Fool.com: Rule Maker Metrics (Stock Research) April 20, 2000

Research Rule Maker Metrics, Part 1

By Matt Richey (TMF Verve), Tom Gardner, and Zeke Ashton (TMF Centaur)
April 20, 2000

Flow Ratio? Cash King Margin? Motley Fool Research Reports often refer to these metrics, but unless you're a devotee of the Rule Maker Portfolio, you may not know what they mean. Never fear. The Rule Makers are here to teach you all about how we evaluate companies the Rule Maker way.

In the Rule Maker corner of Fooldom, our philosophical approach to investing is grounded upon the importance of cash. Cash is a company's lifeblood. The saying, "It takes money to make money," is actually the operating principle here. A company with cash can do all sorts of cool stuff: spend aggressively on brand building, invest in the research and development of new products, fund embryonic business lines, and if nothing else, buy back shares of its own stock. Activities like these grow the value of your investment in a company.

Invested prudently, cash begets more cash. So, since cash is so important, we as investors should look for companies with two traits: cash conservation and cash generation. This week, we'll take a look at cash conservation using the Flow Ratio.

Measuring Cash Conservation with the Flow Ratio

We measure cash conservation through a simple tool called the Flow Ratio. Developed by Tom Gardner, the Flow Ratio tells us how well a company is managing its working capital, or its current assets and current liabilities, as they're referred to on the balance sheet. Allow us to explain.

We want our companies to bring money in quickly, but to pay it out slowly. More cash coming in today, less cash going out today. If that makes sense, then let's go to the balance sheet and dig up some relevant entries, specifically current assets and current liabilities. Current assets represent assets that are expected to turn into cash in the coming year, while current liabilities represent all costs that will have to be paid down in the coming year.

This is where we might get confusing. We're going to try to convince you that non-cash current assets aren't assets at all. They're liabilities! And some liabilities are, for all practical purposes, assets! OK, stay with us, we can explain.

When you take the cash out of current assets, you're left with two primary categories: inventory and accounts receivable. The former is product in various stages of development that hasn't been sold yet. Some of it is raw material; some of it is finished product waiting to be sold. But let us convince you that all of it is a liability. Why? Because there's a cost to storing inventory on shelves in an enormous warehouse outside of town. Wouldn't you be much happier to see that inventory in a store today, in the form of a giant stuffed Donald Duck doll in the hands of a parent out birthday shopping? So would we. Certainly, almost every company on the planet has to carry inventory. We just like those that can quickly assemble product and race it out to the door into the marketplace. Because, after all, inventory is just potential cash sitting on shelves. We'd rather have the cash, thank you.

The remaining current asset category is accounts receivable, which reflect payments that the company hasn't collected yet. Let's say that you've invested in a camera maker that has $43 million in accounts receivable. That entry reflects $43 million of cash from operations that your company is owed by its customers. Maybe $10 million of it came from camera sales into Europe -- from which payments take eight to ten weeks. That cash isn't yet in your company's coffers. It isn't going to work for the business. Its delayed arrival, Fool, is a liability to the business. Well-positioned companies are able to require upfront payments from customers and also have mastered the art of keeping inventory low while driving sales higher.

That's the current assets line. And as we've said, when cash and marketable securities are removed from the grouping, we like to see that number low and falling.

"Low -- huh? Low relative to what?"

Aha, yes. By "low" we mean low relative to current liabilities. Now that you know that current assets represent all things that will be turned into cash in the year ahead, you know as well that current liabilities represent all costs that will have to be paid down over the next year. Contrary to your personal finances, many companies would like to hold off their short-term payments for as long as possible. If they can earn more by holding their cash than they can by doling it out to their suppliers, they should want to hold onto it. The key to that is in their writing of contracts and in the stable, prominent, desirable position they've gained in their industry. For example, small businesses working with General Electric (NYSE: GE) will often gladly accept payments three months after billing. Why? Because working with General Electric brings them steady income, strengthens their reputation, and helps them stay in business.

So what we've just proposed is as contrary as it comes. We're telling you, Fool, that when it comes to large, profitable companies, you should think of current assets as actually being current liabilities, and vice versa. Those accounts receivable and those inventories are a bad thing. Those payments your company can hold off for a few more weeks are a good thing. Except for short-term debt, which carries the burden of interest, all other current liabilities represent a free form of financing. Free is good. We like free.

But, you ask, "How can we possibly measure all that?" Well, with a little something we call the Flow Ratio. The Flow Ratio enables you to cut through accounting shenanigans and artfully constructed income statements to get a clear snapshot of how a company is managing its cash. The simple calculation here is:

(Current Assets - Cash*)
-------------------------------
(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

We generally go in search of Flow Ratios that run lower than 1.25, and ideally below 1.0. If they get below 1.0, it means that the business is able to delay more payments than they're carrying in costs of inventory and unpaid bills. In this group below 1.0, you'll find companies like Microsoft (Nasdaq: MSFT), America Online (NYSE: AOL), Intel (Nasdaq: INTC), and others. These are companies that are in such a strong position that they have leverage over their partners -- both those that supply them with raw materials or services and those that help them distribute stuff to the end consumer.

Ready for an example? Let's take a look at Rule Maker Intel's balance sheet.

Intel Fiscal Year 1999
Cash & Cash Equivalents= $11.8 billion
Current Assets = $17.8 billion
Short-term Debt= $0.2 billion
Current Liabilities= $7.1 billion

             (Current Assets - Cash & Equiv.) 
Flow Ratio=------------------------------------
         (Current Liabilities - Short-term Debt) 

= (17.8 - 11.8) / (7.1 - 0.2) 
= 0.87
The Flow Ratio is just one of many measures of quality, but we think it makes an excellent starting point. Again, we want companies that have a Flow Ratio less than 1.25, and ideally less than 1.0.

The Flowie is your friend. By calculating it, you'll be measuring how tightly the company manages cash as it flows through its business. Is it being lazy in collecting its bills? Is it being sloppy in managing its inventory? Is it in such a weak financial position that its partners demand cash payments from it upfront? If so, look out... this probably isn't a darling horse nor a long-term winner.

Next week, we'll continue our look at Rule Maker metrics with the Cash King Margin.

Related Links:

  • Rule Maker Portfolio
  • The 11 Steps to Rule Maker Investing
  • Rule Maker Strategy Discussion Board