After covering four profitability ratios previously, Axel Tracy turned his attention to liquidity ratios, beginning with the current ratio. His 2012 book, “Ratio Analysis Fundamentals How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet” describes each of these ratios individually.
To begin, let’s note his definition of liquidity, taken from the Merriam-Webster Dictionary: “consisting of or capable of ready conversion into cash.” From an investing and business management perspective, a liquid asset is one that can be converted into cash within 12 months. To take a couple of examples, funds held in a money-market fund can be converted to cash within an hour or two; on the other hand, an aging manufacturing plant might take several years to sell (convert to cash).
The most widely used of the liquidity ratios is the current ratio. In one number, it tells us how quickly or easily a business can settle its short-term liabilities with short-term assets. Or in more formal terms, how easily a company can cover its current liabilities with its current assets.
Tracy wrote, “The Current Ratio is important because if you can't pay your short-term liabilities you are out of business; and you can only pay your debts with your assets that are highly liquid, that is, they can be converted to cash quickly to pay those debts when they fall due.”
That means the current ratio indicates how safe the company is from the bogeyman of business: bankruptcy. Generally, a high current ratio suggests a safer business and vice-versa.
This is the formula for calculating it:
"Current Ratio = Current Assets / Current Liabilities"
For example, a company with $4 million in current (short-term) assets and $2 million in current (short-term) liabilities would have a current ratio of 2 (4 / 2 = 2). Put simply, it has double the amount of easily accessible cash it needs to pay its immediate debts.
That’s far safer than a company that has $1 million in current assets and $2 million in current liabilities, and a current ratio of 0.5 (1 / 2 = 0.5).
Information for the current ratio, that is current assets and current liabilities, can be found in the balance sheet.
GuruFocus subscribers will find the current ratio in the ratios section of the summary page for each company followed. This image shows the current ratio for Proctor & Gamble PG:
We see the current ratio for P&G is 0.72, meaning it does not have enough cash on hand to pay up if all current liabilities came due today. That makes an important point about all ratios: they must be considered in context. Proctor & Gamble is a well-established company with a long history and an exceptional record of growing its dividends, so it would not have any trouble getting a short-term loan if it had to pay all its bills immediately (which is extremely unlikely).
Also note the two red bars to the right of the current ratio number: The first shows its current ratio in comparison with industry averages. The second shows its current ratio in relation to its own history; the red color means the current ratio now is lower than it has been in the past.
If we click on the words “Current Ratio,” we are taken to a full page of current ratio information. There, the highs and lows of P&G’s current ratio are shown: 0.66 is the low, 1.54 is the high and the median is 1.06. Thus, the bar for its own history is shown in red, rather than green.
The current ratio changes from quarter to quarter and year to year. If it is growing, it means the company has additional resources with which to pay its current liabilities, or to put it another way, the company has more liquidity.
Tracy pointed out that there really is no perfect ratio:
“What the ideal ratio figure should be is debatable. Off-the-cuff, a ratio of 2 is regarded as a safe liquidity position in most business. A figure of less than 1 may be of concern as this means, in theory, in your current position you do not have enough liquid assets to meet your obligations when they fall due in the near term; and this may mean you need to sell non-current assets or otherwise quickly rebuild your level of current assets to make sure you are not insolvent.”
He added that a strong current ratio is not only a sign that the company is financially healthy, but is also a sign it is well managed. Good managers carefully balance how much they are borrowing (for example, to buy inventory) and how much they are spending on other costs with the amount and timing of cash they receive from customers.
One of the drawbacks of the current ratio, as noted, is that the number by itself doesn’t tell investors very much. We used the example of P&G above to show how the ratio is essentially meaningless without context, whether in terms of the company’s financial standing, previous history or its comparison with peer companies.
A second drawback is what Tracy called “the inherent assumption that all current assets can be turned into cash to pay current liabilities.” For example, some current assets, such as prepayments, never turn into cash and some assets depend on sales result (think of unsold inventory).
The third drawback he listed was the idea that a high current ratio was better than a low ratio. However, the current ratio refers to just liquidity—it does not consider broader business issues. He wrote:
“If you had a Current Ratio of, say, 25 then this would be great for liquidity but is it best for the business? It is generally agreed that the more liquid an asset, the lower the return you receive for it. Often a higher return is the payment for a lack of liquidity. Therefore, if you had a Current Ratio of 25 then you may have too many low-return current assets that should be invested into higher-return non-current assets.”
Conclusion
Tracy has described in detail the function of the current ratio, as well as its calculation and uses. Essentially, it provides an indication of whether the company is a possible candidate for bankruptcy or other serious business problems.
However, it has limited value if taken on its own. It should be considered as one data point in a collection of data when assessing the potential attractiveness of a stock.
And, Tracy reminded us that a very high current ratio may indicate a company has too much invested in short-term, low-return assets. A smarter business strategy would be to invest more of those assets in long-term, high-return assets.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Ratio Analysis: Return on Equity
- Ratio Analysis: Return on Assets
- Ratio Analysis: Gross Profit Margin
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