8 Stocks Headed in the Right Direction

Quick! What's the main goal of any public company? You, in the back row with the pinstriped suit and golden cufflinks? No, no, it's not to make the CEO as rich as possible.

The ultimate goal for a business is to generate as much cash flow as possible using as few resources as possible. Investors analyze to death revenue and expenses on the income statement, but the vast majority miss out on some very important balance sheet information.

Today, I'll introduce you to a metric you probably haven't seen before and show you how easy it is to determine who the truly efficient companies are.

Meet the Flowie
In the late '90s, Motley Fool co-founder Tom Gardner was running the Rule Maker portfolio -- a collection of well-managed companies with sustainable competitive advantages that could be bought and held for years. He noticed how the truly great ones were extremely efficient in their management of certain components of working capital -- accounts receivable, inventory, and accounts payable.

The basic idea is this: Cash is constantly flowing into and out of a business. An electronics maker, for instance, pays out cash to suppliers for raw materials and then collects cash when selling the completed product to its customers. Tom found that great companies had a very tight control on the two cash spigots and were able to bring money in at a faster rate than they paid it out.

He wanted to be able to quantify this cash inflow and outflow in some way, and invented the Foolish Flow Ratio, or the Flowie for short. This simple metric enables you to cut through accounting shenanigans and artfully constructed income statements to get a clear snapshot of how well a company is managing its cash:

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

What it means
The first part, current assets minus cash (including equivalents, marketable securities, and short-term investments), focuses on inventory and accounts receivable -- things waiting to be turned into cash. The denominator, current liabilities minus short-term debt (notes payable and current portion of long-term debt), isolates accounts payable, or the costs that are coming due in the next year.

It may seem counterintuitive at first, but we want less of the former in relation to the latter. In other words, we want fewer things sitting there waiting to be turned into cash because the best scenario is to already have the cash in hand. Uncollected revenue and unsold products ... blech.

And because we want to hold off paying out cash as long as possible, we don't mind accounts payable growing. When we're talking about the kind of money big businesses toss around, it's a big deal to be able to hold onto it longer and put it to use in the meantime.

Putting it all together
All you mathematicians out there are a step ahead of us: The lower the Flowie, the better. Less than 1.25 is pretty good. Below 1.0 means that the business is able to delay more payments than it's carrying in costs of inventory and unpaid bills.

While we want to see a good ratio, the trend of the ratio is also very important, and we want to see the trend moving lower. Again, it's all about the cash: An increase in a current liability like accounts payable results in an increase in operating cash flow, while an increase in a current asset like accounts receivable results in a decrease in operating cash flow.

A falling flow ratio will always cause cash to be generated on the "changes in assets and liabilities" segment of the cash flow statement -- and vice versa.

Example
One of the best real-world examples of what we're talking about is Wal-Mart's famous ability to extract favorable terms from its vendors and suppliers. Having enough leverage to negotiate 120 days to pay, rather than 90, says something about the strength of the business.

Here's a look at Wally World and a few other studs with efficient Flowies flowing in the right direction:

Data from Capital IQ, a division of Standard & Poor's.

Foolish bottom line
The Flowie is but one tool you can use in evaluating businesses. However, the fact that it's rather obscure is a huge plus in your favor -- the ability to see a business in a different perspective than almost anyone helps you recognize better bargains.

Tom has been using the Flow Ratio during his eight years as co-advisor for Motley Fool Stock Advisor. With it and the rest of his valuation techniques, he and his brother David have beaten the S&P 500 by an average of 60 percentage points per pick. If you'd like to see all their recommendations, as well as their top five stocks for new money now, we're offering a special 30-day free trial. Here's more information.

This article was originally published April 15, 2010. It has been updated.

Rex Moore is the solo member of the Fool's two-man bobsled team. He owns no companies mentioned here. Wal-Mart Stores is a Motley Fool Inside Value pick. The Fool has a disclosure policy.