<THE RULE MAKER PORTFOLIO>
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.
Be sure to check out this week's Rule Maker Challenge (a variation on our Question of the Week). Write a few lines of verse about a Rule Maker, and you may win an autographed copy of Rule Breakers, Rule Makers.
Finally, are you fully Foolish? As a registered Fool, you'll enjoy the full benefits of the site, including special discounts, contests, and news of whenever Fools will be appearing in your neighborhood to speak. Click here to register for free.
Also, if you love Foolishness and want to share it with others, our new feature, Yo!, allows you to send your favorite Foolish features to all of your friends, family, and co-workers. Check it out.
Have a Foolish evening,
- Rule Maker Strategy Board
- Rule Maker Companies Board
- Rule Maker Beginners Board
- Rule Maker Spreadsheet (Excel 97, 68k)
- Rule Maker Spreadsheet (Excel 95, 41k)
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.