On Cross-Sectional Properties and Time-Series Persistence of Finnish Cash-Flow Based Financial Ratio Distributions

Paavo Yli-Olli and Ilkka Virtanen

English summary

The purpose of this study was to analyze the cross-sectional distributions of selected cash-based financial ratios, and to examine the stability of these distributions during different phases of business cycles.

The long Finnish tradition in cash-flow analysis formed the basis for this study. In addition, the international research has began to give growing interest to cash-flow reporting. The special interest in international research has been the importance of cash-based information for the investors. Among a countless number of recent studies dealing with distributional properties of financial ratios this study is the first one where the calculation of the ratios is entirely based on cash-flow numbers.

This study is mainly empirical by nature. When judging the properties of the selected cash-based ratios theoretically, the basis has been that the main task of financial statements is to give information to investors, managers and other interested parties. Another central assumption is that the objective of the management is to maximize the market value of the firm. This means, for example, when dealing with profitability ratios that these ratios should reflect the true profitability of the firm, i.e. such that the effect of all expences, e.g. depreciation has been taken into account in defining the ratios (the Finnish and international tradition in cash-flow research differ a bit from each other).

When examining the cash-based ratios in Finnish literature, we found several ratio classifications differing slightly from each other. We selected for our study the classification presented by Aho. This is because the presented ratios are entirely cash-based, they are numerous enough and they have been used in many Finnish studies.

The final number of selected variables was eleven cash-based ratios. We grouped the ratios slightly differing from Aho's textbook. They were classified into three groups. The first group constisted of ratios measuring profitability or adequacy of income financing (cash-flow from operations) in some studies. The ratios were: cash margin Ia (cash operating income a) to cash from sales, cash margin Ib (cash operating income b) to cash from sales, cash margin II (cash net income) to cash from sales, and cash-based ROI (cash margin Ib to liabilities).

From the theoretical point of view, the main problem in profitability ratios is the lack of the effects of investment expenditures in these measures. This deficiency should be removed in the future development of the ratios. In addition, in the third ratio (cash net income to cash from sales) the numerator measures in the first place the net cash-flow for shareholder's equity (the effect of depreciations is also ignored) whereas the denominator belongs both to shareholder's equity and to debt. So the interest payments should be added back to the numerator to control better for capital structure differences across firms or over time. On the other hand, both the reliability and calculation properties of the ratios are good. In Finland, the ratios do not include so many items subject to consideration as do the accrual income numbers, and the denominator of the ratio is always positive and large as compared with the numerator. A stable behaviour of the profitability ratios was thus to be expected.

The empirical behaviour of the four cash-based profitability ratios was good (if the criterion of goodness is normality as usual). The distributions are normal already in raw data or at least affer removal of one or two outliers. Different business cycles also reflected in the distributions. Outliers appeared when the competitiveness of Finnish firms was at the lowest and disappeared during "normal years" (the period studied was 1974-84). The results were very similar to those of profitability ratios we obtained earlier when we analyzed the distributions of accrual-based financial ratios of Finnish firms. It must be noted here, however, that despite of their similar distributional behaviour, the accrual-based profitability ratios and the cash-based profitability ratios has been shown to measure different properties in the firm's behaviour (Gombola and Ketz 1983, and Yli-Olli 1983).

The second ratio class in this study was already theoretically more heterogeneous than the first one. The ratios in this class describe in the first place how much different cash out-flow can be covered by the cash from sales or by parts of it. The selected ratios were: direct labor and materials to cash from sales, cash-based income to total cash out-flow, cash-based payback period (total debt to cash net income), and cash net income to cash-based investments.

The first variable, the direct labor and materials-ratio, was systematically skewed to the left. The square-root transformation of the complementary variable worked, therefore, well: the transformed variable became normal with no outliers.

The second variable in this class was the income financing-ratio. Also this variable was systematically skewed to the left. The square-root transformation of the complement (the complementary variable can be called the equity financing-ratio) became normal, with a couple of outliers in the years of low competitiveness, however.

The third ratio in the second class was the cash-based payback period. This ratio was already in advance very problematic, both theoretically and technically. The denominator includes the problems mentioned earlier. Technical problems are also many: the denominator has an exceptionally large variance, it is small compared the numerator, and it changes its sign. With negative values of the denominator the ratio has no economic meaning and interpretation. Due to these facts, instead of the original payback period-ratio its inverse, the cash-based payback rate, was analyzed. This ratio was positively skewed. After square-root transformation and removal of some outliers the distribution became approximately normal. As a summary, however, the ratio must be regarded both theoretically and technically quite poor.

The last ratio in the second class was the ratio cash net income to cash-based investments. The ratio is theoretically sensible (reservations concerning the item cash net income must be beared in mind, however). Problems was to be expected in behaviour, however, because the variance of both the numerator and the denominator is extremely large. This is true both across firms and firm-specifically across years. Unstable distributions were thus to be expected. The distributions were, without and with transformation, strongly leptokurtic and thus non-normal.

The third ratio class consisted of different items of profit distribution (interest payments, taxes, dividends) related to cash net income. The ratios are theoretically sensible but technically very problematic. The problem is in small and very unstable denominator. The general empiral conclusion about these ratios was, that normality was not achieved. The distributions were randomly skewed to the left or to the right and strongly leptokurtic. Instead of the unstable cash net income a technically better denominator shoud be find for these ratios.

As a conclusion we can state the following rough rule: the better the ratios were theoretically motivated and the better their calculation technical properties were, the better were also their distributional properties. Theoretical development should be made especially in including the effects of investment expenditures in the ratios. From the technical point of view, attention should be paid for avoiding in the denominator items which are extremely unstable, change their sign or are too small as compared with the numerator.

(The Finnish Journal of Business Economics 4­1989, 374­404)