of
Profitabilityis the ability of the firm to generate
specific financial ratios.
earnings, and profitability ratios measure perform-
ance. The ratios identified as primarily measuring
The Survey profitabilityare listed in Table IV.
We sent a questionnaire to 400 CFAs randomly
The ratios identified as indicating something other
selected from the membership directory of the Finan-
than liquidity, long-termdebt-payingabilityor profit-
cial Analysts Federation. A total of 52 usable respons-
ability are listed in Table V. There were a few ratios
es (13.9 per cent) were received. Typical titles of the
that the majority of CFAs did not categorize as
respondents were partner, vice president-invest-
primarymeasures of liquidity, long-termdebt-paying
ments, vice president-research, president and in-
ability, profitabilityor "other." Table VI lists these
vestment analyst. Thus the usable responses came
ratios. Because a ratio can indicate more than one
from individuals holding high-level positions.
thing, it does not necessarily follow that these ratios
The questionnaire aimed to determine the follow-
are less important than the ratios that were catego-
ing:
rized by the analysts. It did turn out, however, that
* What specific financial ratios do CFAs view pri-
these ratios were awarded relativelylow significance
marily as measures of liquidity, long-term debt-
ratings.
paying ability, profitability or other?
* What are the relative importances of specific Significance Ratings
financial ratios? The significance of a particularratio may be influ-
The survey listed 60 financial ratios drawn from the enced by the circumstancesof a particularcompany.
finance literature; we hoped that the list included all For example, an analyst looking at a company with
the ratios of interest to CFAs, other than industry- very high debt may place more significance on debt
specific ratios. Specifically, we asked the analysts ratios. The survey outlined no particular circum-
how they perceived each ratio-as a primary mea- stances; the CFAs were merely requested to give a
sure of liquidity, long-term debt-paying ability, prof- significance rating in the general case. Their ratings
itability or some "other" aspect of the firm's financial therefore indicate the significance analysts would
health. We also asked the analysts to rate the signifi- typically place on a ratio.
cance of each ratio, using a scale of 0 to 2 for low The surveyed analysts gave the highest signifi-
importance, 3 to 6 for average importance and 7 to 9 cance ratings to profitabilityratios. Returnon equity
for high importance. aftertax was given the highest significanceby a wide
Table I lists the 60 ratios and gives the analysts' margin. Four of the next five most significant ratios
views of their primary role and their significance. were also profitabilityratios-earnings per share, net
profit margin after tax, return on equity before tax
* and net profit margin before tax.
The anuthorthanks Raj Aggarwal of The University,of Toledofor
his helpful comminents.
The price-earningsratio-categorized by the ana-
t See L. S. Chang, K. S. Most and C. W. Brain, "The Utility lysts as an "other" measure-received the second-
of Annual Reports: An International Study," Jouirnalof highest significance rating. CFAs apparently view
InternationalBusiness Studies, Spring/Summer 1983, pp. 63- profitabilityand what is being paid for those profits
84. before turning to liquidity and debt.

FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1987 E 74

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Table I CFAs Views of FinancialRatios

PrimaryMeasure(%of Responses) Significance


Ratio Liquidity Debt Profitability Other (0-9)
1. Cash Ratio 97.87 0.00 0.00 2.13 5.510
Accounts ReceivableTurnover:
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
InventoryTurnover:
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. CurrentDebt/Inventory 66.66 16.67 0.00 16.67 3.561
10. Inventory/CurrentAssets 88.10 0.00 4.76 7.14 2.891
11. Inventory/WorkingCapital 84.09 2.27 6.82 6.82 4.021
12. CurrentRatio 100.00 0.00 0.00 0.00 6.340
13. Net Fixed Assets/TangibleNet Worth 6.82 47.73 6.82 38.64 4.404
14. Cash/TotalAssets 80.00 8.89 0.00 11.11 4.735
15. Quick Assets/TotalAssets 90.70 6.98 0.00 2.33 4.560
16. CurrentAssets/TotalAssets 81.82 9.09 0.00 9.09 4.740
17. RetainedEarnings/TotalAssets 9.30 44.19 25.58 20.93 4.820
18. Debt/EquityRatio 6.52 84.78 2.17 6.52 7.000
19. Total Debt as a % of Net WorkingCapital 14.29 80.95 0.00 4.76 5.176
20. TotalDebt/TotalAssets 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-TDebt as a % of Total Invested Capital 6.38 85.11 2.13 6.38 6.520
23. Funded Debt/WorkingCapital 21.95 60.98 0.00 17.07 4.174
24. TotalEquity/TotalAssets 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 Equityas a % of Total Invested Capital 2.17 58.70 15.22 23.91 5.620
27. CurrentDebt/Net Worth 34.04 55.32 4.26 6.38 4.551
28. Net Worthat MarketValue/TotalLiabilities 8.70 52.17 6.52 32.61 4.857
29. TotalAsset Turnover 8.70 2.17 60.87 28.26 5.500
30. Sales/OperatingAssets 6.52 2.17 65.22 26.09 4.958
31. Sales/FixedAssets 9.09 0.00 63.64 27.27 4.245
32. Sales/WorkingCapital 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. CurrentAssets/Sales 29.55 2.27 18.18 50.00 3.320
Returnon Assets:
37. BeforeInt. and Tax 6.12 0.00 89.80 4.08 6.039
38. BeforeTax 4.17 0.00 91.66 4.17 6.000
39. After Tax 2.08 0.00 93.75 4.17 70059
40. Returnon OperatingAssets 2.13 0.00 91.49 6.38 5.959
41. Returnon WorkingCapital 6.25 0.00 81.25 12.50 4.020
Returnon Total Invested Capital:
42. BeforeTax 4.08 0.00 91.84 4.08 6.400
43. After Tax 4.08 0.00 93.88 2.04 6.882
44. Returnon Equity BeforeTax 2.08 0.00 95.83 2.08 7.412
45. Returnon EquityAfter Tax 2.00 0.00 96.00 2.00 8.212
46. Net ProfitMarginBeforeTax 0.00 0.00 100.00 0.00 7.320
47. Net ProfitMarginAfter Tax 0.00 0.00 100.00 0.00 7.520
48. RetainedEarnings/NetIncome 0.00 6.98 58.14 34.88 4.490
49. Cash Flow/CurrentMaturitiesof L-TDebt 34.04 59.57 0.00 6.38 5.420
50. Cash Flow/TotalDebt 13.04 80.43 0.00 6.53 5.840
51. Times InterestEarned 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 OperatingLeverage 2.13 21.28 57.45 19.15 6.360
54. Degree of FinancialLeverage 0.00 57.14 24.49 18.37 6.608
55. EarningsPer 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

FINANCIALANALYSTSJOURNAL/ MAY-JUNE1987 O 75

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Table II LiquidityRatios Table IV ProfitabilityRatios

Ratio Significance Ratio Significance


Quick Ratio 7.10 Returnon EquityAfter Tax 8.21
CurrentRatio 6.34 EarningsPer Share 7.58
Days' Sales in Inventory 5.82 Net ProfitMarginAfter Tax 7.52
Cash Ratio 5.51 Returnon EquityBefore Tax 7.41
InventoryTurnover(times) 5.46 Net ProfitMarginBeforeTax 7.32
Accounts ReceivableTurnover(times) 5.31 Returnon Assets After Tax 7.06
Accounts ReceivableTurnover(days) 5.15 Returnon Total Invested CapitalAfter Tax 6.88
InventoryTurnover(days) 5.14 Returnon Total Invested CapitalBeforeTax 6.40
Days' Sales in Receivables 5.02 Degree of OperatingLeverage 6.36
Cash/TotalAssets 4.74 Returnon Assets, BeforeInterest and Tax 6.04
CurrentAssets/TotalAssets 4.74 Returnon Assets BeforeTax 6.00
Quick Assets/TotalAssets 4.56 Returnon OperatingAssets 5.96
Inventory/WorkingCapital 4.02 TotalAsset Turnover 5.50
CurrentDebt/Inventory 3.56 Sales/OperatingAssets 4.96
Inventory/CurrentAssets 2.89 Sales/WorkingCapital 4.63
RetainedEarnings/NetIncome 4.49
Sales/FixedAssets 4.25
Sales/Net Worth 4.04
Table III Debt Ratios Returnon WorkingCapital 4.02

Ratio Significance
Fixed Charge Coverage 7.22
Times Interest Earned 7.06
Debt/EquityRatio 7.00 Table V "Other"Ratios
Degree of FinancialLeverage 6.61
L-TDebt as a %of TotalInvested Capital 6.52 Ratio Significance
TotalDebt/TotalAssets 6.50
TotalEquity/TotalAssets 6.42 Price/EarningsRatio 7.65
Cash Flow/TotalDebt 5.84 Stock Priceas a % of Book Value 6.75
Common Equityas a % of Total Invested 5.62 Book Value Per Share 6.31
Capital Dividend Payout Ratio 6.12
Cash Flow/CurrentMaturitiesof L-T 5.42 Dividend Yield 5.76
Debt
TotalDebt as a %of Net Working 5.18
Capital
S-T Debt as a %of TotalInvested Capital 5.08
Net Worthat MarketValue/TotalL-T 4.86 Table VI UncategorizedRatios
Liabilities
CurrentDebt/Net Worth 4.55
Funded Debt/WorkingCapital 4.17 Ratio Significance
RetainedEarnings/TotalAssets 4.82
Net Fixed Assets/TangibleNet Worth 4.40
Fixed Assets/Equity 4.14
Cash/Sales 3.50
The two highest rated debt ratioswere fixed charge Quick Assets/Sales 3.41
coverage and times interest earned, rated seventh CurrentAssets/Sales 3.32
and ninth, respectively. Both these ratios indicate a
firm's ability to carry debt. The highest rated debt
ratiorelatingto the balance sheet was the debt/equity
ratio, rated as the 11th most significant.Surprisingly,
more significance was placed on debt ratios relating The relativeratingsof profitability,debt and liquid-
to the ability to carry debt than on those relating to ity by the CFAs appear to be logical. Apparently, the
ability to meet debt obligations. analyst first wants to know about profitabilityand
The highest rated liquidity ratio was the quick what is being paid for these profits before turning to
ratio, rated eighth. The second-highest liquidityratio debt and liquidity. He likely places more emphasis on
was the currentratio, rated 20th. In general, liquidity debt than on liquidity because debt represents a
ratios were not given high significanceratings. longer-termposition than liquidity.

FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1987 C 76

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