Back to Basics, Part 4
Balance Sheet Analysis

By Matt Richey (TMF Verve)

ALEXANDRIA, VA (July 9, 1999) -- Tonight, we're wrapping up our Back to Basics week with a look at two simple numerics from the balance sheet: the cash-to-debt ratio and the Flow Ratio. If you're new to this stuff, I encourage you to pay especially close attention as these are perhaps the two most important metrics of the following ten Rule Maker Essentials:

  1. Dominant brand
  2. Repeat-purchase business
  3. Convenience
  4. Expanding possibilities
  5. Your familiarity and interest
  6. Sales growth of at least 10%
  7. Gross margins of at least 50%
  8. Net-profit margins of 7% or greater
  9. Cash no less than 1.5x long-term debt
  10. Efficient use of cash (Flow Ratio below 1.25)

Once again, most of the following material is the fine writing of Tom Gardner. As you know, Fools rush in, so let's get started!

9. Cash No Less Than 1.5x Total Debt

We say it of your personal finances, and we'll say it of Rule Maker companies. We'd prefer the financial statements to show little or no debt. Who wants to own a business that announces phenomenal earnings today only because they borrowed heavily from their tomorrow? If we want to invest in a company that's going to thrive for 10 - 20 years or more, we don't want short-term profits at the expense of long-term survival and success. No, no... we'd prefer to find companies that grow their business out of profits from operations and, thus, don't have substantial interest payments to make to banks in the years ahead.

Because most companies will, and must, borrow money at some point, we don't want to cross off our list all businesses with some debt on their balance sheet. Therefore, we require that a company's cash be at least 1.5x greater than their total debt (including both long-term and short-term debt). A moderate amount of debt doesn't particularly worry us, but if and when bad things do occur, when something goes bump in the night, it's essential that the company have ample and immediate cash resources to deal with the problem. We want them to get their business back on track quickly, earning moola for shareholders. And make no mistake about it, over the course of a decade or two, or three, bad things will happen to every company, even the greatest ones imaginable. Do you remember New Coke? How about Microsoft's MSN Online, Version 1? And what about McDonald's infamous McDLT? Or, who remembers their McLean sandwich?

Things can go wrong. Things will go wrong. We want companies with the cash to buy themselves out of trouble when it comes knocking on the door.

Now, pulling numbers from the 1998 balance sheet of pharmaceutical maker Schering-Plough (NYSE: SGP), here's an example:

Cash           ST Debt + LT Debt     Multiple
$1,259 mil    ($558 mil + $4 mil)     2.24x

Again, we want businesses that have savings that amount to 150% (or 1.5x) of their total debt.

10. Efficient Use of Cash (Flow Ratio below 1.25)

Okay, and now for one more important numerical -- the use of that cash. In the day-to-day management of a company's operation, money is going to rush through the front door from sales, and it's going to fly out the window and the backdoor from expenses. As noted earlier in these steps, businesses survive on cash. That's their oxygen. Without dollars coming in, they can't pay for employees, for equipment, for insurance, for holiday parties, for new technology, for anything. So, how a business manages the dollars that flow through their daily operations is of critical importance.

We want companies that we invest in 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, 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, thanks.

The remaining current-asset category is accounts receivable, which reflect payments that your 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 8-10 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 they 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 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

Guidelines for the numbers? We go in search of Flow Ratios that run lower than 1.25, 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, America Online, Intel, and others. Companies in such strong position that they have leverage over their partners -- that being 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?

Schering-Plough Fiscal Year 1998

Cash & Cash Equivalents = $1,259 mil
Current Assets               =   3,958
Short-term Debt              =     558
Current Liabilities           =   3,032

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

           = (3,958 - 1,259) / (3,032 - 558) 

           = 1.09

The Flow Ratio is just one of many measures of quality. But we think it makes for 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 running it, you'll be measuring how tightly the company manages cash as it flows through their business. Are they being lazy in collecting their bills? Are they being sloppy in managing their inventory? Are they in such a weak financial position that their partners demand cash payments from them upfront? If so, look out... this probably isn't a darling horse nor a long-term winner.

Rule Maker Essentials Spreadsheet

Over the past four days, you've seen the rationale behind the core Rule Maker investment criteria. As we said at the outset, the 10 "essentials" do not encompass every factor worth consideration when studying a company, but we think they're a great start. To help you use these 10 principles as you evaluate companies on your own, we've created an easy-to-use Excel spreadsheet, formatted for both Excel 95 and 97. Best of all, it's free! The download link for this sheet is directly below.

In David and Tom Gardner's book Rule Breakers, Rule Makers, Tom expands on the above criteria with a more comprehensive method of measuring a company's Rule-Making authority. If you've read the book or are a veteran of Rule Maker investing, we recommend the more advanced capabilities of the RM Ranker spreadsheet (also free! and linked below).

Finally, you'll notice that we've updated our Rule Maker Steps to Investing to incorporate the new changes in the Criteria Step.

Have a Foolish weekend!

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    07/09/99 Close

    Stock Change    Bid
    AXP   -  1/4    133.50
    CHV   -  7/8     97.25
    CSCO  +  5/8     67.06
    EK    +  7/16    71.13
    GM    -1 5/8     66.13
    GPS   -  1/16    51.56
    INTC  +  1/2     66.25
    KO    +  1/2     63.63
    MSFT  +  11/16   93.25
    PFE   -  3/16    37.00
    SGP   +  5/8     52.38
    TROW  -1 3/8     34.63
    XON   -  3/16    79.44
    YHOO  -4 7/16   160.00
                      Day     Month  Year    History
            R-MAKER  -0.19%   1.75%  15.74%  46.45%
            S&P:     +0.64%   2.22%  14.74%  41.88%
            NASDAQ:  +0.77%   4.00%  27.38%  68.98%
    Rule Maker Stocks
        Rec'd    #  Security     In At       Now    Change
        2/3/98   48 Microsoft     39.13     93.25   138.28%
       6/23/98   68 Cisco Syst    29.21     67.06   129.63%
        5/1/98 82.5 Gap Inc.      22.91     51.56   125.04%
       2/13/98   44 Intel         42.34     66.25    56.48%
        2/3/98   66 Pfizer        27.43     37.00    34.87%
       5/26/98   18 AmExpress    104.07    133.50    28.28%
       2/17/99   16 Yahoo Inc.   126.31    160.00    26.67%
       8/21/98   44 Schering-P    47.99     52.38     9.13%
        2/6/98   56 T. Rowe Pr    33.67     34.63     2.83%
       2/27/98   27 Coca-Cola     69.11     63.63    -7.93%
    Foolish Four Stocks
        Rec'd    #  Security     In At     Value    Change
       3/12/98   20 Exxon         64.34     79.44    23.47%
       3/12/98   15 Chevron       83.34     97.25    16.69%
       3/12/98   20 Eastman Ko    63.15     71.13    12.63%
       3/12/98   17 General Mo    72.41     66.13    -8.67%
    Rule Maker Stocks
        Rec'd    #  Security     In At     Value    Change
        2/3/98   48 Microsoft   1878.45   4476.00  $2597.55
       6/23/98   68 Cisco Syst  1985.95   4560.25  $2574.30
        5/1/98 82.5 Gap Inc.    1890.33   4253.91  $2363.58
       2/13/98   44 Intel       1862.83   2915.00  $1052.17
        2/3/98   66 Pfizer      1810.58   2442.00   $631.42
       2/17/99   16 Yahoo Inc.  2020.95   2560.00   $539.05
       5/26/98   18 AmExpress   1873.20   2403.00   $529.80
       8/21/98   44 Schering-P   2111.7   2304.50   $192.80
        2/6/98   56 T. Rowe Pr  1885.70   1939.00    $53.30
       2/27/98   27 Coca-Cola   1865.89   1717.88  -$148.02
    Foolish Four Stocks
        Rec'd    #  Security     In At     Value    Change
       3/12/98   20 Exxon       1286.70   1588.75   $302.05
       3/12/98   15 Chevron     1250.14   1458.75   $208.61
       3/12/98   20 Eastman Ko  1262.95   1422.50   $159.55
       3/12/98   17 General Mo  1230.89   1124.13  -$106.77
                                  CASH     $70.09
                                 TOTAL  $35235.75

    Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.

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