Value Investing: What is Current Ratio?

stock market value investing series Apr 02, 2021

Welcome to part 2 of our "Value Investing: How to Read and Analyze Financial Statements"! If you haven't checked out part 1 then click here: https://www.ttmeducation.com/blog/value-investing-1

In our first article from the series, we went through the material that we're going to study and made a summary of everything explaining the material. Now it is time to dive in-depth to the essence of the article series. We will start with the ratios which fall under the liquidity category. The first ratio that we're going to analyze is the current ratio.

When we review the current ratio, we should consider a couple of things. What ratio value should we look for? Before we dive into that, let's take a look at the formula below.

Current Ratio = Current Assets / Current Liabilities 

The answer is that the ideal zone is around 1. Values below 1 indicate that the company has more debt than current assets. Values of 1 and above indicate the company can pay their short-term debt at least once if things worsen. What does that mean? If we have a current ratio of 0.75, the company has $0.75 of current assets for each dollar of debt. If the company has a current ratio of 2, it means the company has $2 for each dollar of debt. If things worsen, it can pay twice the debt with the current assets. However, having a high current ratio does not always mean it's a good thing. Having a very high current ratio could mean the company is poorly utilizing the current assets. 

Let's take a look at the graph below. As you can see, the current ratio declined significantly after the peak in 2016, but we remain close to the value from 2015.

As with everything, there should be a reason behind it. Let's take a look at the table below.

After analyzing the data, we can conclude that the company increased its total assets at a slower pace than the total debt. If we look at the long-term debt, since 2015, it increased by 61.06%, while the short-term debt increased by 9.91%. So as we discussed above, long-term debt poses more risk for the company since it tends to stack on an annual basis.

If we compare the current assets' growth pace and current liabilities, which are 17.43% and 18.55%, respectively, we can see the liabilities outpace the asset growth. The reason for the decline is that the liabilities grow at a faster pace than the assets. We reviewed the debt levels first because the long-term debt is one of the critical parameters in the mathematical formula and is very important when comparing two companies. Why is that? Even if they have equal current ratios on paper, the debt background could be completely different between both companies, causing a massive divergence in the comparison. With that said, let's take a look at the table below and analyze the quarterly data for 2020.

After calculating the data for 2020 from the table above, we can conclude a couple of things. If we take a look at the graph below, we can see that the current ratio increased. But is that really a good thing?

The current debt and current liabilities continue to outpace the assets, which leads to the increase of the current ratio. While the current assets from Q4 of 2019 to Q3 of 2020 decreased by 2.71%, the current liabilities for the same time period also decreased by 10.92%. On the surface, things look good. Assets are increasing, and liabilities are decreasing, leading to an increase in the current ratio.

In reality, we should ask ourselves, “Is that increase deceiving?” The answer to that question is “Yes,” that increase is deceiving. Why? One of the most important parameters that we will use in this article series is the debt background. In this situation, the debt background does not look good. The long-term debt, which is the “Bad” debt from Q4 of 2019 to Q3 of 2020, increased by 51.43%. For 3 quarters we gained over 50%, which is an enormous increase for such a short period. Moreover, in addition to the long-term debt, the short-term debt also increased by 9.07%.

This real example shows exactly why we should take any number with a pinch of salt. Looking at the number itself will never tell us enough unless we evaluate other parameters which are indirectly related to the ratio.

With this statement, we put an end to the analysis of this ratio. Our next article from the series will talk about the quick ratio.

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