November 27, 2008

Buy a Company with a Future (Current Ratio) (Session 5)


Current ratio is an important one; it shows us how the company will survive in the short term. As I mentioned earlier there are reasons why the company is currently cheap our job is to figure out why and also to build in a safety margin to make sure they are going to survive the reason they are so cheap.

What is it?

Current assets
Current liabilities

What does it tell us?

We are familiar working with assets and liabilities in calculating book value, but now we are looking at current assets and current liabilities. Current assets include only those things that we can convert to cash quickly things like cash, bonds, inventory, accounts receivable. Current liabilities on the otherhand are only debts that will come due soon (1 year). So this is all about our short term future.
To continue to milk our example, lets say you are buying a company if the company has $1M in loans coming due in the next year but has an account receivable that shows you are due to have $1M in the nextwhile you are going to feel pretty safe in your purchase, if they have .75 M coming due you are going to feel not as good and .5M coming due you are going to worry a bit. This is what the current ratio does for us- tells us if we need to worry about the next little while.

$1M
$1M
= a current ratio of 1

.75M
1M
= a current ratio of .75

We take what they have that can be quickly converted and divide it by what they are expected to owe in the short term and we get a pretty good idea of how the company will hold up over the next year. The higher the ratio, or the number of times they could potentially pay off their bills if they had to, the better.

What does Graham Use?

For industrial companies current assets should be at least twice current liabilities—a so-called two-to-one current ratio. (P.348 The Intelligent Investor)