Can Options Traders Rely on the Fundamentals?
11/13/2014 8:00 am EST
Option trader Michael Thomsett of ThomsettOptions.com outlines how, though the value of fundamentals is clear, sometimes indicators have hidden flaws and can’t be relied on by themselves to draw conclusions about the health of working capital.
As valuable as the fundamentals are, there are hidden flaws in some of the popular ratios. One of these flawed indicators is the favorite one used to test working capital: the current ratio.
This ratio divides current assets by current liabilities to judge and compare how much liquidity a company has to pay current obligations. But this ratio is easily manipulated by increasing the asset side.
By increasing long-term debt to keep the current ratio high, it makes the impression that working capital is in good shape, when it might not be. Nothing illegal is involved here. Increasing current assets by also increasing long-term debt is allowed under GAAP, but it has the effect of artificially holding up current ratio even though working capital is suffering.
One of the many flaws in the GAAP standard is that it does not help analysts or investors to uncover deceptive or inaccurate outcomes. The current ratio is one of many valuable trend tracking indicators. But it cannot be relied upon by itself to draw conclusions about the health of working capital. For that, a more complete analysis is required, combining current ratio and the debt ratio.
By Michael Thomsett of ThomsettOptions.com