Toby Lang sends: 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, and accounts receivable. Current liabilities, on the other hand, are only debts that will come due soon (1 year or less). So this is all about our short term future.
To continue to milk our example, lets say you are buying a company, and the company has $1mm in loans coming due in the next year but has an account receivable that shows you are due to have a $1mm inflow in that time. Assuming the receivable is a good credit, you are going to feel pretty safe in your purchase, but if they only have $750k coming due you are going to feel not as good, and if the receivables total just $500k 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 finances over the next few quarters.

$1mm/
$1mm
= a current ratio of 1

$750k
$1mm
= 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)

The ratios we have looked at so far tend to be a snapshot of the current condition of the company and don’t really explore a company’s history. Graham didn’t believe in investing in the next hot company, he was about buying companies with history and tangible revenues; companies where the paint on the sign out front is dry - basically, boring companies. Graham also wanted a company that had proved that it understood its business and was on a path to continued success.

What Is It?
Some earnings in each of the past 10 years.
Earnings growth of 33% over 10 years (average).
Revenue of more than $100 million (1950 dollars).

A company has to make money. If there has been a period in which they have failed to earn money, they may be in the midst of a change in the company’s direction, are in a market that is too competitive to support future growth, or they may simply be poorly managed. All of these situations indicate something unhealthy that will affect the long term prosperity of the company. Earnings are the heart of any business; you don’t want your heart to stop even for a moment.

Growing earnings is an indication that the company understands its market and is good at capturing their consumer’s dollars. It also indicates that the markets this company is attacking are growing, or at least their percentage of that market is growing. We don’t want to get fooled by a flash in the pan industry that has had just one or two great years because they are servicing a fad. Obviously the company also has to have 10 years in business too, Graham sees young companies as just too risky; they haven’t had a chance to prove what kind of company they are.

Without Graham here to provide us with an updated number, we could probably take the equation and add inflation of 3% annually to the $100mm.

2009 Value (FV) = Present Value (PV) * (1 + average inflation rate) years
FV = $100mm * (1 + 3%) 58
FV = $555.34mm

What Graham was trying to do here though was find companies with a stable base. Any list of things can cause a company to have a bad quarter or bad half; it can be as simple a cause as the condition of the overall economy. Graham and Buffet both believed that trying to guess what the economy is going to do is a fruitless endeavor, better to be safe than to get burned in a downturn. Big companies tend to have the resources to weather these conditions whereas the smaller companies tend to fall by the wayside when things get really tough.

Summary
It is really about not getting fooled. The past is our best indicator of the future unless you have a crystal ball. So if a company has proven it can grow its earnings, has never been in financial trouble, and is big enough that a few waves are not going to turn the boat over then is it not at least somewhat likely that it will continue to perform in this way in the future?

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