In yesterday's article, Phil Weiss gave a refresher course on why the Foolish Flow Ratio is such a cornerstone of Rule Maker investing. When used with care, the importance of this ratio as a tool for investors cannot be overstated. Unfortunately, like most financial ratios, the Flowie isn't a perfect tool for every job. I'd like to use today's column to address a few of the most common questions and comments that I receive about using the Flow, and to provide some helpful suggestions where possible.

If you're not sure about what the Foolish Flow Ratio is or what makes it such a powerful tool, I'd encourage you to take a look at Phil's article: The Foolish Flow Ratio Paradox. I've structured today's column in a question and answer format.

I can't calculate the Foolish Flow because the company doesn't separate current assets and liabilities. What do I do?

You will occasionally happen across companies that don't separate current assets and liabilities, and you can still calculate a Flow. In fact, we have one of these in our portfolio, T. Rowe Price (Nasdaq: TROW). Below I've posted the most recent balance sheet information from T. Rowe Price. Notice that while the balance sheet is very straightforward otherwise, the company doesn't provide a breakdown of what's current and what's not. This doesn't pose an insolvable problem as long as you keep in mind that the Flow Ratio is really a ratio of "bad" current assets to "good" current liabilities.

The "bad" current assets fall into two main categories: accounts receivables and inventory. And "good" current liabilities are those that don't carry interest charges: accounts payable, accrued compensation payable, taxes payable, dividends payable, or Phil's favorite, unearned revenues. Let's see if we can just pick out the items that we need to perform our calculation. Below, I've bolded the "bad" current assets and "good" current liabilities:

Cash and cash equivalents                 $438,435
Accounts receivable                        144,841
Investments in spons. mutual funds         250,260
Other investments                           54,639
Property and equipment                     217,867
Other assets                                19,217
Total assets                            $1,125,259
Accounts pay. and accrued exp.             $48,467
Accrued compensation and related costs      54,899
Income taxes payable                        78,864
Dividends payable                           15,688
Debt                                        17,632
Minority interests                          66,454
Total liabilities                         $282,004
Let's do the assets first. T. Rowe doesn't have any inventory, so that just leaves accounts receivables of $144.8 million as our "bad" assets. On the liabilities side, the first four items are non-interest bearing short-term liabilities, so we'll just add 'em up and use them as our "good" current liabilities. The total for these four accounts are $197.9 million. Thus, our calculation is 144.8 divided by 197.9, which produces a Flow Ratio of 0.73. In short, while it's nice if the company breaks out the current assets and liabilities for us, that doesn't mean that we shouldn't do the best we can.

I love everything else about XYZ company, but it's got a Flow Ratio of 3.20! Should I just forget the company altogether?

Often the above question will refer to a small-cap growth company. Smaller companies will sometimes show great sales growth, high profit margins, and strong cash flow, yet have very high Flow Ratios. In general, if a company has a high Flow, that should be considered a warning sign. That's because a common pitfall of small, fast-growing companies is that they ramp up production quickly and are very aggressive in making sales -- sometimes overly so. What can happen is that they pluck all the low-hanging fruit by selling their big customers 60, 90, or 120 days worth of product with lenient payment terms, often while simultaneously increasing new production capacity.

Suddenly, they realize that their big customers will need a while to work off that last big order, and there aren't any new customers to buy all that new product. When this happens, the company can get whacked with the double whammy of a quarter or two of slowing sales combined with a massive buildup of inventory and accounts receivables. This can lead to disaster in the form of a huge earnings disappointment. To read about how I once got burned by exactly this scenario, check out this article: The Early Warning Flow.

But not all companies that sport lofty Flow Ratios are in danger. Some of them don't have excessive inventory or accounts receivables, but their Flow is very high because they just don't have much in the way of current liabilities. They pay all their bills the day they arrive in the mail, they have relatively small payrolls, and don't have large amounts of taxes or deferred revenue.

To determine which scenario you've got on your hands, calculate Days Sales Outstanding (or "DSOs" in accounting parlance) to make sure that receivables levels aren't excessive. Then, do the same for Days Inventory Outstanding (DIO). As a general rule of thumb, I don't like to see more than 90 days of inventory or accounts receivables. (Here's a link to a great article from Phil about DSOs and DIOs that I highly recommend: The Cash Conversion Cycle.)

If the company is outstanding in every other facet, and you're convinced that the inventory and accounts receivables aren't a problem, then proceed with caution. If you have any doubt, then my advice is to pass on the company for now and check back in a quarter to see if there has been any improvement.

I'm trying to decide between Siebel Systems and EMC. Siebel has a Flowie of 1.27, and EMC's is 1.69. That means Siebel is a much better company, right?

In order to make comparisons between companies in two different industries, it is definitely helpful to first know how the company's Flow ranks against a direct competitor. Software companies like Siebel Systems (Nasdaq: SEBL) should have low Flow Ratios because software companies generally don't carry any inventories. Here's how Siebel's Flow compares to that of i2 Technologies (Nasdaq: ITWO) and Oracle (Nasdaq: ORCL):
Siebel    1.27
i2        1.03
Oracle    0.85
We can see that while Siebel's Flowie appears strong on an isolated basis, it's not as great when compared to direct competitors. You'd want to look at EMC's (NYSE: EMC) Flow Ratio next to a couple of competitors to see how it compares before making a Siebel versus EMC decision.

Looking at some competitors will also give an investor a pretty good indication of how attractive an industry is from a Rule Maker perspective. Siebel is engaged in an industry where very low Flow Ratios are possible, whereas EMC competes in an industry that requires it to carry a lot of inventory.

Hey, Gap's Flow Ratio has gone up the last three quarters. Should I be worried?

This type of question depends on the company and the industry. Generally, the Flow should be compared to the same quarter of the previous year. This is because for some companies, the Flowie won't really be comparable from quarter to quarter due to seasonal fluctuations in the business. Retailers like Gap Inc. (NYSE: GPS), for example, will usually show a slightly higher Flow Ratio in the second and third quarters as they begin building up inventory for the back-to-school and holiday retail seasons. Let's take a look at a series of Flow Ratios for Gap:
      1998    1999
Q1    1.12    1.13
Q2    1.10    1.25
Q3    1.35    1.34
Q4    0.89     ?
As you can see, it is completely normal for Gap's Flowie to expand in the second and third quarters, and contract in the first and fourth quarters. In this case, there is probably no need to worry unless the trend of deterioration continues in the fourth quarter. (As it turned out, Gap's fourth quarter Flowie in 1999 was 1.10, about 25% over the same quarter the year before.) A little historical context can really be helpful when considering whether a company's balance sheet is starting to deteriorate. In this case, Gap is showing marked deterioration in the Flow over the previous year, meaning that you would want to watch this closely for Gap going forward.

Determining a strong trend in the direction in the Flow Ratio can alert investors to a great investment idea -- and can provide an early warning of any bombs waiting to detonate.

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Have a great weekend!