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Sep 1, 2023

The Current Ratio: A Key Metric For Investing In Small Cap Stocks

by Mystery Manager

The current ratio is a financial ratio that measures a company's ability to pay its short-term debts with its current assets. It is calculated by dividing current assets by current liabilities. A current ratio of 1.0 means that a company has enough current assets to cover its current liabilities one-to-one. A current ratio of 2.0 means that a company has twice as many current assets as current liabilities.

The current ratio is an important metric for investors because it provides a quick and easy way to assess a company's liquidity. Liquidity refers to a company's ability to quickly turn its assets into cash. A company with a high current ratio is considered to be more liquid than a company with a low current ratio.

There are a few reasons why the current ratio is important for investing in small cap stocks. First, small cap stocks are often more volatile than large cap stocks. This means that their share prices can fluctuate more dramatically in the short term. A high current ratio can give investors some reassurance that the company has the resources to weather any short-term storms, whether they are company specific or related to market or macroeconomic factors.

Second, small cap stocks are often more cyclical than large cap stocks. This means that their performance is more closely tied to the health of the overall economy. A high current ratio can give investors some confidence that the company will be able to weather macroeconomic headwinds.

Third, having a high current ratio can often mean that a company has a healthy amount of excess cash, which can give it more optionality and the ability to make strategic moves such as buy back shares, initiate or increase a dividend or expand a vital department. This particularly helps a company stand out during tough economic times when other peer companies are struggling. 

Company-specific Considerations

It is important to note that the current ratio is not the only factor to consider when selecting a stock to invest in. Other factors to consider include the company's business model, its growth prospects, profitability, and its management team. Further it is important to understand the story and circumstances of a particular company to help gauge how useful the current ratio is in one’s analysis. 

Here are three small cap Canadian stocks with their current ratios which we will look at to illustrate this point with a short example:

  • Lightspeed Commerce (LSPD): Current ratio of 6.2.
  • Kinaxis (KXS): Current ratio of 2.4.
  • Aritzia (ATZ): Current ratio of 1.4.

If we compare the three stocks mentioned above, LSPD seems to be the most favourable of the three when it comes to short-term liquidity. However, LSPD’s stock has arguably been the most volatile relative to ATZ and KXS. Shouldn’t a high current ratio indicate a more stable company and in turn a more stable stock? Not necessarily. LSPD also has a history of burning through cash, meaning it is not yet profitable, whereas ATZ and KXS are. In other words, ATZ and KXS can afford to have lower current ratios (albeit both having a ratio greater than 1 still quite strong). LSPD, on the other hand, by necessity needs to have a high liquidity and cash reserves to allow it to keep going. This is why it is important to consider all factors when evaluating a company. That said, 6.2 is still a high current ratio and does provide reassurance that the company can weather the storm and uncertainty.

Industry-specific Considerations

The current ratio can also be affected by the industry in which a company operates. For example, companies in the retail industry typically have higher current ratios than companies in the industrial sector. This is because retailers generally have more cash on hand and inventory that can be quickly converted into cash.

Here is a brief overview of how the current ratio can be affected by different industry dynamics:

  • Retail: Retailers typically have high current ratios because they have a lot of cash on hand and inventory that can be quickly converted into cash.
  • Technology: Earlier stage technology companies typically have lower current ratios because they have less cash on hand and inventory. However, due to the asset-light nature of many technology companies, they often end up having high current ratios once they become profitable.
  • Financial services: Financial services companies typically have high current ratios because they have a lot of cash and liquid assets.
  • Healthcare: Healthcare companies typically have lower current ratios because they have a lot of long-term assets, such as property and equipment.
  • Industrial: Industrial companies typically have lower current ratios due to their high capex and working capital needs to service their customers.

By understanding how the current ratio can be affected by different industries, investors can better assess the liquidity of a company and its ability to meet its short-term obligations relative to its peers.

A Complimentary Tool

The current ratio is a valuable tool for investors who are considering investing, particularly in smaller and less established small to mid-cap stocks. Overall, the current ratio can be a useful tool for assessing a company's liquidity and its ability to weather short-term storms. However, we certainly would not consider it a be-all-end-all financial ratio and believe in most cases, it serves better as a complimentary tool in one’s analysis and for detecting red flags related to the financial health of a company. 

Disclosure: The author(s) responsible for this article do not have a financial or other interest in the securities mentioned.