A traditional and widely followed indicator - the current ratio - is intended to work as am measure of working capital. The working capital is a reflection of how well a company manages its money to pay current obligations and expand into the future. But the current ratio is not always a reliable standard to follow. It can be misleading.
The current ratio is derived from dividing two balance sheet elements. Current assets are divided by current liabilities, and the resulting ratio is expressed as a number to one decimal place. Current assets consist of cash and assets convertible to cash within one year (accounts receivable, inventory, etc.). Current liabilities are all debts payable within the next 12 months, including accounts and taxes payable and 12 months' payments on long-term debts.
For example, a company reported a five-year history of the current ratio as:Current Year Ratio 1 1.1 2 1.1 3 1.4 4 1.5 5 1.5
This looks very good. By the end of 2009, the company had 1.5 dollars in current assets for every dollar in current liabilities. But how is this possible, considering their annual net losses?:
Year Profit (Loss)
1 $ (1,455)
2 ( 600)
3 ( 205)
5 ( 233)
The company lost over $2 billion over five years and yet their current ratio improved over the same period. This is mathematically impossible. A company cannot lose money and at the same time improves its working capital. Or can it?
The trick is that current ratio can be artificially kept level or even improved by increasing each year's debt ratio. This is the percentage of long-term debt compared to total capitalization. The percentage is expressed as a value to one decimal, without a percentage sign. (Total capitalization is the combination of long-term debt and equity.) In the case of this company, long-term debt grew over the same period:
Year Long-term debt
This shows the true picture of working capital. The current ratio was kept high even while the company lost money, by incurring long-term debt up to 98.3% of total capitalization. This means that equity (the part shareholders own) was only 1.7% of the total, and the rest of the company was "owned" by lenders. Not only is this a very dangerous trend; the higher the debt ratio, the more difficult it becomes to ever turn the situation around. A growing portion of future profits have to go to interest payments on debt, leaving less for dividends or expansion - assuming that the company ever does become profitable.
The current ratio is a useful indicator, but only as part of a broader test of a company's working capital controls and profitability. When viewed along with the debt ratio and profits (or losses) the real picture emerges. In this case, the company appears to be going down the path of insolvency, even while the current ratio makes it appears that all is well.
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