TOWACO, NJ (December 10, 1999) -- Over the next two reports, I'm going to talk about my favorite Rule Maker analytical tool, the flow ratio, and the important financial concepts that weigh into that simple little ratio. What I like most about the flow is the way it helps tie together the income statement and balance sheet and also gives some insights into what you'll find by taking a gander at the all important Statement of Cash Flows. If you stick with me for tonight's report and then again next week for part two, I think that you'll have a better understanding of how a company's financials reveal what's really happening inside the business.

For tonight, we're going to take a whirlwind tour through the cash flow statement and balance sheet. First, we'll review the concept of free cash flow. Then, we'll discuss the balance sheet concept of "working capital," and how it impacts cash flow. That information will form the backdrop for gaining a comprehensive understanding of exactly what the flow ratio means and why it has such a great impact on a company's cash flow. With that, let's jump into the cash flow statement.

From time to time, you've seen us talk about a company's ability to generate "free cash flow." As economic animals, corporations live to generate as much free cash as possible, while utilizing the least amount of resources in the process. Quite simply, free cash flow is the cash that's left over after everything -- bills from suppliers, salaries, expenses for the annual holiday bash, new equipment to expand the business -- is said and done. In theory at least, free cash flow is the amount of cash a business could issue to shareholders in the form of a dividend check.

To calculate free cash flow, all you have to do is go to the cash flow statement and find the line called "cash flow provided by operations," also known simply as "operating cash flow." Once you've found that, all you have to do is subtract net capital expenditures and what's left is free cash flow. Nothing to it. Really, it's not as tough as you might have it cracked up to be.

Let's walk through an example using Yahoo!'s (Nasdaq: YHOO) cash flow statement for the first nine months of this year (from Yahoo!'s Q3 10-Q). For your viewing pleasure, I've included the relevant portion of the cash flow statement directly below.

                            YAHOO! INC.
  Condensed Consolidated Statements of Cash Flows ($ thousands)

                                                     Nine Months Ended
                                                       September 30,
                                                     1999        1998
Net income (loss)                                 $ 16,395    $ (16,514)
Adjustments to reconcile net income (loss):         
 Depreciation and amortization                      31,940        9,838
 Tax benefits from stock options                    10,493        8,675
 Non-cash charges related to stock option grants     1,868        1,392
 Minority ints. in operations of cons. subsidiaries  1,733        (365)
 Purchased in-process research and development       9,775       15,000
 Changes in assets and liabilities:  
  Accounts receivable, net                          (9,797)     (13,952)
  Prepaid expenses and other assets                 (3,125)       2,752
  Accounts payable                                    (273)       2,583
  Accrued expenses and other current liabilities    31,283       12,331
  Deferred revenue                                  32,569       26,759
                                                 ----------   ----------
 Net cash provided by operating activities (A)     122,861       48,499
                                                 ----------   ----------
 Acquisition of property and equipment (B)         (30,617)     (12,448)
                                                 ----------   ----------
Free Cash Flow (= A + B)                            92,244       36,051

Let's take this step by step. First off, we start with net income (or loss) from the income statement, which always appears as the top line of the cash flow statement. Next, we add back any non-cash expenses, of which depreciation and amortization is the largest. Last, we finish up by adjusting for the changes in current assets and current liabilities. What we're left with after we've adjusted for these items is operating cash flow. The final step in arriving at free cash flow is to simply subtract the "additions to property and equipment." In the case of Yahoo!, its advertising and commerce businesses have generated in excess of $92 million so far this year. Not bad.

(On a somewhat technical note, notice that this last step is labeled as "A + B" because rather than subtracting, it's the addition of a negative number. Within the statement of cash flows, any positive number is an addition of cash and any negative number is a deduction of cash.)

Now that I've laid some foundation, let's take a look at what "working capital" is, how it relates to the way a company manages its business, and its connection with the flow ratio in terms of bringing all of a company's financial statements together. By definition, working capital is current assets less current liabilities. So, when I use the term "working capital management," I'm referring to a company's management of its current assets and liabilities.

When we calculate the flow ratio, even though current assets -- such as accounts receivable and inventory -- are listed on the balance sheet as "assets," we Rule Maker investors consider them to be liabilities for all practical purposes. The reason for this is that accounts receivable represents nothing more than an interest-free loan to customers. In the case of Yahoo!, accounts receivable represents the uncollected cash from advertising customers such as Proctor & Gamble, Victoria's Secret, and other names you see under the "featured stores" section of Yahoo! Shopping. The more diligently a company collects its receivables, the better -- we want cash, not uncollected bills.

Now that we know what working capital is, we're ready to see how changes in the level of working capital on the balance sheet impact the cash flow statement. We'll start off by looking at the first major component of working capital -- accounts receivable. If you compare the balance sheet to the statement of cash flows, you'll see that a company's cash flow increases when accounts receivable decreases, and vice versa. Believe it or not, this means there is actually a financial statement that treats accounts receivable like a liability. That's why, around here, we're big fans of the cash flow statement.

Now, if you're a little confused at this point, don't worry -- that's normal. These concepts are tricky to grasp at first. Here's an example that should clarify how a change in the amount of accounts receivables on the balance sheet translates into a change in the amount of cash on the cash flow statement. Let's look at Yahoo!'s change in accounts receivable over the last nine months:

($ thousands)          9/30/99   12/31/98         Change
Accounts receivable     43,886     34,089    increase of 9,797
If you look at the numbers from the cash flow statement in the table that appears above, you'll see that this increase in accounts receivable appears as a decrease to cash flow provided by operations. Does that make sense? The key to understanding this dynamic is to look at accounts receivable (and other current assets) as investments. Over the first nine months of 1999, Yahoo! had to make an investment of an additional $9,797,000 in accounts receivable in order to meet the needs of its customers. Investments are a use of cash, and thus, this investment shows up as a decrement to operating cash flow. (You should also be aware that the numbers don't always work out this smoothly. Sometimes, foreign currency translation adjustments and financial statement changes related to business combinations can skew your results.)

The same situation holds for other current assets such as inventory, which is the second major component of working capital. Keeping too much inventory around is another practical liability. Think of excess inventory as an unnecessary investment. There are two principal reasons for this. The first is that having inventory sitting on the shelves is really no different than leaving money sitting on that very same shelf. Companies need to get the product out the door and sold -- and then quickly collect cash payment. The other is that, particularly when it comes to high tech companies, the rapid changes in products and the tendency of companies to cannibalize their own product lines can easily lead to excess inventory becoming nothing more than worthless junk sitting on the shelf. Looking back to Yahoo! again, the Internet portal has the fortunate situation of having no inventory whatsoever as their product is digital -- nothing but intangible bits and bytes.

The third major component of working capital is accounts payable. Even though payables are listed as a liability on the balance sheet, the flow ratio treats accounts payables as a practical asset. So does the cash flow statement. Accounts payable represents an interest-free source of cash provided by suppliers. That's why an increase in payables results in higher cash flow from operations and a decrease in payables results in lower cash flow from operations. While I don't endorse a company not paying its suppliers on time, I don't see any reason to pay earlier than necessary. This is also the way that I run my own finances. While interest rates may not be all that high right now, it's better to have the money in my interest bearing account than someone else's, so I schedule all bills for payment a week or less before they are due.

Stop. Take a deep breath.

We've covered a lot of ground. Let's review for a moment and take a look at what's been discussed here. Working capital is current assets less current liabilities, as reflected on the balance sheet. Changes in these items are reflected in the statement of cash flows. Here's a summary of what we've learned about working capital as it relates to the cash flow statement:

 Balance Sheet        translates to    Cash Flow Statement
Increase in current asset Decrease in operating cash flow Decrease in current asset Increase in operating cash flow Increase in current liability Increase in operating cash flow Decrease in current liability Decrease in operating cash flow
Next week, I'll wrap up this lesson with a review of the flow ratio, and how the flowie -- simple ratio that it is -- can tell us all about this connection between the balance sheet and cash flow statement -- all in a single number. I'll also give some further explanation about how the income statement fits into this whole regime.

That's all for tonight. I hope everyone has a Foolish weekend.


Next: Tying It All Together With the Flow Ratio -- Part 2 of 2 »