[This article updated with correct cash and short term investments numbers.]

Welcome to part 7 of our Rule Maker back-to-basics series. We've covered a lot of ground so far, from the importance of sales growth to the advantages of high profit margins. Now it's time to take a look at debt, which is kind of like fertilizer. A little helps a company grow, but it has to be managed properly and applied to seeds ready to flourish.

Before we jump in -- to our lesson on debt, that is, not fertilizer -- if you're interested in the Rule Maker approach, consider signing up for the Rule Maker 2001 Online Seminar. We're not going to be crunching a lot of numbers in this seminar (that's what this back-to-basics Craft of Rule Maker series is for). In fact, we'll be shifting gears entirely and thus we've entitled our seminar, The Art of Rule Maker. We'll be talking about the qualitative side of Rule Maker: competitive advantages, management issues, expanding avenues for growth, and valuation. What makes one company better than another? What are the qualities of an enduring long-term investment? Join us for eight lessons, a few rounds of busy debate on the discussion boards, and a report of the Rule Maker managers' top 25 Rule Maker investing ideas, each fleshed out in a tightly written essay.

On with today's lesson.... In the Rule Maker, we're looking for companies with at least 1.5x as much cash as debt. This is a tough barrier given that many businesses don't generate enough cash from operations to upgrade equipment and expand the business without debt to fund the build out, especially if they are young companies. That's just the way it is. The more asset-intensive a company's business, the more often this is true. This screen, while somewhat arbitrary, sets the bar high. It saves us time by focusing our attention on the most profitable companies.

Now, debt shouldn't be viewed as evil. That's ridiculous. Ask the average farmer what life would be like if they didn't have a bank to draw funds from at planting time, or a start-up retailer that couldn't tap a credit line to build up inventory as the busy shopping season approaches. There's a time for everything under the sun, and there's a time for borrowing money too.

Caution is the key word since debt adds risk to an investment, and excessive debt has gotten good companies in a lot of trouble. Carmike Cinemas, one of the nation's largest theater chains, recently followed peers into Chapter 11 after taking on too much debt to build new theatres. We've got too many theaters in this country already, and old sites are rapidly closing or being sold off. Even Carmike's effective focus on small to midsize markets (an effort aimed at avoiding big-city competition), wasn't enough to save it from a heavy debt load.

Cisco (Nasdaq: CSCO) avoided the debt trap by selling equity in its early years and building a business that generates lots of cash.

Open Cisco's most recent 10-K, and click on the balance sheet. We count short- and long-term debt in our measure of a company's financial fitness. Just scroll to the current liabilities section of the balance sheet and look for short-term debt in the form of notes payable or current portion of long-term debt. Add to this any long-term debt. If there is any it will appear after current liabilities and before the stockholders' equity section.

At this point, if you're following along with us on Cisco's balance sheet, you might be having a bit of trouble finding anything that looks like debt. There's a reason for that: Cisco is totally debt-free. Much of its growth has come from acquisitions, which Cisco has funded by using its own stock as currency. This equity certainly isn't free (that's a story for another day), but it has kept Cisco's balance sheet squeaky clean. Next, check to see how much cash Cisco has in its coffers. Zero debt is nice, but the company still needs cash for flexibility.

Scroll up to the current assets section of the balance sheet and look for cash, equivalents, marketable securities, and short-term investments. Other than pure cash, which speaks for itself, these other instruments are highly liquid (easily converted to cash), safe investments, such as Treasury bills and certificates. Pile it all up to calculate a company's cash hoard. At the end of Cisco's fiscal 2000, its cash situation looked like this ($ millions):

Cash and cash equivalents: $4,234
Short-term investments:    $1,291
Total                      $5,525

Cisco doesn't need all of that $5.2 billion to fund its working capital needs. Rather, this excess gives Cisco a window to take advantage of new opportunities and a cushion in a soft economy. It gives Cisco flexibility and room to operate, and it's what we look for in the hunt for the best companies.