Roy Anderson Foulke, a prominent economic statistican observed in 1945: “The classification of current assets is undoubtedly the most important classification in a balance sheet, as current assets largely determine the going solvency of a business concern.”
Current Assets play a significant part of the Graham NCAV calculation. Once we have a list of NCAV stocks, we might wish to look further at the individual components of the current assets portion of the balance sheet.
The main components are Cash and Cash Equivalents (which are clearly the most liquid items), Short Term Investments, Accounts Receivable, and Inventory. Short Term Investments are quite often insignificant or non-existent for these types of smaller businesses so we can usually ignore them. Factoring Accounts Receivable and Inventory significance is a little bit of effort, but we can use a few ideas. If inventory is very large in relation to the current assets, we might want to bypass the company altogether. The reason for this is it is the least liquid of the current assets and it takes more time to be sold and converted into cash working capital. It really depends on the nature of the business.
Accounts Receivable can be high if a company extends too much credit/financing or has difficulty in getting customers to pay. We can measure accounts receivable turnover which is defined as (Annual Sales / Accounts Receivable). This factor tells us how quickly a company turns its accounts receivable into cash. For example a ratio of 15 tells us the company turns its accounts receivable into cash once every 24 days. If this factor is too high, the company may be too stringent in doling out credit, thus lowering sales and profit.
It’s best to compare the accounts receivable turnover over a longer period to even out seasonal fluctuations. For example you can calculate it from quarterly results and divide by 90, and you would also want to compare it with the industry norm and competitors. If the normal turnover for the industry and competitors is, say, 30 days, you do not want to see a much higher value than that.
If Inventory is reasonable, you can also calculate inventory turnover which is (Sales / Inventory) and convert it to days in the same fashion.
Avoid extremely low turnover values, because that tells you the company will have cash tied up for long periods, and any company that can’t quickly turn inventory and accounts receivable into cash isn’t going to be a going concern for very long.
