The Current Ratio
Analyzing a Balance Sheet
Learning how to calculate the current ratio from a balance sheet is a useful tool that you'll want to remember and use often. The current ratio is another financial ratio that serves as a test of a company's financial strength. It calculates how many dollars in assets are likely to be converted to cash within one year in order to pay debts that come due during that same year. You can find the current ratio by dividing the total current assets by the total current liabilities. For example, if a company has $20 million in current assets and $10 million in current liabilities, the current ratio would be 2.
The calculation would look like this: $20,000,000/$10,000,000 = 2.
Acceptable Current Ratios
What you, as an investor, should consider an acceptable current ratio varies by industry because different types of enterprises have different cash conversion cycles, economic needs, and funding practices. Generally speaking, the more liquid the current assets, the smaller the current ratio can be without cause for concern. For most industrial companies, 1.5 is an acceptable current ratio. As the number approaches or falls below 1 (which means the company has a negative working capital), you will need to take a close look at the business and make sure there are no liquidity issues.
Companies that have ratios around or below one should only be those which have inventories that can immediately be converted into cash. If this is not the case and a company's number is low, you should be seriously concerned. This is especially true when dealing with a business that relies on vendors financing much of the cash by providing credit for goods ultimately sold to the end customer. If the vendors were to become concerned about the financial health of the corporation, they could send the business into a scramble, or even a death spiral, by reducing credit lines or refusing to sell without upfront payment, resulting in a liquidity crisis.
Using the Current Ratio to Gauge Inefficiency
If you're analyzing a balance sheet and find a company has a current ratio of 3 or 4, you may want to be concerned. A number this high means that management has so much cash on hand, they may be doing a poor job of investing it. This is one of the reasons it is important to read the annual report, 10K and 10Q of a company. Most of the time, the executives will discuss their plans in these reports. If you notice a large pile of cash building up and the debt has not increased at the same rate (meaning the money is not borrowed), you may want to try to find out what is going on.
Microsoft has a current ratio in excess of 4; a massive number compared to what it requires for its daily operations. The company has no long-term debt on the balance sheet. What are they planning on doing? No one knew until the company paid its first dividend in history, bought back billions of dollars worth of shares, and made strategic acquisitions.
Although not ideal, too much cash on hand is the kind of problem a smart investor prays to encounter. A business with too much money has options. The biggest danger in such a pleasant situation is that management will begin compensating itself too highly and squander the funds on bad projects, terrible mergers, or high-risk activities. One defense against this, and sign that management is on the side of the long-term owner is a progressive dividend payout policy. The more cash the executives send out the door and put in your pocket as a sort of rebate on your purchase price, the less money they have sitting around to tempt them to do something dumb.
It isn't an accident that overwhelming academic evidence studying nearly a century of stock market returns demonstrates that businesses dedicated to operating efficiently by paying out surplus funds as dividends. By definition, they avoid having what management considers a non-justifiably high current ratio, do far better over the long-run than businesses where the executive team hoards the cash. There are always exceptions, but as a general rule, this is one of the big truths too many investors ignore as they think they are only going to own those outliers.