The following article appeared in the March 2013 issue of the Quant Value newsletter.
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New – External Finance Ratio
In this article I want to tell you about a ratio we also use in the investment model to select investment ideas for the Quant Value newsletter, the called the External Finance Ratio (EFR).
We first read about it in the excellent book by Richard Tortoriello called Quantitative Strategies for Achieving Alpha: The Standard and Poor’s Approach to Testing Your Investment Choices (click the name to go to the Amazon page).
The ratio calculates if a company was able to finance its investments from cash the business generated or if it needed external financing (bank debt or to sell shares) to meet its investment requirements.
How it is calculated ?
The ratios calculated it follows: (Gross change in total assets for the year – net cash generated from operations) / Total assets at the end of the year.
Thus if the ratio is positive (>0) it means that the company was not able to finance its assets growth internally whereas if the ratio was negative (<0) it means that the company was able to finance its assets growth through the cash the business generated.
Back tested results
As you know we don’t just add a new ratio to the investment model without first testing it to see if it can help you achieve higher returns.
We tested the EFR ratio in two ways.
Firstly we divided the EFR ratio into five quintiles (five equal groups) with companies with the highest need for external financing (largest positive EFR) in quintile five and those with the lowest need for external financing (largest negative EFR) in quintile one.
Over the 12 year period we tested the ratio these were the results:
2 Compound annual growth rate
What it means
As you can see, apart from Quintile 1 (Q1), the compound annual growth rates of the quintiles are linear.
This means that EFR has the ability to increase your investment returns if you look for companies with no need for external financing (have a negative EFR).
The fact that quintiles one to three have similar returns means that if you avoid to 40% of companies with the highest EFR ratios you would capture the most of the value this ratio can add to your returns.
Secondly we did an easier test dividing all the companies only into two groups, one group that needed external financing (positive EFR’s) and another group that did not (negative EFR’s).
Again here is a table with the yearly returns:
1 Companies that did not need external financing
2Companies that needed external financing
3 Compound annual growth rate
As you can see the companies did not need external financing (+8.1%) substantially outperformed those that needed either bank financing or had to issue new equity (+3.1%).
So you can clearly see its a worthwhile ratio to add to the investment model.