Unveiling the Flow Ratio

In honor of The Motley Fool's 10th anniversary this month, we'll occasionally be looking back on some of the best columns of our first decade. Today, we republish the historic Fool Port column where Tom Gardner introduced us to the Foolish Flow Ratio, a metric now in wide use six years later. This article has been slightly updated to show short-term debt is included in the ratio. Historians will note the use of fractions instead of decimals in stock prices, and Cowboys fans at Fool HQ (namely, Rex Moore) hope Bill Parcells will also work miracles in Dallas.

The Fool Portfolio skipped right alongside the S&P 500 today, both posting gains of 0.33%. Our account was carried by the $1 9/16 gain from America Online (NYSE: AOL  ) and the $3/8 gain from Iomega (NYSE: IOM  ) . Time and time again, our two best-performing investments have continued rising on the strength of their business. The best have gotten better. Apologies to those of you who don't follow football, but the same simple theory holds true in the National Football League.

Tune into the NFL, and you'll find many of the same dynasties gaining momentum as they dominate. If you'd put a stop-loss on the Pittsburgh Steelers in 1976, "getting out" of steel-curtain shares during their first loss after the Super Bowl win in 1975, you would've missed out on greatness. They won three of the next four world championships. Not every great pro football team gets greater. But enough do that you should be skeptical of their naysayers.

I'm going to leave the football comparison in a second, but success in American business is like a winning NFL franchise in a second way: Greatness in both relies on superior management. Consider the performance of the New York Jets this past Sunday. After losing 15 of 16 games last year, the team signed Bill Parcells -- the best coach in the game -- to "manage" their team in 1997. What happened in game one a few days back? Parcells led the Jets to a 41-3 victory over the Seattle Seahawks. Five-star coaching wins games, creates excellent season records, and leads eventually to decade-long domination.

That makes sense but, getting back to stocks, you might be asking yourself, "How am I to adjudge the merits of my company's management team?"

Do you have to stand outside of corporate headquarters hoping to come upon an executive leaving for a midday walk? In between enduring a tongue-lashing from your boss (a nod to Dilbert), an emergency phone call about your daughter's behavior in KinderMusic class, and your ever-expanding email obligations, should you be expected to call up company management and chat with them about "the vision thing?"

You can't do all that, but I'd like a chance to convince you that one simple balance-sheet ratio can set you on a path to rightly assessing your management team. We have named it -- in our next book due out in January -- The Foolish Flow Ratio, and readers of the Cash-King (now Rule Maker Strategy) discussion board have been working with it through the summer.

The Foolish Flow Ratio measures the flow of products out of a business and the concurrent flow of cash into a business. Tennis shoes out, cash receipts in. Computer software boxed and sent, cash from distributors flowing back to the seller. The nice thing about the Flow Ratio is that your daughter, nephew, or great-grandson (over the age of 10) could complete the tasks necessary to its calculation. (Aside: If your 10-year-old daughter, nephew, or great-grandson isn't yet investing, you should start teaching them the basics now.)

Well, OK, what is the Flow Ratio? Ladies and gentlemen, here it is:

                   (Current Assets - Cash*)Flow Ratio = ---------------------------------             (Current Liabilities - ST Debt**)*Cash = cash & equivalents, marketable securities, and short-term investments
**Short-Term Debt = notes payable and current portion of long-term debt

Let's take an example. We'll start with Dell Computer (Nasdaq: DELL  ) in June 1997 -- noting that, over the past three months, its stock has risen over 50% vs. S&P 500 gains of 10%. Let's run the numbers and then ponder what they mean.

   Dell Computer on 06/01/97:     Cash                 $1.35 billion     Current Assets       $2.74 billion     Short-term debt      $0     Current Liabilities  $1.66 billion                    $2.74 - $1.35     Flow Ratio =   -------------                    $1.66 - $0                        1.39     Flow Ratio =       ----                        1.66     Flow Ratio =       0.837

I haven't done much explaining. Thus far, the most interesting piece of research is that Dell has risen over 50% in three months. But does its Flow Ratio in June have anything to do with that? It's certainly too short of a time period, but it's useful data nonetheless. Let's consider what The Flow does, step by step.

By removing cash from current assets, we've honed our sights on two primary components of current assets: inventories and accounts receivable. But are these really "assets"? Are these strengths? I don't think they are. A high inventory count indicates a lot of stuff that your company hasn't yet sold. Whether the items are high on a warehouse shelf in finished form or moving around a workshop floor as raw materials, they aren't bringing in the money. They aren't yet directing profits back to shareholders.

Beyond inventories are accounts receivable, and hey, there's another bona fide liability. Receivables represent product "loans" -- personal computers sold to distributors in Thailand who haven't yet made their payments to your business. That "cash outstanding," listed as an asset, is actually a liability. Your company has loaned product to a customer, banking on payment in the weeks or months ahead. Your company doesn't have the cash yet.

So, when we have subtracted out the cash from current assets, we're left with detrimental assets. If cash truly is king, then current assets are fiendish and foul knaves.

Conversely, the denominator of the Flow Ratio measures outstanding payments that your company hasn't yet made. Let's say you've invested in Froosh (Ticker: MMMMM), mixer and retailer of fruit sorbet. If current liabilities are high, then your company team has the ice, sugar, and natural fruit juice to blend and freeze the sorbet, but they haven't yet paid for those materials. Meanwhile, they're selling half-pints through to distributors and getting cash for it.

So, to restate, inventory is coming in -- in the form of ice, sugar, and juice -- but cash hasn't yet headed out the door. In a competitive business world where cash is king, outstanding payments are listed as a liability, but instead are an asset.

Whoa there, wait one second. The Fool is not championing those companies that violate contracts by paying bills past due. We've suffered that unprofessional treatment by a partner or two, and that's damaging to their reputation, not a business strength. But what we are celebrating are those companies that have the authority to contract longer pay periods with their suppliers and shorter pay periods with their distributors. Think about that for a second. It simply means that we like to find sorbet companies that don't have to pay upfront for their materials but that get paid upfront by mini-marts across the country because their sorbet is in such great demand. If that's not clear, consider Dell in June 1997:

Current Assets less Cash = $1.39 billion
Current Liabilities less ST Debt = $1.66 billion

What does this indicate? Here are some reasonable inferences:

  • Dell very aggressively assembles inventory and gets it out the door (low inventory).
  • Dell demands speedy payments from customers (low receivables).
  • Because Dell's machines are so popular, it can buy time on payments to suppliers (high payables, or high current liabilities).

The result is that Dell has very large amounts of cash rapidly flowing into the business as it fights to slow the flow of cash out of the business.

OK, if you're with me this far, you might be asking, "If Dell's Flow Ratio of 0.837 is excellent and, in some way, contributed to the latest 50% run (and the 980% growth in the value of the company since August 1995), what's a poor Flow Ratio?

To my eye, any Flow Ratio below 1.00 reflects a company that appears to be very aggressively managed and whose products are in great demand. Conversely, any Flow Ratio above 2.00 reflects a company that appears to be managed sloppily and whose products aren't coveted.

On this basis, I constructed the MoneyHeavy Portfolio in May 1997. And under similar pretenses, I built the Cash-King Portfolio in July 1995. I sought out companies that manage their cash aggressively, that work hard to sell superior products rapidly, and that do not "book" substantial amounts of sales unless they've received cash payment for them (i.e., have low accounts receivable). Below, I list the performance since inception of these portfolios relative to the S&P 500, and I do so to provide objective numerical accountability for a model that I believe in.

  Since July 1995         Since May 1997----------------        --------------- Cash-King +227%        MoneyHeavy +17% S&P 500    +67%        S&P 500    +10%

Is the Flow Ratio the only thing I used to evaluate these businesses? Is it all-powerful? Certainly not. But this balance sheet ratio will concentrate your attention on your company's long-term game plan -- on what frame or model they've constructed for their business. Conversely, your focus on the income statement and on analysts' earnings estimates will reveal your company's short-term operational might. Put another way, the shorter your investment horizon, the more intently and immediately you should attend to quarterly earnings reports. And the longer your horizon, the more emphasis you should place on the sturdiness of the balance sheet -- on how well your company collects cash, on how attractive is its product line, on how hungry is your company's chief financial officer.

Now, let me restate that The Flow is not an all-powerful model. It doesn't account for long-term debt or for cash. And it doesn't reflect the direction of a company's balance sheet. If a low Flow Ratio is ideal, well, which is better?

a) A company whose Flow has risen from 1.10 to 1.40.
b) A company whose Flow has fallen from 2.49 to 1.72.

Direction is more important than location, and the Flow Ratio acts only as a snapshot of the financial location of a company.

And finally, the Flow Ratio doesn't directly recognize new products, research and development success, brand-name value, new management, etc. On its own, it is a weak model (as many are in the financial world). But it does provide clues to a company's present standing and financial game plan. Many of our greatest corporations -- from Coca-Cola (NYSE: KO  ) to Microsoft (Nasdaq: MSFT  ) to Intel (Nasdaq: INTC  ) to Schering-Plough (NYSE: SGP  ) -- have low Flow Ratios. Oppositely, a number of wounded companies -- from Sunglass Hut, to Bombay Company to GranCare to Digi International -- have notably high Flow Ratios.

Flow Ratios for Fool Portfolio stocks will not help you answer questions about these investments but will put you in position to ask intelligent questions about them. Are inventories being sufficiently managed at 3Com? Can Innovex be more aggressive in its collection of international receivables? Is America Online one of our nation's top-tier businesses?

Good luck in your search for answers. And...

Fool on!

Tom Gardner


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