Message Font: Serif | Sans-Serif

No. of Recommendations: 27
The Flow Ratio (see the link below for a description) is a valuable tool which is also quite convenient, hence its popularity. It does, however, have its drawbacks which become increasingly apparent the lighter a company's business model gets. Let me give two extreme examples to illustrate where the flowie is applicable and where it breaks down.

Flowie Example#1
Sales = \$900
Current assets = \$2,000
Cash = \$0
Current liabilities = \$3,000
Short-term Debt = \$2,500

Non-cash current assets = \$2,000 - \$0 = \$2,000
Non-debt current liabilities = \$3,000 - \$2,500 = \$500
Flow Ratio = 2000 / 500 = 4.00

That's a horrible flowie, and a company probably in trouble. Now let me show you an example of an equally bad flowie, but the company is in good financial shape because it has a light business model.

Flowie Example#2
Sales = \$900
Current assets = \$2,000
Cash = \$1960
Current liabilities = \$10
Short-term Debt = \$0

Non-cash current assets = \$2,000 - \$1,960 = \$40
Non-debt current liabilities = \$10 - \$0 = \$10
Flow Ratio = 40 / 10 = 4.00

The difference is in the working capital. Company#1 has alot of money tied up in operating the business, to the tune of \$1,500 (=2000-500), forcing them to grow their business through debt. Company#2, on the other hand, has a much lighter business model which has tied up only \$30 (=40-10), enabling them to grow their business from the cash in their own coffers. But both have terrible flowies. Notice that the lighter the business model, the less relevant is the Flow Ratio. Yet it is the light business model companies which are of most interest to us today. So perhaps the flowie is not our best choice of metric.

To circumvent this problem, I have begun using and relying more upon a metric very similar to the cash conversion cycle (see the link below for a description of the CCC). I don't know its official name, though I've seen it in Fooldom, so I'll call it the Working Capital Cycle (WCC). Simply put, I define the WCC as the number of days worth of sales that is tied up by working capital (non-cash current assets minus non-debt current liabilities). There are 90 days in a quarter (close enough), so if a company has a full quarter of sales tied up in working capital, then its WCC is -90 days. Conversely, if a company's suppliers have loaned it more interest-free money (those non-debt current liabilities) than it has loaned its customers or tied up in inventory (those non-cash current assets), then its WCC is a positive number. I love seeing a positive WCC (e.g. Amazon, Cisco, Dell). [Note: Other folks may reverse the sign of WCC, I don't know for sure; but I like to associate a positive number with positive conditions.] Let me now be explicit:

WCC = (non-debt current liabilities minus non-cash current assets) / daily sales
Daily sales = quarterly sales / 90 days

Now I'll return to the above two examples and calculate the WCC.

WCC Example#1
Sales = \$900
Current assets = \$2,000
Cash = \$0
Current liabilities = \$3,000
Short-term Debt = \$2,500

Non-cash current assets = \$2,000 - \$0 = \$2,000
Non-debt current liabilities = \$3,000 - \$2,500 = \$500
Daily sales = \$900 / 90 = \$10
WCC = (500 - 2,000) / 10 = -150 days

This company has 150 days worth of sales tied up in working capital. Ouch! No wonder they're in so much trouble. Now let's look at the second company. It has merely 3 days worth of sales tied up in working capital. Much better!

WCC Example#2
Sales = \$900
Current assets = \$2,000
Cash = \$1960
Current liabilities = \$10
Short-term Debt = \$0

Non-cash current assets = \$2,000 - \$1,960 = \$40
Non-debt current liabilities = \$10 - \$0 = \$10
Daily sales = \$900 / 90 = \$10
WCC = (10 - 40) / 10 = -3 days

It is also difficult to estimate a change in cash flows from a change in flowie. I can, however, immediately understand the impact of a change in WCC on the cash flows. If the WCC falls by 9 days, then I know that cash flow has been hit by 10% of that quarter's sales (=9/90).

As you might guess, the WCC and the Flow Ratio are related. When the WCC=0, the Flowie=1.000. Always. When the flowie is greater than 1, the company has money tied up (negative WCC); and when the flowie is less than 1, the company is getting free loans from its suppliers to operate its business (positive WCC). So whenever I see a company with a positive WCC, I know its flowie is less than one.

The flowie is a convenient metric and a great teaching tool. The WCC, for a small extra bit of complexity, gives better insight into the company's money management, especially for the lighter business model companies which are of such interest today. I look forward to a discussion on whether WCC would be a better metric than Flow Ratio for the Rule Maker criteria; and if so, what value of WCC one would use.

Cheers,
- FoolishErik

P.S. I'd love to know what the WCC is really called, if anyone knows.

Description of Flow Ratio:
http://www.fool.com/portfolios/rulemaker/rulemakerstep6.htm#10

Description of Cash Conversion Cycle:
http://www.fool.com/portfolios/rulemaker/1999/rulemaker991102.htm