Recently, there was a request on the Rule Maker Beginners discussion board for an article that provides a soup-to-nuts review of the Foolish Flow Ratio. The reason for this request is probably related to the fact that, of all the Rule Maker financial statement metrics, our good friend the Flowie is the one that seems to generate the most puzzled looks. So, today's column will be dedicated solely to a discussion of the Flow Ratio, including a few examples to help drive home all this balance sheet mumbo jumbo.
First, let's start with a review of the Flow Ratio and why it could easily be considered the most important of all the financial metrics that we use in analyzing Rule Makers. The Flow Ratio measures the ratio of a company's "bad" assets to its "good" liabilities. Right about now, some of you might be thinking, "What's this guy talking about? Assets are good. Liabilities are bad. He must be a fool." For those of you who are familiar with accounting terminology, our thinking probably appears to be pure heresy. But, we're Fools, and are prone to thinking about things a bit differently than most.
The assets and liabilities we look at when calculating a company's Flow Ratio are only those that are classified as current (i.e., generally, convertible into cash paid or received in a year or less). The most common current assets found on a balance sheet are cash, accounts receivable, and inventory. On the liability side, you'll probably see accounts payable, accrued liabilities, and perhaps some interest-bearing short-term debt. Allow me to explain each category in turn.
Cash is the first and greatest asset, a true asset if there ever was one. Cash on the balance sheet is available for new ventures, brand marketing, strategic acquisitions and, if nothing else, a buffer for a rainy day -- and rainy days do eventually come, even for great companies.
Accounts receivable, the second current asset, has some drawbacks. These are monies owed to a company by its customers. Take Cisco Systems (Nasdaq: CSCO), for example. When Cisco ships a router to a customer, it invoices the customer to pay the bill within, say, 30 days. Cisco accounts for that invoice as a receivable. You'll notice there is no interest associated with an outstanding receivable, which means it equates to an interest-free loan. Plus, if you take a look at just about any balance sheet, you'll see that companies set aside a provision representing a percentage of those receivables that it does not expect to collect -- monies lost.
Up next is inventory, another asset that's more or less a necessary evil. Inventory represents goods that are either available for sale or in the process of being converted from raw materials into saleable goods. For Intel (Nasdaq: INTC), inventory sits in the form of raw silicon, partially assembled chips, and fully assembled microprocessors ready to be sold. A manufacturer can't make any money if it doesn't have anything to sell; thus, carrying too little inventory is certainly not a good thing. But, there are some significant costs related to carrying too much inventory. Inventory is perishable, prone to obsolescence, and represents a cash investment that's sitting idly on the shelf. All in all, carrying too much inventory can be quite expensive.
There are, of course, a number of other current assets found on the balance sheet. All of them are less liquid than cash and, therefore, not "good" assets for Rule Maker investors. If you come across an asset and you're not sure whether it's cash by another name or just aren't sure what it is, see Current Assets -- Our Likes and Dislikes.
In sum, the goal of a business is to generate cold hard cash. Receivables, inventory, and other non-cash current assets only exist because they might one day be converted into the green stuff. We prefer companies that make good on this goal, having mucho cash and meager non-cash current assets. In other words, we like to see a company's current asset total dominated by cash. Stated mathematically, Current Assets minus Cash should be as low a number as possible.
Hang on to that nugget of Foolishness while we turn to the other side of the Flow Ratio -- current liabilities.
Debt is the antithesis of cash. Cash is opportunity; debt is obligation. In particular, the aspect of debt we abhor is the interest charge. Some liabilities, however, don't require any interest payment whatsoever. Such interest-free liabilities qualify in our book as "good." We don't object when a company owes money, goods, or services to another company, provided there is not an interest charge associated. Minus the interest, a liability amounts to a free loan.
Accounts payable (A/P) is one of the most common examples of a "good" liability. A/P represents the flip side of accounts receivable. A/P are monies a company owes to its suppliers for goods already received. Take JDS Uniphase (Nasdaq: JDSU) for example. JDSU orders and receives the raw materials necessary to manufacture its source lasers and modulators. It's possible that JDSU may not have to pay for these input costs until 30 or 60 days later. In the meantime, JDSU gets a free loan. Earlier, I mentioned objecting to high accounts receivable balances because they represent an interest-free loan given to customers. On the other hand, I like A/P because it represents an interest-free loan from suppliers.
The idea of "good" liabilities can even be applied to our personal finances. If you're Foolish with your personal finances and don't have any outstanding credit card debts, you can charge your everyday expenses and then wait until right before the bill is due to pay it. While the interest rate you may earn on any cash you carry in your bank account is low, it's still better to keep this money working for you as long as you can, rather than turn it over to someone else earlier than required.
Beyond accounts payable, there are several other categories of "good" liabilities, including accrued liabilities. If you're not sure whether a liability is interest-bearing, you can take a look at The Many Faces of Debt. That article will serve as a handy reference for identifying those sinister forms of short-term interest-bearing debt, such as "notes payable," "commercial paper," and "current portion of long-term debt."
The Foolish Flow Ratio
So far I've been long on theory and short on practical examples. It's time to change that. We now have the pieces in place to calculate the Flow Ratio:
(Total Current Assets - Cash) Flow Ratio = ------------------------------------- (Total Curr. Liab. - Short-term Debt)Now, let's pull out our calculators and calculate the Flow for three of our Rule Makers: Pfizer (NYSE: PFE), Coca-Cola (NYSE: KO), and Microsoft (Nasdaq: MSFT). Afterwards, we'll talk about what the results mean.
Pfizer's Flow Ratio
First, here are the only current assets and current liabilities found in Pfizer's most recent balance sheet that are relevant to the Flow Ratio calculation. (Here's Pfizer's full balance sheet.)
($ millions) Cash and cash equivalents $191 Short-term investments $3,589 Total current assets $10,433 Short-term borrowings, including current portion of long-term debt $3,717 Total current liabilities $7,478 Flow = (10,433 - (3,589 + 191)) / (7,478 - 3,717) Flow = 6,653 / 3,761 = 1.77Coca-Cola's Flow Ratio
Next we'll take the exact same approach and complete the calculation for Coca-Cola. (Here's Coca-Cola's full balance sheet.)
($ millions) Cash and cash equivalents $2,454 Marketable securities $230 Total current assets $7,425 Loans and notes payable $6,252 Current maturities of long-term debt $260 Total current liabilities $11,127Microsoft's Flow Ratio
Flow = (7,425 - 2,684) / (11,127 - (6,252 + 260)) Flow = 4,741 / 4,615 = 1.03
Last but not least, we'll calculate the Flow Ratio for Microsoft. (Here's Microsoft's full balance sheet.)
($ millions) Cash and short-term investments $17,236 Total current assets $20,233 Total current liabilities (*) $8,718 Flow Ratio = (20,233- 17,236) / 8,718 Flow Ratio = 2,997 / 8,718 = 0.34 (*Note: Microsoft carries NO interest-bearing debt.)Drawing Conclusions
So, what do all these numbers tell us? When we look at the Flow Ratio, our Foolish standard is 1.25 or less. Microsoft's result of 0.34 is one of the best you'll find, and is helped along by the fact that the company carries no material inventory and carries a relatively low accounts receivable balance. On the other hand, Pfizer takes longer than the vast majority of its competitors to collect its outstanding receivables and to turn over its inventory, a fact that's borne out in a Flow Ratio of 1.77 -- well above our target.
You might wonder why we even care about all this. The Flow Ratio is used to measure how well a company manages its working capital (i.e., current assets and current liabilities). Effective working capital management can add dollars to the bottom line, as it should result in improved cash flow. It's also an indication of the way that a company manages its overall business. Companies that have higher Flow Ratios are often focused more on managing earnings than managing their cash flows. Since we believe that cash earnings are what really drive the value of a business, we prefer companies with tight cash management, as measured by a low Flow Ratio.
If you wish to discuss this report further, please feel free to ask your questions on any of the discussion boards linked below.
Phil Weiss (TMFGrape on the boards)