The current ratio is a popular stock fundamental used to test a company’s liquidity. It primarily tries to answer the question of whether a company has enough resources to pay its debt over the next 12 months. The current ratio is calculated as follows:
Current Assets / Current Liabilities = Current Ratio
Benjamin Graham suggested in The Intelligent Investor that defensive investors should require that companies have at least $2 of assets for every $1 in liabilities to ensure the company is in a strong financial position. However, having too high of a current ratio can also indicate that a company may not be efficiently using its current assets. Let’s take a look at a backtest of this ratio to see how it works.
I used the data and backtesting tool provided by Portfolio123. This backtest uses the same filtered universe of stocks as my recent Stock Returns by Employment Growth Over the Past 14 Years. I’ve designed the filtering criteria for this backtest specifically for individual investors and with a focus on enhancing data quality. The filters include the following criteria:
- No OTC stocks. Stocks not traded on the New York Stock Exchange, NASDAQ, or American Stock Exchange markets are excluded. The quality of fundamental stock data for OTC can be somewhat lower and less timely that that for stocks traded on major exchanges.
- No ADRs. Fundamental data for foreign American Depositary Receipt can include errors due to currency exchange, different accounting standards, and share count.
- Liquidity test. The average daily total amount traded over the past 60 trading days must be larger than $100,000. This amount was selected so that a $1 million dollar portfolio could hold 100 positions and that each new $10,000 position would not exceed 10 percent of a day’s trading volume. The liquidity test also ensures that the backtest has reliable market price information for any of the stocks that are being tested.
- Market Cap > $50 million. Nano cap stocks are excluded to help improve data quality. This filter also ensures that positions in a modest sized portfolio never exceed one percent of shares outstanding or the available float for a company.
- Price > $1. True penny stocks are excluded due to various information issues and manipulation of these stocks.
- Current Ratio >0. This filter insures we are looking at stocks that actually have data on the current ratio.
After these filters are applied, we are left with approximately 2,600 to 3,500 stocks. These stocks are then ranked by the criteria being tested; in this case, we are testing the current ratio. The lowest 20 percent of stocks ranked by the current ratio are placed in the first quintile and the next 20 percent in the second quintile and so forth until we have five portfolios of stocks. The portfolios are rebalanced every 12-months and compounded annually to more realistically replicate what an individual investor might be expected to do to avoid higher short-term capital gains tax and trading costs. The following 5 charts display the quintile returns for the current ratio in red and the S&P 500 Equal Weight Index in blue. The first quintile includes the companies that had the lowest current ratios and the 5th quintile includes the companies that had the highest current ratios.
Current Ratio Quintile Returns – 2000 – 2013
Summary of Results for the Current Ratio Backtest
The average excess returns is highest for the 2nd quintile portfolio. Interestingly, this 2nd quintile contained stocks with a median current ratio of 1.47 at the end of 2013, which is very close to the Benjamin Graham suggestion of a 1.5 minimum current ratio for “enterprising” investors. While the average excess returns for the first quintile was somewhat lower, it is very similar to the returns for the 1st quintile and are not likely significantly different.
The most interesting result is that for the portfolio holding stocks with the highest current ratios. The fifth quintile significantly underperformed the S&P 500 equal weight index that I used as a benchmark. The median current ratio for the 5th quintile was whopping 5.57. Those companies with inefficient utilization of current assets appear to provide some potential ideas for short selling or at least one might want to at least avoid many of those stocks.