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
Analysts View Financial Ratios
ofAccounting,TheUniver-
byCharlesGibson,Professor
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 se-
lected 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 respons-
es (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 pri-
marily 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 mea-
sure of liquidity, long-term debt-paying ability, prof-
itability or some "other" aspect of the firm's financial
health. We also asked the analysts to rate the signifi-
cance 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.
* and net profit margin before tax.
The anuthorthanks Raj Aggarwal of The University,of Toledofor
his helpful comminents.
t See L. S. Chang, K. S. Most and C. W. Brain, "The Utility
of Annual Reports: An International Study," Jouirnalof
InternationalBusiness Studies, Spring/Summer 1983, pp. 63-
84.
FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1987 E
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Primary Importance
A single ratio may measure more than one aspect
of a firm's financialhealth. For example, many CFAs
viewed the ratio of days' sales in inventory as a
primarymeasure of liquidity, while others viewed it
as a primarymeasure of profitability.In most cases,
however, the majorityof the CFAs agreed about the
primarymeasure.
Liquidityratiosmeasure the firm'scurrentabilityto
meet obligations to short-termcreditors, hence indi-
cate short-termfinancial risk. Table II lists the ratios
identified by the responding analysts as primarily
measuring liquidity.
Debt ratios can be effective in indicatingthe 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 primarilymea-
suring long-term debt-paying ability.
Profitabilityis the ability of the firm to generate
earnings, and profitability ratios measure perform-
ance. The ratios identified as primarily measuring
profitabilityare listed in Table IV.
The ratios identified as indicating something other
than liquidity, long-termdebt-payingabilityor profit-
ability are listed in Table V. There were a few ratios
that the majority of CFAs did not categorize as
primarymeasures of liquidity, long-termdebt-paying
ability, profitabilityor "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 catego-
rized by the analysts. It did turn out, however, that
these ratios were awarded relativelylow significance
ratings.
Significance Ratings
The significance of a particularratio may be influ-
enced by the circumstancesof a particularcompany.
For example, an analyst looking at a company with
very high debt may place more significance on debt
ratios. The survey outlined no particular circum-
stances; 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 signifi-
cance ratings to profitabilityratios. Returnon equity
aftertax was given the highest significanceby a wide
margin. Four of the next five most significant ratios
were also profitabilityratios-earnings per share, net
profit margin after tax, return on equity before tax
The price-earningsratio-categorized by the ana-
lysts as an "other" measure-received the second-
highest significance rating. CFAs apparently view
profitabilityand what is being paid for those profits
before turning to liquidity and debt.
74
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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