<THE RULE MAKER PORTFOLIO>

Short-term Debt
Closing the Loophole

By Matt Richey (TMF Verve)

ALEXANDRIA, VA (March 26, 1999) -- Springtime has finally arrived here on the East Coast. The sun is shining, flowers are blooming, green leaves are budding, and -- best of all -- annual reports are arriving! This past week, I received reports from three of our companies -- Coca-Cola, Schering-Plough, and Pfizer. On the balance sheet of all three of these companies exists a nasty culprit -- short-term debt. He's an elusive critter that resides in the region known as "Current Liabilities." Like a chameleon, he tries to blend into the background by using a variety of names including any and all of the following (not to mention combinations thereof):

Loans payable
Notes payable
Current maturities of long-term debt
Short-term borrowings

Until now, he has craftily slipped through the cracks of our Rule Maker analysis, but no longer. Tonight, I've pinned him down and will expose him for the costly current liability that he is. Allow me to explain.

In and of itself, short-term debt isn't quite as horrific as I may have painted it. In its favor, short-term debt typically carries a lower interest rate than long-term debt. Nevertheless, unlike all other current liabilities, short-term debt does indeed carry an explicit interest cost. Other current liabilities such as accounts payable and accrued expenses represent a free form of short-term financing for a company.

Here's an example. Let's consider how Coca-Cola's (NYSE: KO) accounts payable represent a free source of financing from its vendors, which supply Coke with the raw materials that go into the bubbly concoction. Because of the beverage giant's tremendous size and strength, it has the upper hand in negotiating the terms of purchase for its raw materials. Vendors of corn syrup, caramel, etc. happily let Coca-Cola take its sweet time in paying them. Why? The vendors have no choice. Coca-Cola drives a hard bargain by forcing the commodity producers to compete against one another for its business. Thus, it is the vendors that finance much of Coca-Cola's current assets in the form of accounts payable.

Similarly, Coke's employees finance another big chunk of the company's current assets in the form of accrued compensation (one of the components of the broader category "accrued expenses"). As with most companies, Coca-Cola only pays its employees periodically, and not until after the work is complete. For each day that employees work without receiving immediate payment, compensation expense is said to "accrue." Like accounts payable, this compensation accrual represents a free form of financing for the company.

In contrast, short-term debt is distinctly different from accounts payable and accrued expenses in that it carries a very explicit cost -- interest. Even though short-term debt carries a relatively low interest cost, it's a cost nonetheless. Just to make this crystal clear, here's how the major categories of current liabilities stack up:

Accounts payable... Good
Accrued expenses... Good
Short-term debt... BAD!

Okay, so what? Well, let's think about how this information fits into our Foolish Flow ratio. (For those who need a refresher on the Flowie, check out our step on QuaVa & the Flow ratio.) Using our original definition of the Flowie, here's how Coca-Cola looks (as of 12/31/98):

Flow Ratio = (Current Assets - Cash & Equivs.)
             ---------------------------------
              Current Liabilities

           = (6,380 - 1,807) / 8,640

           = 0.53
Considering that we look for companies with a Flowie less than 1.0, this is awesome... right? Not exactly -- over half of Coke's current liabilities take the form of interest-bearing short-term debt.

The premise behind the original Flow ratio was that all current liabilities are good. Now we see, however, that in the case of short-term debt, that premise is flawed. But, the ratio is not fatally flawed. By simply subtracting short-term debt from current liabilities, the usefulness of the ratio is restored. Here's how Coke's Flowie looks after making the modification:

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

           = (6,380 - 1,807) / (8,640 - 4,462)

           = 1.09
As you can see, the issue of short-term debt is not a trivial matter. Removing short-term debt from the equation causes Coke's Flowie to more than double. To Coca-Cola's credit, its Flowie is still pretty darn good even after the adjustment. But without adjusting for short-term debt, the original definition of the Flow ratio is somewhat misleading.

So, what do you think? Bring your approval or criticism to the Strategy message board. And, if none of this made sense to you, bring your questions and concerns to the Beginners board. Both message folders are linked below.

Phil Weiss is back next week with official changes to the Rule Maker criteria. Also, prepare yourself for more than a little bragging about his favorite Rule Maker, the Duke Blue Devils, if they win college basketball's big dance.

Have a great weekend!

Matt

03/26/99 Close

Stock  Change    Bid
AXP   -1 3/4   120.75
CHV   -  1/8   86.81
CSCO  -2 1/4   105.19
KO    -  9/16  65.31
GPS   -  5/8   66.25
EK    -  3/8   65.25
XON   +  1/8   71.56
GM    +  3/4   87.94
INTC  -1 1/4   116.69
MSFT  -1 13/16 178.13
PFE   -2 3/4   135.00
SGP   -  11/16 55.69
TROW  -  1/16  33.56
YHOO  -7 5/8   171.38
                   Day   Month    Year  History
        R-MAKER  -1.28%   6.38%  10.89%  40.31%
        S&P:     -0.56%   3.59%   4.68%  29.53%
        NASDAQ:  -0.64%   5.73%  10.33%  46.36%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   24 Microsoft     78.27    178.13   127.58%
    5/1/98   55 Gap Inc.      34.37     66.25    92.76%
   6/23/98   34 Cisco Syst    58.41    105.19    80.08%
    2/3/98   22 Pfizer        82.30    135.00    64.04%
   2/13/98   22 Intel         84.67    116.69    37.81%
   2/17/99   16 Yahoo Inc.   126.31    171.38    35.68%
   8/21/98   44 Schering-P    47.99     55.69    16.03%
   5/26/98   18 AmExpress    104.07    120.75    16.03%
    2/6/98   56 T. Rowe Pr    33.67     33.56    -0.33%
   2/27/98   27 Coca-Cola     69.11     65.31    -5.49%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo    72.41     87.94    21.45%
   3/12/98   20 Exxon         64.34     71.56    11.23%
   3/12/98   15 Chevron       83.34     86.81     4.16%
   3/12/98   20 Eastman Ko    63.15     65.25     3.33%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   24 Microsoft   1878.45   4275.00  $2396.55
    5/1/98   55 Gap Inc.    1890.33   3643.75  $1753.42
   6/23/98   34 Cisco Syst  1985.95   3576.38  $1590.43
    2/3/98   22 Pfizer      1810.58   2970.00  $1159.42
   2/17/99   16 Yahoo Inc.  2020.95   2742.00   $721.05
   2/13/98   22 Intel       1862.83   2567.13   $704.30
   8/21/98   44 Schering-P   2111.7   2450.25   $338.55
   5/26/98   18 AmExpress   1873.20   2173.50   $300.30
    2/6/98   56 T. Rowe Pr  1885.70   1879.50    -$6.20
   2/27/98   27 Coca-Cola   1865.89   1763.44  -$102.45

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo  1230.89   1494.94   $264.05
   3/12/98   20 Exxon       1286.70   1431.25   $144.55
   3/12/98   15 Chevron     1250.14   1302.19    $52.05
   3/12/98   20 Eastman Ko  1262.95   1305.00    $42.05

                              CASH    $185.03
                             TOTAL  $33759.34

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it adds $2,000 in cash (which is soon invested in stocks) every six months.

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