Use This Simple Quality Ratio To Improve Your Investment Returns by Tim du Toit, Quant Investing

What if I told you that there is a simple quality ratio you could use to increase your returns, irrespective of what investment strategy you follow?

The reality is you can, but before I show you how, first some background information.

External Finance Ratio

We first read about the External Finance Ratio (EFR) 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 shows you if a company is able to finance investments from cash the business generated or if it needed external money (bank debt or to sell shares) to meet its investment needs.

How it is calculated?

The External Finance ratio is calculated it follows: (Gross change in total assets for the year – net cash generated from operations) / Total assets at the end of the year.

Positive means external financing needed

If the ratio is positive (greater than 0) it means that the company was not able to finance its assets growth internally whereas if the ratio was negative it means that the company generated more than enough cash to finance its assets growth.

Back tested results

As you know we don’t just add a ratio to the screener without first testing it to see if it can help you achieve higher returns.

First test – it works

We tested the EFR ratio in two ways.

Firstly we divided the External Finance ratio values into five quintiles (five equal groups) with companies with the highest need for external financing (largest positive EFR) in quintile five (Q5) and those with the lowest need for external financing (largest negative EFR) in quintile one (Q1).

Over the 12 year period from June 2000 to June 2012 this was what we found:

Quality Ratio

Click image to enlarge

1 Quintiles

2 Compound annual growth rate

What it means

As you can see, apart from the CAGR of Quintile one (Q1) being less than Q2, the growth rates of Q2 to Q5 are linear.

This means that the External Finance ratio has the ability to increase your investment returns if you avoid companies with the highest need for external financing.

Avoid the bottom 40%

The fact that Quintiles one to three have similar returns means that if you avoid the 40% (Q4 and Q5) of companies with the highest EFR ratios you would capture the most of the value this ratio can add to your returns.

How can I avoid the 40% of companies with the highest need for external financing you may be thinking?

More on that shortly, first I want to show you a second test we did.

Second test – it definitely works

In the second test we divided companies into two groups, one group that needed external financing (positive External Finance ratio) and another group that did not (negative External Finance ratio).

Here is the table with the yearly returns over the 12 year period from June 2000 to June 2012:

Quality Ratio

1 Companies that did not need external financing (negative External Finance ratio)

2 Companies that needed external financing (positive External Finance ratio)

CAGR = Compound annual growth rate

5% per year over 12 years higher return

As you can see the companies that did not need external financing on average returned +8.1% over 12 years, substantially better than companies that needed external financing which on average returned only +3.1% over 12 years.

On average a 5% higher return per year over 12 years, this is a substantial improvement.

So it’s clearly worth your while to use the External Finance Ratio when you screen for investment ideas.

How you can get the benefit

I said I will show you how you can exclude the 40% of companies with a bad (positive) external finance ratio.

It’s very easy as the following screenshot shows:

Quality Ratio

Click image to enlarge

Select the best external finance companies

You simply select the External Finance ratio, and then use the slider below to show only the 60% (0% to 60%) of companies with the best external finance ratio.

And you can combine the External Finance ratio with your favourite investment strategy, irrespective of what it is.

In the above screenshot I combined it with Earnings Yield but you can combine it with the more than 79 ratios and indicators the screener offers.

You can find the definitions and calculations of all ratios and indicators in the Glossary

In summary

  • The external finance ratio shows you if a company is able to finance investments from cash the business generated or if it needed external money
  • The ratio can definitely improve your investment returns, +5% per year in our 12 year test
  • The best way to apply it to your portfolio is to exclude the 40% of companies with the worst ratio (highest positive values)

Your external finance analyst

Tim du Toit