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Another Look at the Current Ratio

November 14, 2011 | About:

David Chulak

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Benjamin Graham’s Defensive strategy and what has commonly become known as his “Last Will & Testament” strategy both advocate that the investor seek stocks that have a current ratio of 2 or greater.

The current ratio is intended to indicate the ability of the current assets to satisfy the current liabilities. It is simply determined by dividing current assets by the current liabilities. A higher ratio is nearly always considered better, and a number of at least two determines that the company in question may comfortably satisfy all of its current debts. This is what Graham established to be a safe current ratio for investors.

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That said, investors should seek stocks with safe ratios and a current ratio of two or higher is objectively a good number to seek out. I would, however, discourage an investor from actually using the current ratio for selecting stocks through a stock screener. That is not to say that they should not consider the current ratio. They absolutely should. What I am suggesting is that it is not wise to place that criterion in any type of stock screener in order to locate stocks that may interest you. Let me offer a few reasons why you should not include it as a screening tool:

1. By inserting the minimum criteria of two for your current ratio, you may overlook such gems as these (and scores of others):

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2. The current ratio is imperfect in that it is based upon liquidation values, which is not a likely occurrence. Presumably, investors intend to invest in businesses that will continue to thrive. As demonstrated in the chart above, Exxon Mobil (XOM) has a current ratio of less than one. Its current assets are less than the current liabilities listed on their balance sheet. One would have to make the leap that Exxon Mobil is unable to pay its current bills, a highly unlikely scenario.

3. Don’t just look at the number, look at the assets. For instance, it was reported recently by Reuters that Microsoft (MSFT) has approximately $56 billion in cash of which nearly 90% or $51 billion is held outside of the U.S. and consists mostly of Treasuries. If you are inclined to be one that holds that Treasuries are no longer safe or not as safe as you prefer, you might become a little more concerned even though Microsoft boasts a much higher current ratio. That is not to suggest, even for a moment, that Microsoft is in any type of jeopardy, but only serves to show how you must look at the assets involved to make an objective decision as to the strength of the number shown by the ratio.

4. The type of business in question may allow it to have a lower current ratio, suggesting that strong companies can often perform quite well with current ratios not only less than two, but less than one. For instance, companies like Walmart (WMT) can turn their inventory over more rapidly than their accounts payables become due, making their current ratio of 0.9 a non-issue. It behooves the investor to study the cash conversion cycle alongside the current ratio to get a much better picture than the current ratio may offer alone.

5. It is best two look at the industry as a whole and see how competitors compare to one another. The chart below would appear to indicate that both Aetna (AET) and United Healthcare (UNH) are unable to meet their current obligations. We now know that this is not necessarily so. Therefore, when you compare companies industry wide, now a decision has to be made…..is the current ratio of United Healthcare and Aetna a problem or does it merely reflect superior companies that are able to place their money to work elsewhere? Or, does it possibly indicate that Humana and WellPoint carry too much cash on their books that could be used elsewhere to make shareholders more money?

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6. Companies may have current ratios that are too high. When is high too high? That’s up to the individual investor. What you must consider is that too much cash sitting around on a company’s books may indicate that management is unable to come forth with ideas to put the money to work.

Do not conclude that I am dismissing Graham’s suggestion that companies have current ratios of two or greater. I’m suggesting that there is more to the number and by simply placing it in a stock screener limits your stock selection and doesn’t offer a complete picture.

Disclosure: I am long UNH and WAG

About the author:

David Chulak
David Chulak is a private investor that uses a value approach to investing in the styles of Graham & Dodd and Warren Buffet. Looks for that margin of safety in an effort to preserve capital and attempts to guard against short term market fluctuations by having clear rules laid down in advance for selling an equity. Likes to visit the company's where his investments are in order to understand the business better.

Rating: 3.8/5 (6 votes)

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