Back to Basics, Part 17
We've been talking the last few weeks about cash flow and how the true value of a company is based not on earnings per share (EPS) or sales revenues, but rather on the generation of free cash flow. When you get right down to it, free cash flow is the fuel in the tank that motors a business down the fast lane.
Tonight, we'll look at cash flow efficiency. Think about the blood flowing through your veins and arteries. Keep the passage clean and smooth, free of cholesterol and plaque, and you're a finely tuned specimen of athletic supremacy. Look out, Sydney Games! However, throw in a few roadblocks along the way, an obstruction here, a narrowing there, and you're at risk of a coronary. Cash is indeed the blood of a business. Let's look how to identify the warnings signs of a flow attack.
When we talk about cash flow efficiency, we're looking at how well a company is managing its working capital, or the balance between current assets and current liabilities. The definition of working capital is the excess of current assets over current liabilities. We need to tweak that definition a bit, though, because not all assets are good and not all liabilities are bad. Efficient cash flow really means the excess of the good over the bad.
Good assets are cash and its cousins -- marketable securities and short-term investments. Cash is always good and its cousins can become cash at the drop of a Jester's cap. Bad assets are inventory and accounts receivable. Inventory is waiting to be to converted to cash, but it's sitting idle, stalled in traffic. It costs money to store it, and frankly, it's just doesn't benefit the company at this stage of development. Cash, good. Inventory, often necessary, but bad. Accounts receivable are the promises of cash that have thus far gone unfulfilled. It's money that could be very useful, taunting you from a distance. Cash, good. Waiting for cash, bad.
Current liabilities are mostly bills the company has not yet paid. This is very good. That means that cash is still there doing its thing and not leaving the circulatory system of the company. Cash, good. Cash flying out the door, bad.
Do you get the idea we like cash? Yep, you betcha. Cash is King. Cash is the very reason any business exists at all. Generating cash, then doing everything you can to keep that cash flowing through your business is the key to prosperity.
So, how do we know if a company is efficiently managing its cash flow? Easy, call the CEO and ask him how he feels about cash, and then ask how he feels about cash flying out the door. If he likes the latter and doesn't have a strong positive reaction to the former, hang up immediately. Maybe think about shorting that puppy.
OK, seriously, it's really not all that difficult thanks to perhaps the best Fool invention to date -- the Flow Ratio, developed by Mr. Big himself, Tom Gardner. The Flow Ratio is an absolute beauty because it measures cash flow efficiency and pounds it into a measurable and comparable number, a statistic that can easily be followed and tells as much about a company's cash flow status as the ERA tells about Pedro Martinez's pitching dominance.
Get out your T-square, compass, charting programs, and spreadsheet and we'll walk through how to determine a company's Flow Ratio. OK, now throw all those things out the window and take out a simple calculator. The easy formula is this:
(Current Assets - Cash & Cousins*)
(Current Liabilities - ST Debt**)
* Cash's cousins = marketable securities and short-term investments
** Short-term debt = notes payable and the portion of long-term debt that is current
What we want here is a low number. Why low? Because we've eliminated the good stuff from the numerator and we've likewise slashed the bad from denominator. Remember that bad current assets decrease operating cash flow and good liabilities increase operating cash flow. We want a low bad to good ratio.
How low? Well, the lower the better. A Flow Ratio below 1.0 means the company is delaying the outflow of cash in greater sums than is tied up in inventory and due bills. This leverage is a huge asset (the good kind of asset, naturally) when it comes to making a business go and grow. A benchmark figure that the Rule Maker chain gang generally uses as a ceiling is a Flowie of 1.25 or lower. And better yet is a ratio that sinks from quarter to quarter. That tells us the company is not only efficiently flowing the blood through its vessels, it's also cutting cholesterol and removing plaque as it moves along. We love companies that keep it low. As the band War used to sing, "Low-ri-der is a real goer."
What does a high Flowie mean? It means the company has lost its leverage. Its tying up crucial cash instead of letting it flow freely and fuel the business. It's weakening its financial position and decreasing its opportunities. If not corralled, it usually means trouble is on the horizon. A high Flow Ratio puts a company at risk for a flow attack.