The Flow Ratio as a Measure of Business Strength

By Phil Weiss

TOWACO, NJ (March 30, 1999) -- So much for my ability as a prognosticator. My hat goes off to UConn. They were the better team last night. Moving on...

In last Friday's report, Matt said the following:

"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."

This prompted Al to send his fellow Rule Maker managers the following note:

"Phil and I had a HUGE, public Foolish argument about whether it was good or bad for a company to use the float on employee compensation for its own purposes. I said it was good, Phil said what was bad for the employees was bad for the company (more or less). It seems that brother Matt is on my side. Is this the final word on this, or do we open up this debate again? I guess we'll find out next week in Phil's column."

A little later in Matt's column he went on to summarize current liabilities like this:

"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! "

I hope that you haven't gotten the impression that all the Managers of this portfolio agree on everything (except, of course, for Oak's feelings about Microsoft). Fortunately, that's not the case. It's actually more constructive when we have conflicting viewpoints to reason our way through.

I believe that the disagreement between Al and me started when we both wrote about Tellabs (Nasdaq: TLAB) last September (my column; Al's column). This debate was what led me to propose that the Pure Flow Ratio might be an even better metric than our recently revised Flow Ratio (formerly known as the "unleveraged Flow Ratio"). Unfortunately, our further research has shown that the Pure Flow Ratio yields inconsistent results, although I haven't yet given up on it altogether.

I think that Matt's characterization of the current liabilities section of the balance sheet is just too generic. Some accrued expenses are good, while some don't mean much of anything at all to me. If you really want to split hairs about things, I could even say that not all accounts payable are good current liabilities. I say this because sometimes the payment terms for accounts payable provide the purchaser with a discount for prompt payment. Unfortunately, the financial statements do not reveal this level of detail. Since I believe in the management of our companies, I assume that they take advantage of any discounts offered for prompt payment.

When I read Al's note Friday night, I first thought more about the issue from a generic perspective. Then, I decided to pick apart the current liabilities section of Cisco's (Nasdaq: CSCO) balance sheet as a way of really explaining my position. We'll go through the generic part of my analysis tonight. Tomorrow night, I'm going to walk through the different line items that can be found in the current liabilities section of Cisco's balance sheet. When we're done, I hope that I'll have given you some more insights into why we bother to calculate the Flow Ratio, what it can tell us, and why we think it's such an important measure of quality.

First off, let me say that there are parts of what Al and Matt have said that do make sense to me. Other than short-term debt, current liabilities can represent a form of free financing from our suppliers, employees, customers, and other service providers. We're more than happy to see our companies delay such payments without incurring any additional financing costs. I don't dispute that accrued payroll expense represents free financing for the company.

I also don't dispute that some companies have the ability to defer payment of salaries more than others. For example, many Merck employees are paid monthly. My complaint with accrued expenses as a general category is that a number of its individual components fluctuate much more wildly than accounts payable. Further, a lot of the amounts included in accrued liabilities are actually just dependent upon a company's ability to generate sales and profits rather than exhibiting financial strength.

When it's company policy to compensate employees a certain way, that's fine. This applies no matter who's being paid. When you work for a company, you take the job and you know how you're going to be paid. If you accept stock options (which don't even appear on the company's balance sheet), you're deferring things even more (and with a bit of risk as well). But, I think that if companies started paying employees, service providers, suppliers or anyone else erratically, there'd be problems. For one, erratic payment could cause the company to have bad employee relations. That's the 7th of Philip Fisher's 15 points. It could also lead to one questioning the integrity of the company's management (Fisher's 15th point). The point is that a payment policy that improves the Flow Ratio by increasing accrued expenses could potentially be an overall negative event for the company.

The lesson is that you have to be careful with how you view accrued expenses. Some are good; others are bad. If a company accrues some expenses (e.g., advertising or for a reserve for an anticipated expense), then all it's done is bump up current liabilities without doing anything that's even remotely Rule Makerish. Since accounts payable represent the best of all current liabilities, I really like the Pure Flow Ratio concept. Unfortunately, there is substantial variation in Pure Flow Ratio results from one company to the next.

I'll be back tomorrow to work my way through the current liabilities section of Cisco's balance sheet.

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Have a Foolish evening,


03/30/99 Close

Stock  Change    Bid
AXP   -1 13/16 121.50
CHV   -  15/16 89.00
CSCO  -  1/16  109.94
KO    -1 1/2   63.25
GPS   +1 9/16  69.00
EK    -  3/4   64.88
XON   -1 11/16 71.31
GM    -  1/8   87.38
INTC  +  1/8   121.56
MSFT  +  5/8   93.00
PFE   +1 3/16  142.19
SGP   +  11/16 56.31
TROW  -  5/8   33.94
YHOO  -3 11/16 172.31
                   Day   Month    Year  History
        R-MAKER  -0.17%   8.89%  13.51%  43.63%
        S&P:     -0.72%   5.04%   6.14%  31.32%
        NASDAQ:  -0.50%   8.40%  13.12%  50.06%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   48 Microsoft     39.13     93.00   137.64%
    5/1/98   55 Gap Inc.      34.37     69.00   100.76%
   6/23/98   34 Cisco Syst    58.41    109.94    88.22%
    2/3/98   22 Pfizer        82.30    142.19    72.77%
   2/13/98   22 Intel         84.67    121.56    43.57%
   2/17/99   16 Yahoo Inc.   126.31    172.31    36.42%
   8/21/98   44 Schering-P    47.99     56.31    17.33%
   5/26/98   18 AmExpress    104.07    121.50    16.75%
    2/6/98   56 T. Rowe Pr    33.67     33.94     0.78%
   2/27/98   27 Coca-Cola     69.11     63.25    -8.48%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo    72.41     87.38    20.67%
   3/12/98   20 Exxon         64.34     71.31    10.85%
   3/12/98   15 Chevron       83.34     89.00     6.79%
   3/12/98   20 Eastman Ko    63.15     64.88     2.74%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   48 Microsoft   1878.45   4464.00  $2585.55
    5/1/98   55 Gap Inc.    1890.33   3795.00  $1904.67
   6/23/98   34 Cisco Syst  1985.95   3737.88  $1751.93
    2/3/98   22 Pfizer      1810.58   3128.13  $1317.55
   2/13/98   22 Intel       1862.83   2674.38   $811.55
   2/17/99   16 Yahoo Inc.  2020.95   2757.00   $736.05
   8/21/98   44 Schering-P   2111.7   2477.75   $366.05
   5/26/98   18 AmExpress   1873.20   2187.00   $313.80
    2/6/98   56 T. Rowe Pr  1885.70   1900.50    $14.80
   2/27/98   27 Coca-Cola   1865.89   1707.75  -$158.14

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo  1230.89   1485.38   $254.49
   3/12/98   20 Exxon       1286.70   1426.25   $139.55
   3/12/98   15 Chevron     1250.14   1335.00    $84.86
   3/12/98   20 Eastman Ko  1262.95   1297.50    $34.55

                              CASH    $185.03
                             TOTAL  $34558.53

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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