Working Capital: Fundamentals as a Form of Money Management
The best-known working capital test is called the current ratio. This is an indicator derived by dividing current assets by current liabilities.
The current ratio is rounded to a whole number and one decimal place. For example, if a company reports current assets of $1,462,000 and current liabilities of $845,400, the current ratio is:
$1,462,000 ÷ $845,400.= 1.7As with all fundamental tests, it makes sense to track current ratio for a full year. For example, in the case of General Mills and Caterpillar, current ratio over 10 years was:
Current ratio, 10 years
Both of these are consistent enough over time, although in the case of GIS, current ratio has often been below 1. However, the consistency in both companies is reassuring, if the analysis is limited to a study of only the current ratio. However, it is quite easy to manipulate this ratio by borrowing money and holding proceeds in cash. This raises the current asset level, but the offsetting liability is long-term and does not show up as a current liability (except the coming 12 months of debt service). This hides a potential problem: the rise of long-term debt. As long as the current ratio remains constant and is used as the sole test of working capital, this situation does not come to light.
With this in mind, a second test is needed. The debt ratio is a comparison between long-term debt and total capitalization. The debt ratio is a percentage, but it is normally expressed as a value to one rounded decimal place, without percentage signs.
Key PointThe current ratio is the best-known test of working capital, but it does not tell the whole story. The real long-term trend can only be understood by studying both current ratio and debt ratio.
For example, a company reports current long-term debt of $41,200,000 and stockholder's equity of $98,600,000. Total capitalization is a combination of these two:
$41,200,000 + $98,600,000 = $139,800,000The debt ratio is found by dividing long-term debt by total capitalization. The debt ratio is:
$41,200,000 ÷ $139,800,000 = 29.5This company is capitalized 29.5 percent by debt and 70.5 percent by equity. However, it is not the relative portion of debt or equity that is conclusive, since the levels of debt capitalization vary by industry. What is important is how the debt ratio changes over time. Whenever you see a growing debt ratio, it is a danger sign. The more long-term debt a company is obligated to repay, the worse future working capital will be. As a growing amount of annual earnings have to be paid to bondholders and note holders in interest, less is left for payment of dividends to stockholders or to fund future expansion.
An analysis of General Mills and Caterpillar for the 10-year period ending in 2009 shows how the debt ratio evolved.
Debt ratio, 10 years
In the case of General Mills, the high debt ratio at the beginning of the period was troubling, especially considering that the current ratio was less than 1 for most of the period. However, the company cut its debt ratio by nearly one-half over the decade. Caterpillar, an industry in which high debt ratios are expected, maintained a consistent level with a sudden increase in 2008 and a surprising decline in 2009. However, the consistency of the company's current ratio, coupled with the debt ratio history, indicates sound cash flow management and healthy working capital.
In addition to determining whether to buy stock in any one company, you also need to determine whether it makes sense to own stock directly, or to rely on management of a mutual fund to build a portfolio and to buy shares in the overall holdings of that fund. Alternatives: Stocks or Mutual Funds examines the role that mutual funds might play in your investment plan.
Key PointIt is not the debt ratio in the current year that matters, but the long-term trend. When you see the debt ratio climbing every year, it spells trouble for future cash flow.
By Michael C. Thomsett