Welcome back to the Rule Maker, loyal Fools! I'd like to spend today talking about one of my favorite new toys, the Cash Flow Net Margin. For those of you who aren't familiar with this metric, it was introduced by Matt Richey way back in September of last year. I don't know about you, but since reading that column, my approach to investing hasn't been the same. I pay a lot more attention to cash now than I ever did before, and I am seeing things that have really altered the way I evaluate companies.

In fact, while clicking through our archived columns for the past six months, I find that cash flow and control of cash has been a strong recurring theme: Matt highlighted Microsoft's (Nasdaq: MSFT) incredible cash flow generation, while Phil highlighted Pfizer's (NYSE: PFE) recent lack thereof and why the newly announced merger with Warner-Lambert (NYSE: WLA) was so important to our company.

Of course, the Fool has been on to the importance of cash for a long time. It was in the old Fool Portfolio (now Rule Breaker) back in the dawn of Fool history that our fearless Rule Maker leader, Tom Gardner, discovered the sublime beauty that is the Foolish Flow Ratio. For this landmark contribution to investing, Tom received the Nobel Peace Prize... er, what's that, Tom? You didn't win the Nobel Prize for the Flowie? Okay, well, Tom didn't win a Nobel, but he did shed new light on the previously mysterious subject of measuring how well companies control the flow of cash that is the lifeblood of every business. We're confident that the Nobel committee will come to its senses one day and give Tom the award.

Considering the importance of cash when evaluating a business, I feel that it's time to officially add to our Foolish Rule Maker Criteria a second view of how efficient a company is in generating cash. Enter the Cash Flow Net Margin (CFNM, for now), which follows in the footsteps of the flowie by revealing important truths about the cash dynamics of a business without any unnecessary complexity. The CFNM is the equivalent of the standard net margin, except that it measures profits by using the cash flow statement instead of the income statement. What's the difference, you say? Almost nothing at all, but in fact everything in the world.

The income statement measures earnings, whereas the cash flow statement measures cash. We prefer the latter. Here's why: Accountants have been known to massage the income statement in order to produce "earnings." The income statement includes a lot of stuff that can get between sales and net income, and a lot of those items don't have much to do with a company's cash profitability. In contrast, the cash flow statement reveals the unmanipulated truth of what's going on inside the business. While standard net margins are important, what hits the bank account at the end of the day -- CASH, as measured by the cash flow statement -- is a lot more real from an economic standpoint. The Cash Flow Net Margin lets us shove all that income statement stuff aside and see what really happens to the money that the company is bringing in via sales.

Here's how CFNM is calculated (please note that this is the same thing as the Free Cash Flow Margin that Matt has written about):

CFNM  =  (Operating Cash Flow  -  Capital Expenses)
Before defining these terms and getting into an example, it may serve you well to revisit a few of our past columns on the cash flow statement if you are new to the concept or if you need a refresher. Most investors will be surprised at how uncomplicated the cash flow statement actually is. Here are a few of the best Rule Maker columns that explain cash flow:
Ready to move on? Okay, to calculate the CFNM, we only need two line items from the cash flow statement: operating cash flow and capital expenses. With only a little practice, your eyes will soon clue in directly on these two important numbers, and all the other numbers will fade to the background. Let's run an example using one of our Rule Maker holdings. I've extracted just the essential data from T. Rowe Price's (Nasdaq: TROW) 1996-1998 cash flow statement:
                                         Year ended December 31
                                         1996     1997     1998
                                       ________ ________ ________
                                             (in thousands)
Cash flows from operating activities:

  Net income                           $ 98,453 $144,397 $174,140
  Net cash provided by 
  operating activities                  141,156  197,808  231,975
Cash flows from investing activities:

  Additions to property and equipment   (58,771) (70,081) (56,558)

The first number on the cash flow statement that we zoom in on is the bottom line of operating cash flow, entitled "Net cash provided by operating activities." We usually just refer to this number as "operating cash flow." As a general rule, this number should NEVER be negative for a Rule Maker candidate, and hopefully will be significantly larger than the corresponding net income figure. Also, if you are looking at a series of yearly figures, you want to see this number growing at a rate of at least 10% annually (note that this is equal to our target of 10% or greater annual sales growth.) As you can see above, T. Rowe passes both tests: 1) cash from operations is greater than net income, and 2) is growing substantially faster than 10% per year.

We can calculate a slightly easier version of Cash Flow Net Margin with this figure, which we'll call Operating Cash Net Margin (OCNM). We'll need to click over to the 1998 income statement and pull out the sales revenue for the comparable period. For 1998, I quickly see that the sales revenue for the full year was $886.142 million. By dividing operating cash of $231.975 million into sales, we find that T. Rowe has generated an Operating Cash Flow Net Margin of 26.1%, which is excellent.

Because most of our companies -- especially those like Coca-Cola (NYSE: KO) and Intel (Nasdaq: INTC) -- require regular capital expenditures to build and maintain plants and purchase new equipment to keep the business growing, we want to go one step further and see how profitable our companies are on a cash basis after the deduction of these capital expenses. We refer to the resulting figure as a company's Free Cash Flow, or FCF.

To this end, we have to delve down into the section of cash flows from investing activities. The number we look at here is "Additions to plant, property, and equipment (PP&E)," or some similar variation. Some companies will call this "capital expenditures." Subtract this number from our operating cash flow. For T. Rowe, we can see that the company spent $56.558 million on capital expenses in the PP&E category. Subtract that from the operating cash of $231.975 million, and we get free cash flow of $175.417 million, which happens to be just about where net income was for the year. This won't always be the case, and we like to see our companies post free cash flow equal to or greater than net income. Dividing our FCF of $175.417 million into annual sales of $886.142 million yields us 19.8%. This is the Cash Flow Net Margin for T. Rowe Price.

That 19.8% represents the real economic profitability on every dollar of sales. For Rule Makers, we want to set our bar extremely high here. As far as a minimum, we'll set the initial requirement for Cash Flow Net Margin at 10%. More likely, however, unless a given company scores extremely high on the other Rule Maker criteria, we would expect our Rule Makers to generate CFNM of no less than 15%. Additionally, we want to see this metric be equal to or greater than standard net margin.

As a side note, you should be aware that it is common accounting convention for companies to report cash flow on a year-to-date basis, which means that if you are looking at the 10-Q, cash flow will be presented for the full portion of the fiscal year that's completed thus far. For example, if you are looking at first quarter results, you are only going to get cash flow information for the first three months of the fiscal year. If, however, you are looking at third quarter results, you'll get cash flow for the entire nine month period. This is fine, but you'll want to be sure to divide those three quarters of cash flow by the full three quarters of sales in the denominator. Also, you might want to look at the previous year's 10-K or annual report as well just to get a big picture of how well the company does on a cash flow basis for a longer period.

We'll be busy updating our Rule Maker criteria to officially include CFNM, but we need a favor from you, our readers. Although we love the concept of Cash Flow Net Margin, we think the name is a little, well, lame. (Matt's original "FCF Margin" certainly isn't any better.) We'd love to come up with a better term for this awesome metric, and we hereby ask for your help. It's gotta be simple, light on the tongue, and intuitive. Ponder it, then post your best idea to the Rule Maker Strategy board (linked below). We'll review the list of candidates and announce the winner next Friday. Oh, I almost forgot, you probably need an incentive. Well, we've really outdone ourselves this time. We have what I believe is the best prize we've ever offered for a user response event. The only problem is, I can't tell you what it is. Trust me, though, it's going to be awesome, and of course, totally Foolish! I'll announce the prize at the same time we disclose the winning suggestion. (And, of course, this requires no purchase, and it's void where prohibited. For the complete rules, e-mail MattR@fool.com.)

Some of the ideas that we've generated in-house, and which are not eligible for you to use, are:
  • Cash King Margin
  • Foolish Flow Margin
  • Rule Maker Margin
  • Foolish Cash Margin
  • Foolish Cash Flow Margin
  • "The Cashy"
Finally, be sure to return on Monday for our long-awaited announcement of a pair of new Rule Maker buys. At that time, we'll also announce the winner of last month's contest for the best Rule Maker analysis on the boards. Have a great weekend!