Seeking Alpha

Thomsett's  Instablog

Thomsett
Send Message
Michael C. Thomsett is a widely published options author. His "Getting Started in Options" (Wiley, 9th edition) has sold over 300,000 copies. He also is author of "Options Trading for the Conservative Investor" and "The Options Trading Body of Knowledge" (both FT... More
My company:
Michael C. Thomsett, author
My blog:
Thomsett Options
My book:
Getting Started in Stock Investing and Trading
  • Flaws In Working Capital Tests 0 comments
    Feb 15, 2014 1:06 PM

    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, one company's five-year summary of the current ratio is:

    current

    year ratio

    5 1.6

    4 1.3

    3 1.2

    2 1.2

    1 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

    5 63.1

    4 60.2

    3 44.5

    2 39.0

    1 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, 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.

    To gain more perspective on insights to investing observations and specific analysis, I hope you will join me at ThomsettStocks.com where I publish many additional articles. I also maintain a virtual portfolio of stock at ThomsettStocks.com. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site to learn more.

Back To Thomsett's Instablog HomePage »

Instablogs are blogs which are instantly set up and networked within the Seeking Alpha community. Instablog posts are not selected, edited or screened by Seeking Alpha editors, in contrast to contributors' articles.

Comments (0)
Track new comments
Be the first to comment
Full index of posts »
Latest Followers

StockTalks

More »

Latest Comments


Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.