Traditional financial analysis
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Written by Atila on September 16, 2008 – 10:54 am
Traditional financial analysis relies on the following rule: A company must maintain a buffer between sources and uses of funds maturing in less than 1 year to cover risks inherent in its business (loss of inventory value, deadbeat customers, decline in sales, business interruption costs that suddenly reduce shareholders’ equity capital), because liabilities are not subject to such losses in value.
By maintaining a current ratio above 1 (more current assets than current liabilities), the company protects its creditors from uncertainties in the ‘‘gradual liquidation’’ of its current assets; namely, in the sale of its inventories and the collection of its receivables. These uncertainties could otherwise prevent the company from honouring its obligations, such as paying its suppliers, servicing bank loans or paying taxes.
If we look at the long-term portion of the balance sheet, a current ratio above 1 means that sources of funds due in more than 1 year, deemed stable,4 are greater than fixed assets – i.e., uses of funds ‘‘maturing’’ in more than 1 year. If the current ratio is below 1, then fixed assets are being financed partially by short-term borrowings or by a negative working capital. This situation can be dangerous. These sources of funds are liabilities that will very shortly become due, whereas fixed assets ‘‘liquidate’’ only gradually on the long term.
The current ratio was the cornerstone of any financial analysis years ago. This was clearly excessive.
The current ratio reflects the choice between short-term and long-term financing. In our view, this was a problem typical of the credit-based economy, as it existed in the 1970s in continental Europe.
