Let's riff a little bit this week on one of our favorite ratios - the current ratio. First, for any beginners out there, the current ratio is current assets (anything that can be converted to cash within a year) divided by current liabilities (anything due within a year).
In the "old days," a 2 to 1 current ratio was something credit execs liked to see. That 2 to 1 seemingly gives you a nice "margin of safety," knowing that the company you're looking at has 2 times the current assets as current liabilities. Not bad.
And it's still kind of a good benchmark.
But (and I've got to say this real soon, before the more experienced analysts out there want to throw tomatoes at the screen) it's WAY too simplistic. And if you stop there, you'll really be in trouble.
First, we'll note the group of financial types that - over the last decade, roughly - has been in the camp of wanting to lower all the components of current assets to reduce "the investment in" receivables or inventory. That's a really sound analytical framework and what it does is emphasize the quality of a current asset much more than the quantity. Another way to look at it is that quality is a function of efficiency or how fast everything is moving.
And if you think about it, that's really true. Let's say you've got a customer with $100 million in sales, selling on 30 days terms. They normally have about $10 million in receivables, representing a DSO of 36 days.
Now, if you are analyzing things solely from a current ratio standpoint, a rise in receivables might make you feel good - more assets means they can more easily cover their payables, and you're thus safer, right?
On the contrary, of course, a rise actually means you've got a higher risk. As receivables slow, they're less collectible. And as inventory rises, it's a sign it's not selling. Both are serious problems.
So if suddenly - absent a rise in sales - this $10 million in receivables went to $20 million, you might have a much higher current ratio, but a much riskier customer.
So how do you reconcile this issue?
Well, you can still start with a current ratio benchmark of some sort (it will depend on your industry), but then you should always compare that to the company's turnover ratios - how fast everything is turning over. The two most important are typically receivables and inventory.
I remember as a beginning analyst seeing a company with a sub 1 current ratio and being somewhat alarmed. But my boss pointed out that the customer I was looking at typically sold on 7 day terms, so they were turning their receivables very quickly, with plenty of leeway to pay suppliers. They could afford to have a sub-1 current ratio (though I can attest that, while they always paid, they were sometimes a challenge to deal with, and we would have preferred they had a greater "margin of safety").
It's also critically important to look at the trend of the current ratio over time.
If it's rising, you always want to know why.
Is it because of inventory that's not moving or receivables getting stretched out? If so, then you've got a real problem. But if it's rising simply because of great cash flow and inventory and receivables are still turning nicely, then this might be the type of customer you can pay much less attention to as it's not likely to be a credit issue.
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