Value Investor Questions: Has The Current Ratio Lost Its Importance?
Value Investor Questions is a series about the common and uncommon questions asked by value investors around the world. I aim to educate and inspire anyone with interest in value investing.
In a value investor group on Facebook, we recently discussed the importance of using the price-to-book ratio in finding and evaluating undervalued stocks. One group member asked how much weight one should put on this well-known, value-indicating ratio, and my answer was simple: very little.
In the old days, when Benjamin Graham used the price-to-book ratio to find undervalued stocks, most companies derived their value from material assets that could be sold in times of distress. Therefore, it made sense to look for companies trading at prices below the book value of their assets.
In the group, I argued that the price-to-book ratio has partly lost its relevance since the most valuable companies in the world today derive most of their value from intangible assets instead of material assets. This fact makes it difficult to find undervalued companies that satisfy Graham’s rather strict criteria of a P/B-ratio below 2/3 of tangible book value.
While our discussion of the P/B-ratio was interesting, another question about Graham’s criteria emerged. Has the current ratio also lost its meaning, or is it still relevant in evaluating undervalued stocks?
What is the current ratio?
To find the current ratio, we must start with knowing the accounting definition of “current”. For good measure, below is the definition of current assets and liabilities:
Current assets. Assets that are reasonably expected to be realized in cash (or sold or consumed) within one-year or normal operating cycle,
whichever is longer.
Current liabilities. Obligations that are reasonably expected
to be liquidated within one-year or normal operating cycle,
whichever is longer.
Now that we know that current assets and liabilities are generally realized or due within one year, we can move on to find the ratio between the two.
The current ratio is pretty simple to calculate. The ratio is simply the company’s current assets divided by its current liabilities.
Current Ratio = Current Assets / Current Liabilities
Below is a snapshot from Apple’s (AAPL) latest quarterly filing.
To find Apple’s current ratio, one simply divides the total current assets with the total current liabilities, like so:
Current Ratio of AAPL = 163,231 / 102,161 = 1.6
Therefore, Apple has 1.6 times current assets compared to current liabilities.
Great. But what does it mean?
It’s great to know that Apple has 1.6 times current assets compared to its current liabilities since you would be able to impress the folks attending your dinner party by throwing around random “fun facts” about Apple. Definitely a conversation starter.
Investors use the current ratio to judge if a company can meet its short-term liabilities. The current ratio is, therefore, a liquidity measure that indicates the financial health of the company.
According to Investopedia, the current ratio can be split into three categories:
- Current ratio < 1: The company could have trouble meeting its short-term liabilities.
- Current ratio between 1.5 and 3: The company will have no trouble meeting its obligations in the short run.
- Current ratio >3: The company has not optimised the use of its working capital.
As mentioned, Apple’s current ratio is 1.6, which means that the company is unlikely (surprise) to have any short-term liquidity issues.
Nice. Anything else I should know?
Yes! You should know that all assets are not created equal.
It’s good to know how to find the current ratio, but it is even more important to know the individual components of a company’s current assets and liabilities.
Let’s start by looking more closely at current assets. As seen above, Apple’s current assets consist of:
- Cash and cash equivalents
- Marketable securities
- Accounts receivable, net
- Inventories
- Vendor non-trade receivables
- Other current assets
As previously mentioned, investors look to the current ratio to judge a company’s ability to meet its short-term obligations. What we really want to know is, however, that if everything goes wrong, and the company needs to do a fire sale, will it be able to avoid bankruptcy?
To judge this, we need to take into consideration that current assets in a fire sale situation will not be liquidated at book value. Depending on the type of business and assets, it is, in general, a good rule of thumb to use the following discounts:
- Cash and cash equivalent. No discounts needed.
- Marketable securities. Likely no discount needed, but it depends on the nature of the securities.
- Accounts receivable, net. Likely discount of 20–50%.
- Inventories. At least 50% discount depending on the nature of the product (e.g. fashion clothes have almost no value, but gold jewellery have)
- Other current assets. Must be investigated to see how liquid it is, e.g. is it mostly like marketable securities or inventory?
Now that we know that all assets are not created equal, we can move on to see how the father of value investing used the current ratio in his approach to investing.
Benjamin Graham and the current ratio
From his original 10 items checklist, Benjamin Graham recommended companies with a current ratio above 2. In his book “The Interpretation of Financial Statements” revised in 1955, Graham wrote:
When a company is in a sound position, the current assets well exceed the current liabilities, indicating that the company will have no difficulty in taking care of its current debts as they mature. What constitutes a satisfactory current ratio varies to some extent with the line of business. In general, the more liquid the current assets, the less the margin needed above current liabilities.
Overly simplified, Graham used the current ratio as a criterion to judge a company’s short-term ability to survive. Also, as he wisely notes, there is variation in “a satisfactory current ratio” depending on the company’s industry (see table below).
There are two key lessons from Graham for today’s investors:
- Current ratios differ by industry, so one needs to analyze the industry to see if the company of interest is less or more solid than average. One should also go a step further and look at the composition of the current assets, as mentioned earlier.
- Beware of the current ratio’s little brother: the quick ratio. The quick ratio is the current ratio less inventory which means you’re able to get a somewhat more accurate fire sale scenario snapshot of the current assets.
In Graham’s days, the stock market consisted mainly of asset-heavy manufacturing companies that were likely to keep inventory at hand. This is in contrast to today’s stock market, which is more skewed towards service companies that are less likely to hold a significant inventory. The manufacturing companies that we do have enjoy the benefits of a modern and global supply chain that has dramatically reduced the need to keep inventory.
Has the current ratio lost its importance?
The short answer is no, but I think one needs to have an open mind and determine on a case-by-case basis if a company is solid by analyzing its fundamentals.
As described above, not all assets are created equal, so when one “mindlessly” uses a stock screener and sets a minimum current ratio of 2 as a criterion, one risks eliminating great companies such as Apple.
The greatest danger, however, is to automatically assume that if a company passes the current ratio criterion, it must be safe, but this cannot be determined without analyzing the assets and the industry.
Since our goal is to find financially sound companies, we could look at the ratio between EBITDA and interest expenses to investigate the likelihood of default. Although it is not a liquidity measure, we can, in general, assume, that if the company covers its interest expenses by 3–4 times with EBITDA, it is thought to be sound (again, dependant on the industry).
The problem is that interest coverage ratios are generally not available in stock screeners (to the best of my knowledge), so one would need to calculate it based on information from SEC filings. This makes the analysis process a bit more tedious.
A workaround when using stock screeners, therefore, is to set the current ratio criterion lower, e.g. at one, so the other criteria in one’s screen are given greater weight. This would allow for some elbow space in finding value cases but also puts greater emphasis on the investor’s analytical abilities and the time he can dedicate to researching stocks.
