The Current Ratio
By Joshua Kennon. Investing for Beginners Expert
Thanks to his straight-forward approach and ability to simplify complex topics, Joshua Kennon's series of lessons on financial statement analysis have been used by managers, investors, colleges and universities throughout the world. "If an investment idea takes more than a few sentences, or cannot be explained to a reasonably intelligent fourth grader, you've moved into speculation," Joshua insists. "Whether you're dealing with a public company such as McDonald's, or a private company such as Chanel, these are the types of firms that are easy to understand. You know where the sales originate, what the costs are, and how profits are generated. These are the types of enterprises that aren't going to cause you to wake up in the middle of the night, breaking into a cold sweat because of the sub-prime crisis or esoteric securities trading in illiquid markets. That's a huge advantage to growing your wealth. Focus on what you know, pay a fair price, and invest for the long-term.
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Using the Current Ratio to Gauge Inefficiency
If you're analyzing a balance sheet and find a company has a current ratio of 3 or 4, you may want to be concerned. A number this high means that management has so much cash on hand, they may be doing a poor job of investing it. This is one of the reasons it is important to read the annual report. 10K and 10Q of a company. Most of the time, the executives will discuss their plans in these reports. If you notice a large pile of cash building up and the debt has not increased at the same rate (meaning the money is not borrowed), you may want to try to find out what is going on.
Microsoft has a current ratio in excess of 4; a massive number compared to what it
requires for its daily operations. The company has no long term debt on the balance sheet. What are they planning on doing? No one knew until the company paid its first dividend in history, bought back billions of dollars worth of shares, and made strategic acquisitions.
Although not ideal, too much cash on hand is the kind of problem a smart investor prays to encounter. A business with too much money has options. The biggest danger in such a pleasant situation is that management will begin compensating itself too highly and squander the funds on bad projects, terrible mergers, or high risk activities. One defense against this, and sign that management is on the side of the long-term owner, is a progressive dividend payout policy. The more cash the executives send out the door and put in your pocket as a sort of rebate on your purchase price. the less money they have sitting around to tempt them to do something dumb.
In fact, it isn't an accident that overwhelming academic evidence studying nearly a century of stock market returns demonstrates that businesses dedicated to operating efficiently by paying out surplus funds as dividends, meaning by definition they avoid having what management considers a non-justifiably high current ratio, do far better over the long-run than businesses where the executive team hoards the cash. There are always exceptions, but as a general rule, this is one of the big truths too many investors ignore as they think they are only going to own those outliers. Next page > Quick Test Ratio > <<back. 15. 16, 17. 18. 19. 20. 21. more >>
This page is part of Investing Lesson 3 - Understanding the Balance Sheet. To go back to the beginning, see the Table of Contents . If you have already read this lesson, you can skip directly to the Balance Sheet Quiz .Source: beginnersinvest.about.com