"Flow Ratio" Explained

The flow ratio is a handy measure you can calculate using a company's balance sheet. It reveals how effectively cash flow is managed. Here's the formula:

Flow Ratio = (current assets - cash) / (current liabilities - short-term debt)

Note that if you run across a separate entry called "marketable securities" in current assets, you should treat that like cash and subtract it from current assets, too. Marketable securities are things like stock holdings that can be liquidated into cash very quickly.

Let's consider the "Flowie" of Johnson & Johnson (NYSE: JNJ  ) as an example. For its fiscal year ended in 2003, it sported $23 billion in total current assets. Subtract its $5.38 billion in cash and its $4.14 billion in marketable securities, and you get $13.48 billion. Next, take current liabilities ($13.45 billion), and subtract short-term debt ($0). Divide the first result ($13.48 billion) by the second ($13.45 billion), and you'll arrive at a flow ratio of about 1.00.

Any result below about 1.25 is admirable, so 1.00 is pretty good. A little more number-crunching will reveal that in 2001, J&J's flow ratio was 1.31, and the year before that, 1.37, so there's improvement happening. (In 1999, it was 1.25, and in 1998, it was an excellent 1.05.)

Think about the ratio's components, and you'll better understand what it's showing you. When you subtract cash from current assets, you're mainly left with accounts receivable and inventories. Ideally, a powerful company will demand rapid payment from its customers, keeping its accounts receivables at low levels. Likewise, it will manage to keep only necessary minimum inventory on hand. So, a low number for this part of the flow ratio equation is a good thing.

Meanwhile, current liabilities, after you subtract debt, are usually dominated by accounts payable. That's money a company owes and can temporarily use -- interest-free. Industry-dominating companies often wield enough clout to demand favorable payment terms. A high number for this part of the flow ratio is preferred.

Divide an ideally low asset number by an ideally high liability number, and you get a low flow ratio. This suggests a company aggressively collecting payment from others, while gradually making its own payments, resulting in more cash at its disposal. And, since cash is the lifeblood of a company, a low (and preferably declining) flow ratio is indicative of a strong and healthy business.

If you'd like to learn a lot of terms at once, and also become skilled at reading financial statements, look into our "Crack the Code: Read Financial Statements Like a Pro" How-to Guide. Give it a whirl -- what do you have to lose, except your fear of financial statements?

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