Excerpt

## Abstract

In the study of Financial Management and Financial Accounting, the Financial Ratios have always played important roles in determining the quality of operational and financial performances of a business organization. This research paper’s objectives are *primarily* two – fold: first, to formulate *composite indices* under five major categories, namely; Liquidity, Leverage, Operating Efficiency, Profitability, and Market Measures (Fraser and Ormiston, 2012) and review whether the composite indices under each category could be regressed by their own financial ratios; and second, to formulate a *Grand Financial Index* (GFI) comprising of all the *five* composite indices which would be able to represent a *holistic* view of a business organization by taking into consideration all the necessary *key* points covering all the aspects of financial accounting.

In this context, a time – series empirical study of 30 years (1987 – 2016) has been conducted on Wal-Mart, the leading company (in terms of revenue) on the FORTUNE 500 ® list, in order to supplement empirical evidence to the findings. In addition to that, an attempt has been made to formulate a regressionary relationship between the Grand Financial Index (GFI), the Composite Short – term Liquidity Index (CSLI), the Composite Financial Leverage Index (CFLI), the Composite Activity Ratio Index (CARI), the Composite Profitability Ratio Index (CPRI), and the Composite Market Ratio Index (CMRI).

## Keywords

Composite Short – term Liquidity Index (CSLI); Composite Financial Leverage Index (CFLI); Composite Activity Ratio Index (CARI); Composite Profitability Ratio Index (CPRI); Composite Market Ratio Index (CMRI); and Grand Financial Index (GFI).

## JEL Classifications

C10; C32; C53; C65

## Introduction

According to Horngren *et al*. (2002), “Ratios are useful for financial analysis by investors because ratios capture critical dimensions of the economic performance of the entities”.

According to Fraser and Ormiston (2012), the financial ratios may be broadly classified intofivecategories:

### a)Short – term liquidity ratios:

The short – term liquidity ratios may be ofsixtypes:

- Current Ratio (CR):The current ratio is the most common measure for short – term solvency of business firm which is expressed as a ratio of Current Assets (numerator) to Current Liabilities (denominator),

- Quick or Acid – Test Ratio (QR):The quick or acid – test ratio is more rigorous compared to current ratio as it is expressed as a ratio of the *difference* between Current Assets and Inventories (numerator) to Current Liabilities (denominator),

- Cash Flow Liquidity Ratio (in times) (CFLR):The cash flow liquidity ratio is another instrument to assess the short – term solvency of a business entity. It is expressed as a ratio of the *sum* of Cash and cash equivalents, Marketable Securities and Cash Flow from Operating Activities (numerator) to Current Liabilities (denominator),

- Average Collection Period Ratio (days) (ACPR):This ratio helps us to analyze the nature of collection of payments cycle of the business firm from its customers (buyers). It is expressed as a ratio of the Net accounts receivable (numerator) to Average daily sales (denominator),

- Days Inventory Held Ratio (DIHR):This ratio helps us to understand the frequency or rate of circulation / turnover of inventories held by the business organization. It is defined as the ratio of Inventories (numerator) to Average daily cost of goods sold (denominator),

- Days Payable Outstanding Ratio (DPOR):This ratio helps us to understand the payment cycle of the business firm to its suppliers or creditors. It is defined as the ratio of Accounts payable (numerator) to Average daily cost of sales (denominator).

Apart from these ratios, the *Cash Conversion Cycle (CCC)* or *Net Trade Cycle* helps the financial analyst to understand whether the cash flow generation has improved or deteriorated overtime for the business organization. It is measured as the *difference* between the *sum* of Average collection period and Days inventory held and Days payable outstanding;

### b)Long – term solvency ratios / Leverage ratios:These ratios measure the business firm’s potential of debt – financing related to its equity and other interest payments along with fixed costs in the long run. The long – term solvency or leverage ratios are ofseventypes:

- Debt Ratio (DR):The debt ratio or debt to assets ratio measures the proportion of all assets that are financed with debt. It is defined as the ratio of Total liabilities (numerator) to Total assets (denominator),

- Long – term Debt to Total Capitalization Ratio (LDCR):This ratio helps to analyze the extent to which the long – term debt is used to finance the firm’s permanent financing (both long – term debt and equity).

It is defined as the ratio of Long – term debt to the *sum* of Long – term debt (numerator) and Total shareholders’ equity (denominator),

- Debt to Equity Ratio (DER):The debt to equity ratio measures the degree of risk for the firm’s capital structure in relation to the funds supplied by the creditors and investors. It is defined as the ratio of Total liabilities (numerator) to Total stockholders’ equity (denominator),

- Times Interest Earned Ratio (TIER):This ratio measures the proportionate change in the Operating Income or Earnings before Interest and Taxes (EBIT) due to 1 percent change in the total Interest Expenses. It is defined as the ratio of Operating profit (numerator) to Total stockholders’ equity (denominator),

- Cash Interest Coverage Ratio (CICR):This ratio measures how many times interest payments can be covered by Cash Flow from Operating Activities (CFOA) before interest and taxes. It is defined as the ratio of the *sum* of CFOA, Interest paid and Taxes paid (numerator) to Interest paid (denominator),

- Fixed Charge Coverage Ratio (FCCR):This ratio gives us a broader measure of coverage capabilities of the business organization related to operating lease payments. Operating lease payments are generally referred to as rent expenses in the annual reports of the firm. It is defined as the ratio of the *sum* of the Operating Profit / Income (OI) and Rent Expenses (RE) [numerator] to the *sum* of Interest Expenses (IE) and Rent Expenses (RE) [denominator],

- Cash Flow Adequacy Ratio (CFAR):The CFAR is used to evaluate the ability of a firm to cover its Capital Expenditures (CE), Debt Repayments (DRP), and Dividends paid (DIV) by using its Cash Flow from Operating Activities (CFOA). It is expressed as the ratio of Cash Flow from Operating Activities (CFOA) (numerator) to the *sum* of Capital Expenditures (CE), Debt Repayments (DRP), and Dividends paid (DIV) (denominator);

### c)Profitability Ratios:Profitability ratios measure the overall financial performance of a business firm and its efficiency in managing its assets, liabilities and equity. The profitability ratios may be broadly divided intoseventypes:

- Gross Profit Margin / Gross Profit Ratio (GPR):It is defined as the ratio of Gross Profit (numerator) to Net Sales (NS) (denominator),

- Operating Profit Margin / Operating Profit Ratio (OPR):It is defined as the ratio of Operating Profit (numerator) to Net Sales (denominator),

- Cash Flow Margin / Cash Flow Ratio:It is defined as the ratio of Cash Flow from Operating Activities (CFOA) (numerator) to Net Sales (denominator),

- Net Profit Margin / Net Profit Ratio (NPR) :It is defined as the ratio of Net Income (numerator) to Net Sales (denominator),

- Return on Total Assets (ROA):It is defined as the ratio of Net Income (numerator) to Total Assets (A) (denominator),

- Return on Stockholders’ Equity (ROE):It is defined as the ratio of Net Income (numerator) to Stockholders’ Equity (E) (denominator),

- Cash Return on Assets (CRA):It is defined as the ratio of Cash Flow from Operating Activities (CFOA) (numerator) to Total Assets (denominator),

### d)Activity Ratios:Activity ratios give us the idea about the business firm’s efficiency in managing its assets. The activity ratios are offivetypes:

- Accounts Receivable Turnover Ratio (ARTR):It is defined as the ratio of Net Sales (NS) (numerator) to Net Accounts Receivable (ACR) (denominator),

- Inventory Turnover Ratio (ITR):It is defined as the ratio of Cost of Goods Sold (CGS) (numerator) to Inventory (INVN) (denominator),

- Accounts Payable Turnover Ratio (APTR):It is defined as the ratio of Cost of Goods Sold (CGS) (numerator) to Accounts Payable (ACP) (denominator),

- Fixed Asset Turnover Ratio (FATR):It is defined as the ratio of Net Sales (numerator) to Net Fixed Assets (NFA) (denominator),

- Total Asset Turnover Ratio (TATR):It is defined as the ratio of Net Sales (numerator) to Total Assets (A) (denominator); and

### e)Market Ratios:Market ratios help the financial analysts to understand how well the business firm is performing in the stock markets. The market ratios are broadly classified intofourtypes:

- Basic Earnings per Share Ratio (EPS):It is defined as the ratio of Net Income (NI) (numerator) to Average Shares Outstanding (denominator),

- Price to Earnings (P/E) Ratio (PER):It is defined as the ratio of Market Price of Common Stock [ *Closing Price* ] (MPS) (numerator) to Earnings per Share (EPS) (denominator),

- Dividend Payout Ratio (DPR):It is defined as the ratio of Dividends per Share (DIV) (numerator) to Earnings per Share (EPS) (denominator), and

- Dividend Yield Ratio (DYR):It is defined as the ratio of Dividends per Share (DIV) (numerator) to Market Price of Common Stock [ *Closing Price* ] (MPS) (denominator).

## Literature Review

The studies related to capital structure and profitability issues of the firms are also broadly connected to the researches about financial accounting. Since all these aspects are intertwined, hence an overall review of the interconnected subjects would suffice to yield a “bird’s eye – view” of this paper’s major objectives.

The studies related to the capital structures of firms are formally related to the analyses of leverage ratios. For example, a series of high profits will help to lower the leverage of a firm below its target leverage ratio and exactly the opposite scenario occurs for low profits.

There are studies which have established a negative correlation between leverage and profit for the business firms. Dittmar (2004) has argued that if profits are correlated with other growth factors which are not measured by the existing techniques, then the trade – off between leverage and profit holds true. Fischer *et al.* (1989) have discussed about the futility of using leverage ratios to assess the capital structure of the firm as those ratios depend on past observations. Shyham – Sunder and Myers (1999) analyzed the historical data on capital structures and did not rule out the possibility of trade – off between leverage ratios and capital structure.

Gilson (1997) found that high transaction costs lead firms to retain a higher level of debt.

Hovakimian et al. (2001) found that firms move toward a ‘target’ leverage ratio when they issue securities. Dittmar (2004) in her study has found that “the average debt to value of the subsidiaries is significantly lower than that of their pre and post – spin – off parents”.

The other important findings from her study reveal that growth is *negatively* and collateral value is *positively* related to the leverage choice respectively and firms allocate assets and choose capital structures for the newly – formed, stand – alone subsidiaries post spin – offs.

According to the empirical findings of Bradley *et al*. (1984), Chaplinsky and Niehaus (1993), Graham (1996a, 1996b), and Berger *et al*. (1997), firms with higher tax rates are accompanied by higher leverage ratios.

According to Fama and French (2000), the standard economic argument “profitability of firms is mean reverting” holds true. By using a simple partial adjustment model, the rate of mean reversion is approximately 38 percent per year, although the nature of mean reversion of profitability is highly nonlinear.

Sundaram *et al*. (1996) formulated a measure of responsiveness of firms’ profits to changes in their competitors’ strategies. Their *Competitive Strategy Measure* (CSM) is the correlation - coefficient between the ratio of a firm’s change in profit to the change in its sales and its competitors’ combined sales. Formally,

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According to Lyandres (2006), there are three major theories that attempt to explain the cross – sectional variations in firms’ capital structures based on the works by Smith and Watts (1992), Rajan and Zingales (1995), and Frank and Goyal (2004) respectively.

Myers’s (1984) pecking order theory predicts that the firms’ primary source of raising capital is retained earnings and the secondary sources are debts and equities respectively. A firm’s profitability is negatively related to its leverage.

Smith and Watts (1992) hypothesized that the ratio of the value of a firm’s investment opportunities to the value of its assets is *expected* to be negatively correlated to its leverage.

Rajan and Zingales (1995) observed that banks’ and insurance companies’ debt liabilities are *not* directly compatible to the debt structures of non – financial firms.

Frank and Goyal (2004) have classified *seven* factors which play the most important role in determining firms’ leverage options:

- Mix of growth options and assets,

- Magnitude of collateral (*collateral* is defined as the ratio of sum of Net Fixed Assets and Inventories to Total Assets),

- Profitability (It is measured as the ratio of Operating Income to Total Assets),

- Dividends and Repurchases - Dividend – paying firms are supposed to have lower leverage and larger internal funds,

- Size – A firm’s size is hypothesized to be *positively* related to its leverage,

- Median industry leverage, and

- Expected inflation.

Lyandres’s study (2006) established a positive relationship between the firms’ optimum leverage and the degree of competitive interaction in their industries.

Lie’s study (2005) found that firms increase dividend payouts (in the forms of increasing regular dividends, paying special dividends and repurchasing shares) when they have large volumes of cash in hand, low debt ratios, low capital expenditures and poor growth opportunities in terms of market – to – book ratio whereas ‘dividend - decreasing’ firms tread roughly the opposite way. Moreover, the ‘dividend – increasing’ firms have experienced low volatility of past operating incomes and the levels of volatility tend to decrease overtime. Lie’s study corroborates the *maturity hypothesis* of Grullon et al. (2002).

According to Grullon et al. (2002), the market value of a firm can be divided in two parts: Value from its assets in place and the value from future growth opportunities. As a growth firm enters the maturity phase, its growth opportunities become restricted and hence its assets in place play a significant role in determining its value and mitigate its systematic risk.

Hence by summing up findings and analyses of all the major works mentioned above, it may be interpreted that *three* major factors for firms, that is, phase of operations, dividend – payout structure and volume of cash in hand determine the basic capital structuring of firms.

## Objectives

The major objectives of formulation of Composite Indices and Grand Financial Index (GFI) are discussed below:

a) To construct composite indicators which would be able to provide a simplified and holistic picture about the effects of short – term leverage ratios, long – term or financial leverage ratios, profitability ratios, activity ratios, and market ratios separately on a business firm depending upon their individual components. They are termed as Composite Short – term Liquidity Index (CSLI), Composite Financial Leverage Index (CFLI), Composite Profitability Ratios Index (CPRI), Composite Activity Ratios Index (CARI) and Composite Market Ratios Index (CMRI),

b) To readily evaluate the performance of a firm under five different accounting heads by using the composite indices and also statistically predict the importance of *micro* accounting factors like Current Ratio (CR), Quick Ratio (QR), Net Profit Ratio (NPR) etc. under the different heads of composite indices,

c) To formulate a Grand Financial Index (GFI) consisting of all the composite indices which essentially captures all the aspects and qualities of different types of financial ratios, and

d) To present the *macro accounting index* Grand Financial Index (GFI) in the functional form of *micro accounting ratios* which are statistically regressed at 5 percent level of significance or better.

In order to fulfill the objectives mentioned above, calculations are done for *thirty* major ratios (including Cash Conversion Cycle (CCC)) under *five* distinct heads for Wal-Mart1 for a time – series study of thirty years (1987 – 2016) and the necessary model is supplemented by rigorous econometrical approach.

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## Methodology

First step:

In an attempt to formulate composite ratio indices, the traditional statistical method is used to express those indices as the *Geometric Means (GM)* of different ratios under five broad categories as:

i) Composite Short – term Liquidity Index (CSLI) = (CR * QR * CFLR * ACPR * DIHR * DPOR * CCC) 1 ∕ 7

where CR = Current Ratio, QR = Quick Ratio, CFLR = Cash Flow Liquidity Ratio, ACPR = Average Collection Period Ratio, DIHR = Days Inventory Held Ratio, DPOR = Days Payable Outstanding Ratio, and CCC = Cash Conversion Cycle;

ii) Composite Financial Leverage Index (CFLI) = (DR * LDCR * DER * TIER * CICR * FCCR * CFAR) 1 ∕ 7

where DR = Debt Ratio, LDCR = Long – term Debt to Total Capitalization Ratio, DER = Debt to Equity Ratio, TIER = Times Interest Earned Ratio, CICR = Cash Interest Coverage Ratio, FCCR = Fixed Charge Coverage Ratio, and CFAR = Cash Flow Adequacy Ratio;

iii) Composite Profitability Ratio Index (CPRI) = (GPR * OPR * NPR * CFR * ROA * ROE * CRA) 1 ∕ 7

where GPR = Gross Profit Ratio, OPR = Operating Profit Ratio, NPR = Net Profit Ratio, CFR = Cash Flow Ratio, ROA = Return on Total Assets, ROE = Return on Total Equity, and CRA = Cash Return on Assets;

iv) Composite Activity Ratio Index (CARI) = (ARTR * INTR * APTR * FATR * TATR) 1 ∕ 5

where ARTR = Accounts Receivable Turnover Ratio, ITR = Inventory Turnover Ratio, APTR = Accounts Payable Turnover Ratio, FATR = Fixed Assets Turnover Ratio, and TATR = Total Assets Turnover Ratio;

v) Composite Market Ratio Index (CMRI) = (EPS * PER * DPR * DYR) 1 ∕ 4

where EPS = Earnings per Share, PER = Price Equity Ratio, DPR = Dividend Payout Ratio, DYR = Dividend Yield Ratio.

Note:

- The notations used for necessary explanatory variables for calculation of *CSLI* are as follows (Refer to Accounting):

CA = Current Assets, CL = Current Liabilities, INVN = Inventory, AINVN = Average Inventory, CSH = Cash in hand, MS = Marketable Securities,

CFOA = Cash Flow from Operating Activities before interest and taxes, ACR = Net Accounts Receivable, ACP = Net Accounts Payable, CGS = Cost of Goods Sold, NS = Net Sales, NI = Net Income, ADCGS = Average Daily Cost of Goods Sold, ADS = Average Daily (Net) Sales;

- The notations used for necessary explanatory variables for calculation of *CFLI* are as follows (Refer to Accounting.xlsx):

A = Total Assets, L = Total Liabilities, D = Total Debt, L = Total Liabilities,

E = Total Equity, OI = Operating Income, CFOA = Cash Flow from Operating Activities before interest and taxes, IE = Interest Expenses, T = Taxes paid,

RE = Rent Expenses, CE = Capital Expenditure, DRP = Debt Repayments, and DIV = Dividends paid;

- The notations used for necessary explanatory variables for calculation of *CPRI* are as follows (Refer to Accounting)

GP = Gross Profit, OI = Operating Income, CFOA = Cash Flow from Operating Activities before interest and taxes, NI = Net Income, NS = Net Sales, A = Total Assets, and E = Total Equity;

- The notations used for necessary explanatory variables for calculation of *CARI* are as follows (Refer to Accounting):

ACR = Net Accounts Receivable, ACP = Net Accounts Payable, CGS = Cost of Goods Sold, INVN = Inventory, A = Total Assets, NFA = Net Fixed Assets, and NS = Net Sales;

- The notations used for necessary explanatory variables for calculation of *CMRI* are as follows (Refer to Accounting):

MPS = Market (Closing) Price of Stock, EPS = Earnings per Share, and DPS = Dividend per Share;

Second step:

In the second step, linear regression equations are formed for CSLI, CFLI, CPRI, CARI and CMRI respectively by the help of independent variables (regressors) which are statistically significant at 5 percent level of significance or better;

Third step:

In the third step, the Grand Financial Index (GFI) is formulated as the *Geometric Mean (GM)* of *five* composite indices, that is, CSLI, CFLI, CPRI, CARI and CMRI respectively.

Formally,

Grand Financial Index (GFI) = (CSLI * CFLI * CPRI * CARI * CMRI) 1 ∕ 5, and

**[...]**

- Quote paper
- Debasish Roy (Author), 2017, Formulation of Grand Financial Index (GFI). An Empirical Study on Wal-Mart (1987-2016), Munich, GRIN Verlag, https://www.grin.com/document/378989

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