7 Stocks Headed in the Right Direction

Quick! What's the main goal of any public company? You, in the front row with the pinstripe 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 overanalyze 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.

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, so he 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 other uses in the meantime.

Putting it all together
All you mathematicians out there are a step ahead of us: The lower the Flowie, the better. A number of 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 very important, and we want to see the number 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.

Need proof?
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.

The Foolish bottom line
The Flowie is just one tool you can use in evaluating businesses. However, its relative obscurity is a huge plus in your favor. The ability to see a business in a different perspective than everyone else helps you recognize better bargains.

This valuable ratio is just one of many fundamental analysis tools Tom passed on when he founded Million Dollar Portfolio. This real-money service is building out a complete portfolio by investing $1 million of the Fool's own money -- with all trades announced before they're made, so that members can follow along. MDP will be opening to new members soon, for one week only. Just click here for more information, or put your email in the box below.