With this article we propose to discuss two things: a) the efficiency of the current ratio as a tool to screen for profitable stocks whose prices sharply declined over a 12-month period, b) the reliability of the ratio as a tool to assess the short-term financial strength of those stocks mentioned before.
In order to show that a low current ratio does not always mean a bad thing, we will bring the results of an academic study covering a sample of more than 5,000 US companies (observations) whose data covers a period of 10 years . One practical example will be sufficient to show that a very high current ratio is not always synonymous with corporate health.
The current ratio measures the capacity of the company to meet its own short-term obligations.
Current ratio = Total Current Assets / Total Current Liabilities
If the current ratio is low, it means that there is a shortage of cash to pay debts and to get discounts.
However, the presence of a low index does not necessarily mean that the company is not reliable in the short term or that things are not going well.
An example is the one that emerged from a study of Piotr Arendarski (2012) on U.S. stocks that suffer losses of 50% or more in relation to S&P 500 in the last 500 trading days and with a stock price above $0.50. An average number of 5.376 was screened during the period 31/03/2001 - 05/11/2011. When the dataset was screened on the basis of strategies depending on the level of three conditions, debt / equity (the lowest levels within industry), current ratio (the highest levels within industry), and Altman Z-Score (in the range between 1.2 - 2.8), a surprising point came up: 'falling knives' with the higher cumulative return were the ones with the higher interval for current ratio.
The author classifies stocks according their position within a industry with regard to the current ratio, and divides the stocks into following groups of intervals:
Within 10% (or 0.1) of the best in the industry in terms of current ratio; within 15% (or 0.15) of the best in the industry; and so on until 50% or 0.5.
The Brandes Institute defines falling knives as stocks whose prices declined 60% or more over a 12-month period.
So the quantitative analysis of this study confirms the existence of a strong and significant linear relationship (positive) between intervals (levels) with regard to the strategy based on current ratio.
The purpose of the Polish study is to explore which measures of financial stability should be used to select falling stocks that produce risk-adjusted abnormal returns, since the previous research of Kochman, Ladd and TOMPKINS, James (2008) suggests there is a need to check financial strength when 'falling knife' stocks are selected.
On the other hand, if the current ratio is high, this does not automatically mean that the company is doing well. It could mean that availability of cash equivalents are not used to the fullest. Furthermore, it does not take into account the type of receivables or inventory that may have led to the high value.
An example is represented by Biostar Pharmaceuticals Inc. (NASDAQ:BSPM).
A few weeks ago Biostar Pharmaceuticals experienced a sharp share price depreciation, hitting a new 52-week low. As of 09/30/2012, the total Current Assets are $48.55 million and total Current Liabilities are $4.19 million. Then the current ratio of BSPM is $48.55 / $4.19 = 11.58
In this case, one would say that the higher the quick ratio, the better the position of the firm. But if we examine the Cash Conversion Cycle for the third quarter of 2012, it reveals the following:
Item (data in millions of USD)
3 months ending 2012-09-30 (for income statement items)
As of 2012-09-30 (for balance sheet items)
As of 2012-06-30 (for balance sheet items)
- BSPM's days inventory outstanding = $0.92 / ($4.73 / 92 days) = 17.89 days
- BSPM's days sales outstanding = $26.2 / ($9.97 / 92 days) = 241.77 days
- BSPM's days payable outstanding = $ 3.02 / ($4.73 / 92 days) = 58.74 days
- BSPM's Cash Conversion Cycle for the 3rd quarter of FY 2012 = 17 + 241 - 58 = 200 days
Calendar or working days can be considered in the cash conversion cycle formula because although managers may not be working on these days, many retail operations are still open and still selling.
So the question is how fast Biostar Pharmaceuticals converted in the third quarter of 2012 its current assets into cash in order to meet current liabilities.
The answer is 200 days. That is Biostar needs 241 days to collect its receivables, its inventory turns over 5 times in a quarter and company's current liabilities have an average payment period of 58 days.
The high amount of account receivables accumulated and the consequent difficulty of the company to convert them into cash reveal that Biostar is not as liquid as it would seem at first sight from the analysis of the current ratio. And that is also the major concern that emerged among investors during the Conference Call August 15th, 2012. For the 2nd quarter of FY 2012, BSPM's cash conversion cycle was about 312 days. That is Biostar needed 374 days to collect its receivables, its inventory turned over four times in a quarter and company's current liabilities had an average payment period of 85 days.
Here you can find BSPM's cash conversion cycle for the last 12 months ended September 30, 2012, assuming that the year began the 1st of October 2011 and ended the 30th of September 2012.
In conclusion, the current ratio is not the most efficient criterion to search for profitable falling knives. When we analyze the financial strength of a falling knife, it cannot be considered a 100% reliable index, and deeper investigation is needed.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.