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Flawed Tests For Working Capital -- And How To Overcome Those Flaws

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Are you a "true believer" in fundamental analysis? As valuable as the fundamentals are, there are hidden flaws in some of the popular ratios. One of these flawed indicators is the favorite one used to test working capital: the current ratio.

This ratio divides current assets by current liabilities to judge and compare how much liquidity a company has to pay current obligations. But this ratio is easily manipulated by increasing the asset side. For example, here is a five-year summary of the current ratio for one company:

current

year ratio

2012 1.6

2011 1.3

2010 1.2

2009 1.2

2008 1.3

This looks acceptable. The year-to-year ratio is consistent and even improves in the most recent outcome. So what's the problem. Next, take a look at the same company's debt ratio (long-term debt divided by total capitalization:

long-term

year debt

2012 63.1

2011 60.2

2010 44.5

2009 39.0

2008 36.8

Notice how the percentage of long-term debt has risen each year. The latest, 63.1, is quite high compared to the 36.8 a few years earlier. What has taken place here is the replacement of equity with debt, so that over time, a growing portion of net profits and working capital will have to go toward debt service and interest; and a falling portion will be available for expansion or payment of dividends.

Nothing illegal took place, here. Increasing current assets by also increasing long-term debt is allowed under GAAP (Generally Accepted Accounting Principles), but it has the effect of artificially holding up current ratio even though working capital is suffering.

One of the many flaws in the GAAP standard is that it does not help analysts or investors to uncover deceptive or inaccurate outcomes. The current ratio is one of many valuable trend tracking indicators. But it cannot be relied upon by itself to draw conclusions about the health of working capital. For that, a more complete analysis is required, combining current ratio, quick assets ratio when big changes in inventory apply, and most important of all, the debt ratio.

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