Investing 101: Using the Current Ratio to Determine a Company’s Health

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Any study of financial statements includes basic tests in two areas: profitability (and the growth trends that includes) and working capital, or the availability of liquid assets needed to fund current operations.

Working capital “liquidity” means not just cash, but those assets that can be converted to cash within one year. This includes accounts receivable (minus a realistic reserve for bad debts), inventory, and marketable securities (investments). Collectively, cash plus these other classifications are called current assets because they are “liquid.”

This distinction from other assets (such as long-term, or capital assets) is the liquidity itself. It is one-half of the test of a company’s working capital health.

The other half is current liabilities. This includes accounts currently payable, accrued taxes, and 12 months’ of payments due on notes. In other words, current assets are convertible to cash within one year, and current liabilities have to be paid within one year. The distinction is not perfect because it changes every month; but it does provide a sense of how strong or weak a company is in terms of its cash management.

The current ratio is an important test of working capital. To determine the current ratio, divide current assets by current liabilities. The result is usually expressed as a single digit and one decimal place. For example, a company’s current assets are $1.62 million and current liabilities are $1.03 million. To compute current ratio:

$1.62 ÷ $1.03   =   1.6

This company’s current ratio of 1.6 is considered generally very healthy. You want to see current assets higher than current liabilities, and a current ratio of 2.0 or higher is desirable. However, anything above 1.0 is considered acceptable. The real test of the current ratio is not today’s ratio but the longer-term trend. You would like to see a consistency over five years or more, in which the ending current ratio is above 1.0.

Be cautious, though. Also track long-term debt through the debt ratio, which is long-term debt divided by total capitalization (long-term debt plus net worth). If this percentage is rising each year, that is a more important — and negative — factor than a consistent debt ratio. A company could be losing money every year but maintaining its strong current ratio by taking on more long-term debt and holding it in cash or inventory. That is not a good trend. Future earnings will have to be used increasingly to repay the borrowed money and interest, leaving less for dividends and expansion.

Checking working capital demands not only a check of the current year, but also of the long-term trend. Five years is a minimum for checking any financial trend. When you are concerned about working capital, be aware of the definitions of current assets and current liabilities; also keep an eye on the debt ratio.

Michael C. Thomsett is author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons, scheduled for release in Fall, 2010). He lives in Nashville, Tennessee and writes full time.

Investing 101: Using the Current Ratio to Determine a Company’s Health was provided by Minyanville.com.