Today, we continue our Craft of Rule Maker series with a look at one of my favorite financial ratios -- the Foolish Flow Ratio, conceived by our own Tom Gardner. (Speaking of Tom, we hope you had a chance to see his invitation to our upcoming seminar, The Art of Rule Maker, which starts on Monday.) The Flow Ratio allows you to quickly gauge how well a company manages its working capital (i.e., current assets and current liabilities) and whether or not it's making maximum use of the cash that's available to it. Let's take a look at why.

If you really want to understand the use of the Flow Ratio, you have to start by throwing conventional financial wisdom out the window. At first, this was something that was a bit difficult for me, as I'm a CPA. To be honest, straying from the norm is difficult for many CPAs. Fortunately, I don't put myself in that crowd. I've come to learn the value of looking at financial statements in an unconventional way, so I'm sure you can too.

Traditionally, the assets you find on a balance sheet are good, and owing money (or having liabilities) is bad. But, I don't believe that's always the case. The only class of current assets that I really like to see a company have is cold, hard cash (or cash equivalents). Every other current asset is less desirable than cash.

Many might view accounts receivable as a good asset, as it represents money that should be on its way into a company's coffers. In today's world the majority of purchases are paid for by utilizing credit rather than cash, and accounts receivable is how those credit sales are accounted for. The reality, however, is that credit sales represent interest-free loans to customers. It's really no different than what happens when you pay your credit cards in full each month. You buy an item today and then you pay for it by the due date of your credit card bill. As long as you pay your balance in full by the due date, the financial institution that issued the card has given you an interest-free loan. While that's a Foolish way to use your card, it's not nearly as profitable for the banks.

Plus, there's no guarantee that accounts receivable will ever be collected. For example, in December, Lucent Technologies (NYSE: LU) announced the reversal of $679 million of reported revenues that had arisen in part because one of its staff had promised customers unapproved credits to close a sale. That's why accounts receivable isn't an asset we're too fond of here at Rule Maker Central.

Besides accounts receivable, another important current asset is inventory. Companies need to have a certain amount of product on hand in order to meet customer needs. But inventory is a risky asset to hold. Rapidly changing technology quickly makes tech goods obsolete. Additionally, products can spoil or lose their effectiveness if they go beyond their expiration date. Even in the best of circumstances, having unsold inventory can be akin to taking a pile of cash, putting it in a shoebox, and letting it sit on a shelf. In short, inventory is another bad asset.

On the flip side of the balance sheet, current liabilities can be thought of as "good liabilities." The most prominent type of current liability is accounts payable. These are monies a company owes to its suppliers, but which don't result in any interest charge. To see why this is a "good" scenario, let's return to the credit card example. If you Foolishly use your credit cards, then the amount you owe when you pay your bills each month is an interest-free loan from your financial institution. Similarly, a company's accounts payable represent an interest-free loan from suppliers. Free is good.

Fortunately, the Flow Ratio wraps up all of this complexity into one tidy number that's easy to calculate and evaluate. Let's pull out our calculators and take a look at how this is done. If you want to follow along, you should open up Cisco's (Nasdaq: CSCO) latest earnings press release in a separate window and scroll down to its balance sheet. We just plug the numbers into the following formula:

Flow Ratio = (Current Assets - Cash) / (Current Liabilities - Short-Term Debt)

Since Cisco doesn't have any short- or long-term debt, that means that there are really only three lines from its balance sheet that we're concerned about (amounts in millions):

Cash, Equivs., and ST Investments   $  4,782
Total Current Assets                $ 12,912
Total Current Liabilities           $  6,335

Now, let's plug those numbers into the above equation. We get: (12,912 - 4,782) / (6,335 - 0). That means Cisco's Flow Ratio was 1.28 in its most recent quarter. That's just a shade over our target of 1.25. It's also up 28% from the year ago figure of 1.00 -- not a healthy direction. With the Flow Ratio, the lower the number, the better. We prefer to minimize the non-cash current assets in the numerator and maximize the non-interest-bearing current liabilities in the denominator. So the rule is:

We like to see a Flow Ratio of less than 1.25, and the lower, the better.

One note before we go on. Determining what's debt and what isn't can often be confusing. Learning to recognize the many faces of debt will go a long way toward helping you figure out whether or not an account represents debt.

While you're at it, take a minute to walk through this Flow Ratio example comparing Cisco and Lucent, which shows how valuable the ratio can be in helping you separate the winners from the losers in an industry.

Now, for you hard-core Rule Maker devotees, let's take these concepts to the next level of sophistication. When a company's Flow Ratio is rising, I like to look at its three key components -- accounts receivable (AR), inventory, and accounts payable (AP) -- to try and understand why. As a company grows in size, each of these components is going to grow in size almost by default. So we need some tools to assess and gauge the rate of growth.

The simplest method is to compare the rate of growth of a company's revenues to the rate of growth of its accounts receivable and its inventory. If receivables or inventories are outgrowing sales, then it's possible that the company's revenue recognition policy may be abusive. Here's what we find for Cisco:

               Q2 '01     Q2 '00    % Growth
Revenues       $6,748     $4,357         55%
Accnts. Rec.   $3,512     $1,715        105%
Inventory      $2,533     $  700        262%

That's certainly not a pretty picture. And, as we've discussed in the past in Cisco's Lending Habits and Cisco's Aggressive Call, this is part of an ongoing trend.

Believe it or not, I like to turn up the dial of sophistication even a few more notches when judging the growth of the key components of a company's Flow Ratio; i.e., AR, inventory, and AP. These three elements are also used to calculate a company's cash conversion cycle (CCC), or how long it takes to buy and pay for a raw material, turn that raw material into a finished good, sell that product, and then collect the amount due from the customer. We've discussed CCC in detail in the past, so we'll just review it here.

CCC has three components:

  • Days Sales Outstanding (DSO) -- AR / (Sales/90)
  • Days Inventory Outstanding (DIO) -- Inventory / (Cost of Sales/90)
  • Days Payable Outstanding (DPO) -- AP / (Cost of Sales/90)

You can then combine these three numbers to determine the cash conversion cycle:


Our goal is for a company to very quickly convert raw materials into cash. Thus, the shorter a company's CCC, the better.

These numbers can be looked at in two different contexts. First, the ratios can be compared among competitors. This will give you a sense of which company has the most efficient operations in the industry. Second, the company's results should be compared on a quarter-by-quarter and year-over-year basis. Comparing a company's CCC over time will reveal whether the company is gaining or losing ground in its cash efficiency.

Here, for reference, are the results for Cisco:

         Q2 '01    Q1 '01    Q2 '00
DSO        47        40        35
DIO        88        74        41
DPO        33        38        28
CCC       102        76        48

Clearly, Cisco's working capital management is much weaker than it was a year ago. Cisco's numbers do, however, look at lot better when compared to those of competitors like Lucent and Nortel (NYSE: NT).

Have a great day. Tomorrow, we'll conclude our Craft of Rule Maker series by explaining how The Craft fits together with The Art.

Part 9: The Art of Rule Maker Investing �

Phil Weiss and his family reside in northwestern New Jersey. With two young boys and two dogs, things there can be crazy at times. At the time of publication Phil owned shares of Cisco. He doesn't own any shares of Lucent, as he sold his shares due to some of the issues discussed in this column. You can see his other stockholdings in his profile. The Motley Fool is investors writing for investors.