MILWAUKEE, WI (December 14, 1999) -- This past Friday, Phil began a two-part series explaining how a lot of a company's inner-financial workings can be summed up in our very own easy-to-calculate flow ratio. Today, I'm going to pick up where Phil left off because he's away on business this week. (When not playing the role of a Fool, Phil is an international tax man of mystery -- yeah, baby, yeah!)

As you may have noticed on today's byline, I'm also traveling this week, but I won't let that hold me back from investigating this oddly interesting thing called the flow ratio. We've written TONS about the flow in this space, but how well do you really understand what it means? Sure, a low flowie is better than a high one -- that's clear enough -- but what does a declining (or rising) flow ratio tell us about the status of the underlying business? That's the question we'll seek to answer in today's column.

On Friday, Phil set the stage in part 1 by first establishing the ultimate goal of a company: to generate as much free cash flow as possible while utilizing as few resources as possible. In that aim to generate free cash flow, it's not just a game of revenues, expenses, and other income statement items. No sir, free cash flow is equally impacted by developments on the balance sheet.

What we're getting at here is the idea of thinking of companies as dollar machines. Here's a quick example of two hypothetical dollar machines: the Green Machine and the Bloated Beast. In some ways, the two are quite similar. If you insert a dollar today, either one will forever "produce" 25 cents per year of net income (accounting profits). But net income is just a book entry inside the machine. Each machine's tangible output is quite different. For example, the Green Machine annually spits out a shiny silver quarter, whereas the Bloated Beast only coughs up a dime and a nickel. Thus, even though both machines are equivalent on the basis of net income, their capabilities of generating free cash flow are quite different.

The reason for the disparity in physical output between the two machines boils down to efficiency. The Green Machine is lean and well-constructed, and thus its net income actually survives and becomes cash reality -- a silver quarter in your hand that you can take to the candy store. In contrast, the Bloated Beast wasn't well built so it has to spend a dime each year to fix loose cogs and the like. That leaves only a dime and a nickel of real output.

In our search for well-built, efficient dollar machines, the flow ratio goes a long way in leading us to companies that create real value in the form of free cash flow. As we explain in Rule Maker Step 6, the flow ratio is a measure of working capital efficiency, where the lower the number, the better. On Friday, Phil defined working capital as current assets less current liabilities. He went on to explain in detail the three major components of working capital: accounts receivable (uncollected revenues), inventory (unsold products), and accounts payable (unpaid bills).

One of the most important parts of Phil's Friday column was his demonstration of how an increase in a current asset like accounts receivable results in a decrease in operating cash flow -- and vice versa for a current liability. Phil summarized these principles in the following table:
      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
If you're confused at this table, hang with me because I'm about to show you precisely where the flow ratio -- a balance sheet metric -- intersects the cash flow statement. This direct relationship between the flow ratio and the cash flow statement is what gives the flowie its great importance. Here we go!

Let's look again to Yahoo! (Nasdaq: YHOO) as our example. Yahoo! makes a good demonstration because I think what we're about to look at partly explains why the market has valued this company so dearly. Below, I've reproduced the cash flow statement from Friday's column, except that this time, I've italicized the section that reflects the flow ratio. (By the way, all of these numbers are taken directly from Yahoo!'s Q3 10-Q financials.)
                             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 interests 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

The italicized section above is where the flow ratio hits the cash flow statement. Now that we have our bearings, let's zoom in on just that "changes in assets and liabilities" section for Yahoo!'s nine months ended September 30 of this year. Here's what we find:
                           YAHOO! INC.
     A Portion of the Statements of Cash Flows ($ thousands)

                                                  Nine Months Ended
                                                 September 30, 1999
Changes in assets and liabilities:     
  Accounts receivable, net                              (9,797)
  Prepaid expenses and other assets                     (3,125)
  Accounts payable                                        (273)
  Accrued expenses and other current liabilities        31,283
  Deferred revenue                                      32,569
Cash Generated from working capital                   $ 50,657
Okay, what we see is that Yahoo! generated $50.7 million just from its working capital efficiencies. That's more than three times the amount of its reported net income ($16.4 million) during the same period! To say the least, Yahoo! is a lot more like the Green Machine than the Bloated Beast.

Finally, let's see how this connects back to the flow ratio. Using the flow ratio formula and balance sheet segments listed below, let's compare Yahoo!'s working capital management efficiency for the most recent quarter (9/30/99) versus the end of last year (12/31/98). (By the way, you'll notice that Yahoo! has no short-term debt, so that portion of the formula doesn't come into play.)
                (Current Assets - Cash & Marketable Securities) 
Flow Ratio  =  -------------------------------------------------
                    (Current Liabilities - Short-term Debt)

                             YAHOO! INC.
            A Portion of the Balance Sheet ($ thousands)

                                             September 30,  December 31,
                                                    1999       1998
Current assets:      
 Cash and cash equivalents                       $ 141,542  $ 230,961
 Short-term investments in marketable securities   534,770    341,822
 Accounts receivable, net                           43,886     34,089
 Prepaid expenses and other current assets          14,036     10,860
                                                -----------  ---------
 Total current assets                              734,234    617,732

Current liabilities:     
 Accounts payable                                 $ 11,225    $ 9,986
 Accrued expenses and other current liabilities     74,131     46,147
 Deferred revenue                                   72,365     39,796
                                                -----------  ---------
 Total current liabilities                         157,721     95,929

                                   Flow Ratio  =      0.37       0.47
So what did we find? Yahoo!'s flow ratio has dropped from 0.47 to 0.37 over the first nine months of 1999 -- a 21.3% improvement. Yahoo!'s declining flow ratio is what caused the "changes in assets and liabilities" segment of the cash flow statement to be a source of cash for the company. A falling flow ratio will always cause cash to be generated on the "changes in assets and liabilities" segment of the cash flow statement. And vice versa -- a rising flowie will cause that section of the cash flow statement to be a cash drain. That was the situation with Pfizer that I explained in a column back in October.

To say the least, Yahoo!'s improving working capital efficiency has been a major source of cash. The $50.7 million generated from working capital accounts for more than 50% of the company's $92.2 million of free cash flow. Thus you see the direct importance of the flow ratio on a company's cash flow.

The lesson here is that while a flow ratio's current location is important, it's the direction -- whether rising or falling -- that matters on an ongoing cash flow basis.

Okay, now let's quickly tie it all together in the big picture of a business that we own. To start, our company purchases raw materials and turns them into inventory. That's "cost of goods sold" on the income statement. Then, it sells the inventory to customers, thereby creating accounts receivable on the balance sheet and revenues on the income statement. Finally, our company collects our money, and thus we have cash on the balance sheet. So, it all fits together. The income statement tells us how much product was sold; the balance sheet shows what resources were used to run the business; and the cash flow statement reveals the actual inflows and outflows of cash.

Hey, Phil and I flew through this stuff, so if you have any questions at all, please ask on one of the Rule Maker boards listed below.

One last note: If you're looking to air your thoughts on the millennium, check out how you can get on The Motley Fool Radio Show.

Have a great night, and Fool On!

- Matt Richey