FOOL ON THE HILL
An Investment Opinion
I've found this simple numeric to be the most revealing metric in my analytical toolbox. Why? It lends a great deal of insight into how well a company generates cash. Today, I want to demonstrate the power of the Flowie by comparing the two titans of networking, Cisco Systems (Nasdaq: CSCO) and Lucent Technologies (NYSE: LU).
First a little background on ye olde Flow Ratio. Invented by Tom Gardner in the early days of the Rule Maker Portfolio, the Flow Ratio is easy to calculate, involving just four numbers from the balance sheet:
Flow Ratio = Current Assets - Cash
Current Liabilities - Short-term Debt
Okay, so what does that mean? Well, the numerator -- current assets minus all cash and equivalents -- represents a company's investment in inventory, accounts receivable, and prepaid expenses. These are items that the company has already paid for, and now they're just sitting around and waiting to be converted into cash at a future date. If that doesn't sound like such a good scenario, you're exactly right! With the Flow Ratio, it's best to see as low a numerator as possible.
If the logic behind the numerator makes sense to you, then just reverse your thinking for the denominator. Current liabilities are essentially a company's interest-free IOUs. In other words, these monies represent goods and services which the company has already purchased and received but hasn't yet paid for. In the corporate world, such a scenario is a very good thing because current liabilities are a chance to get something for nothing -- for a short period of time, at least. The only "bad" type of current liability is short-term debt because it carries interest charges. Thus, we subtract short-term debt from the current liability total. The end result is that, compared to the Flow Ratio's numerator, we like to see the denominator as high as possible.
All in all, we're generally looking for Flow Ratios below 1.25 -- and the lower the better -- but the direction of the number over time is perhaps more important than the static location during any one quarter. More on that later. (If you're still a little foggy on the Flow Ratio, here's a more thorough explanation.)
Okay, with that explanation behind us, let me continue my tale. Last week, I was updating my financial spreadsheets, which I keep for a number of companies that I follow. Two of those companies are Cisco and Lucent. I found it more than a little interesting to compare the two companies' Flow Ratios over the past ten quarters. Here's what I found:
Date Flow Stock Flow Stock
12/97 1.47 $22.05 1.44 $10.51
03/98 1.56 $38.01 1.31 $12.21
06/98 1.57 $46.07 1.17 $15.96
09/98 1.69 $40.01 1.13 $18.84
12/98 1.89 $56.19 1.12 $27.89
03/99 2.03 $59.92 1.03 $28.52
06/99 2.18 $65.62 0.87 $31.06
09/99 2.26 $64.19 1.03 $44.59
12/99 2.67 $55.48 0.99 $54.75
03/00 2.80 $62.19 0.87 $69.33
CHANGE 90.5% 182.0% -39.6% 559.7%
As you can see, both companies began with similar Flow Ratios of around 1.4. But since then, the two companies have taken opposite roads entirely. Cisco has worked its Flow down by nearly 40% to a marvelous 0.87, whereas Lucent has allowed its Flow to skyrocket by more than 90% to a hideous 2.80. What's the difference, you say? Well, for one, Cisco's stock has more than doubled Lucent's performance -- and I think the Flow Ratio may tell us why.
The Flow Ratio's basic purpose is to tell us how well a company is managing its working capital. (Working capital defined simply as current assets and current liabilities.) It doesn't show up on the income statement, but working capital needs can take a huge toll on a company. The quality of a company's working capital management, as measured by the Flow Ratio, has an enormous impact on the company's ability to generate cash. To see what I mean, let's dig deeper into Lucent and Cisco's net investment in working capital. The calculation here is just a slight twist on the Flow Ratio:
(Current Assets - Cash)
- (Current Liabilities - ST Debt)
Net Investment in Working Capital
Below, I calculated both Cisco and Lucent's net investment in working capital at the end of 1997.
$ Millions Cisco Lucent
Cash 1,614 1,225
Current Assets 3,556 13,256
Short-term Debt 0 1,757
Current Liabilities 1,350 9,962
in Working Capital 592 3,826
As you can see, Cisco's working capital needs were only a fraction of Lucent's even in 1997. But look at what's happened since then:
$ Millions Cisco Lucent
Cash 4,653 1,709
Current Assets 9,080 22,414
Short-term Debt 0 1,890
Current Liabilities 5099 9,292
in Working Capital -672 13,303
Over the past ten quarters, Cisco has reduced its net investment in working capital to a negative number. This is a CFO's dream. Negative net working capital means Cisco's inventory and receivables are more than totally financed by suppliers and customers on an interest-free basis. In contrast, Lucent has nearly quadrupled its working capital investment, which now measures in the tens of billions of dollars. That's a serious cash outlay. Here's the tale of the tape:
Dec. '97 thru Mar. '00
$ Millions Cisco Lucent
Change in Net Investment
in Working Capital -1,264 +9,477
The change in net working capital between 1997 and today represents the inflow or outflow of cash. A negative number means an inflow of cash; a positive number means an outflow. Cisco, by reducing its working capital needs through efficiency gains, generated an extra $1.26 billion in cash. In stark contrast, Lucent's working capital slothfulness drained the company of nearly $9.5 billion. Any guesses as to which company has the lighter business model?
Over the past year, Lucent's free cash flow has been, well, non-existent -- to the tune of negative $1.15 billion. Cisco, on the other hand, has generated positive free cash flow of better than $4.5 billion over the same period. In the quarters ahead, continue to watch those Flow Ratios instead of P/E ratios to determine the better investment.