The Early Warning Flow

By Zeke Ashton

[Editor's note: Today's report is a special guest appearance by Zeke Ashton, who goes by Zeke2 on the message boards.]

-- The Fool Flow Ratio. It's a cornerstone of Rule Maker company analysis. Even so, I am continually amazed at how useful this simple ratio can be. Although here in the Rule Maker column we talk about the Flow mostly within the context of large-cap companies, I'd like to emphasize that the Flow is very applicable to companies of any size.

In fact, the Flowie is now one of the first data points I look at when sizing up a potential investment, and I am careful about monitoring the Flow ratio for every company in my portfolio on a quarterly basis. This may sound extreme. It is extreme. But you see, not calculating the Flowie can have nasty consequences.

What turned out to be the worst investment I ever made could have been easily prevented had I just taken the time to calculate a quick Flowie. Instead, I lost half of my investment in a Wall Street minute by purchasing shares in a company with a Flowie that was practically screaming at me, "RUN AWAY! RUN AWAY!"

But before I begin my tragic tale, I'd like to quickly review the theory behind the Flowie. The Flow Ratio is calculated with the following formula:

Flow   (Current Assets - {Cash + Short-term Investments})
Ratio = ------------------------------------------------
            (Current Liabilities - Short-term Debt)
Let's start with the numerator. Current assets are similar to cholesterol levels: It's the ratio of good to bad that determines the quality of health. Cash is the ultimate good current asset. Short-term investments are also good assets. To isolate the bad current assets in the numerator, we subtract cash and short-term investments from the total current assets. Everything left over is bad.

Bad current assets come primarily in two flavors: accounts receivable and inventory. Accounts receivable represent sales for which the company hasn't received payment. The longer it takes to collect on them, the less valuable those original sales become to the company. Inventory represents goods waiting to be sold, but like accounts receivable, the longer those goods have to wait before they get sold, the less valuable they are to the company.

In the denominator of the Flowie, we have the good current liabilities. These are generally bills the company has to pay. The most common of these are accounts payable, which are simply goods and services the company has received but hasn't yet paid for. Good current liabilities are those that don't accrue interest. Each day that the company can put off paying these bills without being assessed an interest penalty is another day that they can keep that cash earning interest. Dividing the bad current assets by the good current liabilities gives us the Flow Ratio. The lower the Flow, the better the business is at maximizing the value of its cash flow. But that's not all.

A low Flowie tells an investor that the company in question features a light business model and/or excellent financial management; the company might also possess powerful financial leverage due to leadership in the industry. A rising Flowie reflects the deterioration of these qualities. If the Flowie gets up over 3.0, get as far away as you can, because a nuclear meltdown is imminent.

I'm speaking from experience. To illustrate, I will now relate the epic tale of how the Flowie could have saved me from a poor investment decision. Safeskin Corp. (Nasdaq: SFSK), a leading manufacturer of medical gloves, appeared to have the makings of a great small-cap investment when I first analyzed the company in early 1998. The company had a string of nine consecutive years of 25% or greater sales growth. Earnings per share (EPS) growth was nothing short of spectacular, and the company was generating very strong cash flow and buying back oodles of shares.

I started my analysis with a look at the 1997 annual report. I noted with interest the exceptional sales and earnings growth and increasing profit margins. At the time, novice that I was, I hadn't yet started applying the Flow Ratio for small-cap companies. I wouldn't have touched a big-cap stock with a Flowie over 1.25 (even if I was wearing Safeskin latex-free medical gloves), but I figured that the Flowie just wasn't all that applicable to smaller companies. The Flow Ratio was 1.65 for Safeskin at year-end 1997. Now, a Flow of 1.65 certainly doesn't cut the mustard for a Rule Maker stock, but it is fairly respectable for a small manufacturer. I was intrigued by the company, but didn't invest. I kept Safeskin on my radar and checked up on it the next quarter.

The financial results for the second quarter of 1998 were even more impressive, with EPS growth of 50% over the year before. Gross profit margins increased to 52% from 44%. I began to salivate. In my enthusiasm, I failed to notice that inventories were growing much faster than sales. The Flow Ratio, had I thought to calculate it, would have given me pause; it had swollen to 2.23. Still, I held off with my investment. I wanted to be really sure that I was getting top quality for my money. For Q3 1998, the company once again posted sparkling sales and earnings growth.

What I really, really should have noticed, and can't explain why I didn't, was that accounts receivable had almost doubled from the previous quarter, and was growing at three times the rate of sales! Had I calculated a Flow, it would have probably laughed at me for even considering an investment in this company. Sadly, I was oblivious to a Safeskin Flow that had ballooned to 3.19, which -- just so you know -- is spontaneous combustion territory.

Smart shareholders had begun to notice, and buyers of the stock were staying away in droves. The share price drifted down from a high of $47 in January '98 to about $25 by November. In December of '98, the stock dropped to under $20, where I finally made my move, jumping on it at $18. In the earnings call for Q4, Safeskin CEO Richard Jaffe predicted a record year in 1999. Several analysts in the call pointed out the high inventory totals, which Jaffe explained as simply being a precautionary measure associated with the move of the production facilities from Malaysia to Thailand. Jaffe assured the analysts that this was nothing to be concerned about. The stock experienced a short-term rally to $26, which I took as evidence that I'd made a great investment.

Finally, in March, the Flow hit the fan. The company warned that it would miss earnings estimates by a whopping $28 million, or $0.25 a share. This shortfall was due to increasing pressure on profit margins, caused in large part by inventory channels that were stuffed full of gloves. This did not please the analysts, whose consensus estimate for the quarter had been� $0.26 per share. Investors dropped the stock like nobody's business, and I was left with less than half my initial investment by the end of the day. Customers and distributors are still working off the excess inventory, and it doesn't look like Safeskin will be recapturing their profitable touch for quite a while.

In doing a post-mortem analysis, it became obvious that the Flow had been trying to tell me all along to stay clear. (On March 17, Louis Corrigan wrote a great piece in the Fool on the Hill, listing several other clues that a smart investor could have used to avoid my fate.) Thus, my new policy: Every company, every quarter, I calculate the Flow Ratio. Consistent deterioration of this ratio for three quarters rates a serious review of the financials. If the Flow gets over 3.0, I'm outta there. With that, fellow Fools, my story is ended. Go forth, prosper, and may the Flow be with you!