Source:
http://www.fool.com/portfolios/rulemaker/1999/rule
maker991210.htm
Tying It All Together with the Flow Ratio -- Part 1 of 2
... and an explanation of Free Cash Flow
By Phil Weiss (TMF Grape)
TOWACO, NJ (December 10, 1999) -- Over the next two reports, I'm going to talk about
my favorite Rule Maker analytical tool, the flow ratio, and the important financial concepts that
weigh into that simple little ratio. What I like most about the flow is the way it helps tie
together the income statement and balance sheet and also gives some insights into what you'll
find by taking a gander at the all important Statement of Cash Flows. If you stick with me for
tonight's report and then again next week for part two, I think that you'll have a better
understanding of how a company's financials reveal what's really happening inside the
business.
For tonight, we're going to take a whirlwind tour through the cash flow statement and balance
sheet. First, we'll review the concept of free cash flow. Then, we'll discuss the balance sheet
concept of "working capital," and how it impacts cash flow. That information will form the
backdrop for gaining a comprehensive understanding of exactly what the flow ratio means and
why it has such a great impact on a company's cash flow. With that, let's jump into the cash
flow statement.
From time to time, you've seen us talk about a company's ability to generate "free cash flow."
As economic animals, corporations live to generate as much free cash as possible, while
utilizing the least amount of resources in the process. Quite simply, free cash flow is the cash
that's left over after everything -- bills from suppliers, salaries, expenses for the annual
holiday bash, new equipment to expand the business -- is said and done. In theory at least,
free cash flow is the amount of cash a business could issue to shareholders in the form of a
dividend check.
To calculate free cash flow, all you have to do is go to the cash flow statement and find the
line called "cash flow provided by operations," also known simply as "operating cash flow."
Once you've found that, all you have to do is subtract net capital expenditures and what's left
is free cash flow. Nothing to it. Really, it's not as tough as you might have it cracked up to be.
Let's walk through an example using Yahoo!'s (Nasdaq: YHOO) cash flow statement for the
first nine months of this year (from Yahoo!'s Q3 10-Q). For your viewing pleasure, I've
included the relevant portion of the cash flow statement directly below.
YAHOO! INC.
Condensed Consolidated Statements of Cash Flows ($ thousands)
Nine Months Ended
September 30,
1999 1998
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 16,395 $
(16,514)
Adjustments to reconcile net income (loss):
Depreciation and amortization 31,940 9,838
Tax benefits from stock options 10,493 8,675
Non-cash charges related to stock option grants 1,868 1,392
Minority ints. in operations of cons. subsidiaries 1,733 (365)
Purchased in-process research and development 9,775 15,000
Changes in assets and liabilities:
Accounts receivable, net (9,797)
(13,952)
Prepaid expenses and other assets (3,125) 2,752
Accounts payable (273) 2,583
Accrued expenses and other current liabilities 31,283 12,331
Deferred revenue 32,569 26,759
---------- ---------
-
Net cash provided by operating activities (A) 122,861 48,499
---------- ---------
-
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of property and equipment (B) (30,617)
(12,448)
---------- ---------
-
Free Cash Flow (= A + B) 92,244 36,051
Let's take this step by step. First off, we start with net income (or loss) from the income
statement, which always appears as the top line of the cash flow statement. Next, we add
back any non-cash expenses, of which depreciation and amortization is the largest. Last, we
finish up by adjusting for the changes in current assets and current liabilities. What we're left
with after we've adjusted for these items is operating cash flow. The final step in arriving at
free cash flow is to simply subtract the "additions to property and equipment." In the case of
Yahoo!, its advertising and commerce businesses have generated in excess of $92 million so
far this year. Not bad.
(On a somewhat technical note, notice that this last step is labeled as "A + B" because rather
than subtracting, it's the addition of a negative number. Within the statement of cash flows,
any positive number is an addition of cash and any negative number is a deduction of cash.)
Now that I've laid some foundation, let's take a look at what "working capital" is, how it
relates to the way a company manages its business, and its connection with the flow ratio in
terms of bringing all of a company's financial statements together. By definition, working
capital is current assets less current liabilities. So, when I use the term "working capital
management," I'm referring to a company's management of its current assets and liabilities.
When we calculate the flow ratio, even though current assets -- such as accounts receivable
and inventory -- are listed on the balance sheet as "assets," we Rule Maker investors consider
them to be liabilities for all practical purposes. The reason for this is that accounts receivable
represents nothing more than an interest-free loan to customers. In the case of Yahoo!,
accounts receivable represents the uncollected cash from advertising customers such as
Proctor & Gamble, Victoria's Secret, and other names you see under the "featured stores"
section of Yahoo! Shopping. The more diligently a company collects its receivables, the better
-- we want cash, not uncollected bills.
Now that we know what working capital is, we're ready to see how changes in the level of
working capital on the balance sheet impact the cash flow statement. We'll start off by looking
at the first major component of working capital -- accounts receivable. If you compare the
balance sheet to the statement of cash flows, you'll see that a company's cash flow increases
when accounts receivable decreases, and vice versa. Believe it or not, this means there is
actually a financial statement that treats accounts receivable like a liability. That's why,
around here, we're big fans of the cash flow statement.
Now, if you're a little confused at this point, don't worry -- that's normal. These concepts are
tricky to grasp at first. Here's an example that should clarify how a change in the amount of
accounts receivables on the balance sheet translates into a change in the amount of cash on
the cash flow statement. Let's look at Yahoo!'s change in accounts receivable over the last
nine months:
($ thousands) 9/30/99 12/31/98 Change
Accounts receivable 43,886 34,089 increase of 9,797
If you look at the numbers from the cash flow statement in the table that appears above,
you'll see that this increase in accounts receivable appears as a decrease to cash flow provided
by operations. Does that make sense? The key to understanding this dynamic is to look at
accounts receivable (and other current assets) as investments. Over the first nine months of
1999, Yahoo! had to make an investment of an additional $9,797,000 in accounts receivable in
order to meet the needs of its customers. Investments are a use of cash, and thus, this
investment shows up as a decrement to operating cash flow. (You should also be aware that
the numbers don't always work out this smoothly. Sometimes, foreign currency translation
adjustments and financial statement changes related to business combinations can skew your
results.)
The same situation holds for other current assets such as inventory, which is the second major
component of working capital. Keeping too much inventory around is another practical liability.
Think of excess inventory as an unnecessary investment. There are two principal reasons for
this. The first is that having inventory sitting on the shelves is really no different than leaving
money sitting on that very same shelf. Companies need to get the product out the door and
sold -- and then quickly collect cash payment. The other is that, particularly when it comes to
high tech companies, the rapid changes in products and the tendency of companies to
cannibalize their own product lines can easily lead to excess inventory becoming nothing more
than worthless junk sitting on the shelf. Looking back to Yahoo! again, the Internet portal has
the fortunate situation of having no inventory whatsoever as their product is digital -- nothing
but intangible bits and bytes.
The third major component of working capital is accounts payable. Even though payables are
listed as a liability on the balance sheet, the flow ratio treats accounts payables as a practical
asset. So does the cash flow statement. Accounts payable represents an interest-free source
of cash provided by suppliers. That's why an increase in payables results in higher cash flow
from operations and a decrease in payables results in lower cash flow from operations. While I
don't endorse a company not paying its suppliers on time, I don't see any reason to pay
earlier than necessary. This is also the way that I run my own finances. While interest rates
may not be all that high right now, it's better to have the money in my interest bearing
account than someone else's, so I schedule all bills for payment a week or less before they are
due.
Stop. Take a deep breath.
We've covered a lot of ground. Let's review for a moment and take a look at what's been
discussed here. Working capital is current assets less current liabilities, as reflected on the
balance sheet. Changes in these items are reflected in the statement of cash flows. Here's a
summary of what we've learned about working capital as it relates to the cash flow statement:
Balance Sheet translates to Cash Flow Statement
Increase in current asset Decrease in operating cash flow
Decrease in current asset Increase in operating cash flow
Increase in current liability Increase in operating cash flow
Decrease in current liability Decrease in operating cash flow
Next week, I'll wrap up this lesson with a review of the flow ratio, and how the flowie -- simple
ratio that it is -- can tell us all about this connection between the balance sheet and cash flow
statement -- all in a single number. I'll also give some further explanation about how the
income statement fits into this whole regime.
That's all for tonight. I hope everyone has a Foolish weekend.
Tying It All Together with the Flow Ratio -- Part 2 of 2
By Matt Richey (TMF Verve)
MILWAUKEE, WI (December 14, 1999) -- This past Friday, Phil began a two-part series
explaining how a lot of a company's inner-financial workings can be summed up in our very
own easy-to-calculate flow ratio. Today, I'm going to pick up where Phil left off because he's
away on business this week. (When not playing the role of a Fool, Phil is an international tax
man of mystery -- yeah, baby, yeah!)
As you may have noticed on today's byline, I'm also traveling this week, but I won't let that
hold me back from investigating this oddly interesting thing called the flow ratio. We've
written TONS about the flow in this space, but how well do you really understand what it
means? Sure, a low flowie is better than a high one -- that's clear enough -- but what does a
declining (or rising) flow ratio tell us about the status of the underlying business? That's the
question we'll seek to answer in today's column.
On Friday, Phil set the stage in part 1 by first establishing the ultimate goal of a company: to
generate as much free cash flow as possible while utilizing as few resources as possible. In
that aim to generate free cash flow, it's not just a game of revenues, expenses, and other
income statement items. No sir, free cash flow is equally impacted by developments on the
balance sheet.
What we're getting at here is the idea of thinking of companies as dollar machines. Here's a
quick example of two hypothetical dollar machines: the Green Machine and the Bloated Beast.
In some ways, the two are quite similar. If you insert a dollar today, either one will forever
"produce" 25 cents per year of net income (accounting profits). But net income is just a book
entry inside the machine. Each machine's tangible output is quite different. For example, the
Green Machine annually spits out a shiny silver quarter, whereas the Bloated Beast only
coughs up a dime and a nickel. Thus, even though both machines are equivalent on the basis
of net income, their capabilities of generating free cash flow are quite different.
The reason for the disparity in physical output between the two machines boils down to
efficiency. The Green Machine is lean and well-constructed, and thus its net income actually
survives and becomes cash reality -- a silver quarter in your hand that you can take to the
candy store. In contrast, the Bloated Beast wasn't well built so it has to spend a dime each
year to fix loose cogs and the like. That leaves only a dime and a nickel of real output.
In our search for well-built, efficient dollar machines, the flow ratio goes a long way in leading
us to companies that create real value in the form of free cash flow. As we explain in Rule
Maker Step 6, the flow ratio is a measure of working capital efficiency, where the lower the
number, the better. On Friday, Phil defined working capital as current assets less current
liabilities. He went on to explain in detail the three major components of working capital:
accounts receivable (uncollected revenues), inventory (unsold products), and accounts
payable (unpaid bills).
One of the most important parts of Phil's Friday column was his demonstration of how an
increase in a current asset like accounts receivable results in a decrease in operating cash flow
-- and vice versa for a current liability. Phil summarized these principles in the following table:
Balance Sheet translates to Cash Flow Statement
Increase in current asset Decrease in operating cash
flow
Decrease in current asset Increase in operating cash
flow
Increase in current liability Increase in operating cash
flow
Decrease in current liability Decrease in operating cash
flow
If you're confused at this table, hang with me because I'm about to show you precisely where
the flow ratio -- a balance sheet metric -- intersects the cash flow statement. This direct
relationship between the flow ratio and the cash flow statement is what gives the flowie its
great importance. Here we go!
Let's look again to Yahoo! (Nasdaq: YHOO) as our example. Yahoo! makes a good
demonstration because I think what we're about to look at partly explains why the market has
valued this company so dearly. Below, I've reproduced the cash flow statement from Friday's
column, except that this time, I've italicized the section that reflects the flow ratio. (By the
way, all of these numbers are taken directly from Yahoo!'s Q3 10-Q financials.)
YAHOO! INC.
Condensed Consolidated Statements of Cash Flows ($ thousands)
Nine Months
Ended
September 30,
1999 1998
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 16,395
$(16,514)
Adjustments to reconcile net income (loss):
Depreciation and amortization 31,940
9,838
Tax benefits from stock options 10,493
8,675
Non-cash charges related to stock option grants 1,868
1,392
Minority interests in operations of cons. subsidiaries 1,733
(365)
Purchased in-process research and development 9,775
15,000
Changes in assets and liabilities:
Accounts receivable, net (9,797)
(13,952)
Prepaid expenses and other assets (3,125)
2,752
Accounts payable (273)
2,583
Accrued expenses and other current liabilities 31,283
12,331
Deferred revenue 32,569
26,759
---------- ------
--
Net cash provided by operating activities (A) 122,861
48,499
---------- ------
--
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of property and equipment (B) (30,617)
(12,448)
---------- ------
--
Free Cash Flow (= A + B) 92,244
36,051
The italicized section above is where the flow ratio hits the cash flow statement. Now that we
have our bearings, let's zoom in on just that "changes in assets and liabilities" section for
Yahoo!'s nine months ended September 30 of this year. Here's what we find:
YAHOO! INC.
A Portion of the Statements of Cash Flows ($ thousands)
Nine Months Ended
September 30, 1999
Changes in assets and liabilities:
Accounts receivable, net (9,797)
Prepaid expenses and other assets (3,125)
Accounts payable (273)
Accrued expenses and other current liabilities 31,283
Deferred revenue 32,569
---------
Cash Generated from working capital $ 50,657
Okay, what we see is that Yahoo! generated $50.7 million just from its working capital
efficiencies. That's more than three times the amount of its reported net income ($16.4
million) during the same period! To say the least, Yahoo! is a lot more like the Green Machine
than the Bloated Beast.
Finally, let's see how this connects back to the flow ratio. Using the flow ratio formula and
balance sheet segments listed below, let's compare Yahoo!'s working capital management
efficiency for the most recent quarter (9/30/99) versus the end of last year (12/31/98). (By
the way, you'll notice that Yahoo! has no short-term debt, so that portion of the formula
doesn't come into play.)
(Current Assets - Cash & Marketable Securities)
Flow Ratio = -------------------------------------------------
(Current Liabilities - Short-term Debt)
YAHOO! INC.
A Portion of the Balance Sheet ($ thousands)
September 30, December
31,
1999 1998
Current assets:
Cash and cash equivalents $ 141,542 $ 230,961
Short-term investments in marketable securities 534,770 341,822
Accounts receivable, net 43,886 34,089
Prepaid expenses and other current assets 14,036 10,860
----------- ---------
Total current assets 734,234 617,732
Current liabilities:
Accounts payable $ 11,225 $ 9,986
Accrued expenses and other current liabilities 74,131 46,147
Deferred revenue 72,365 39,796
----------- ---------
Total current liabilities 157,721 95,929
Flow Ratio = 0.37 0.47
So what did we find? Yahoo!'s flow ratio has dropped from 0.47 to 0.37 over the first nine
months of 1999 -- a 21.3% improvement. Yahoo!'s declining flow ratio is what caused the
"changes in assets and liabilities" segment of the cash flow statement to be a source of cash
for the company. 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 -- a rising flowie will
cause that section of the cash flow statement to be a cash drain. That was the situation with
Pfizer that I explained in a column back in October.
To say the least, Yahoo!'s improving working capital efficiency has been a major source of
cash. The $50.7 million generated from working capital accounts for more than 50% of the
company's $92.2 million of free cash flow. Thus you see the direct importance of the flow ratio
on a company's cash flow.
The lesson here is that while a flow ratio's current location is important, it's the direction --
whether rising or falling -- that matters on an ongoing cash flow basis.
Okay, now let's quickly tie it all together in the big picture of a business that we own. To start,
our company purchases raw materials and turns them into inventory. That's "cost of goods
sold" on the income statement. Then, it sells the inventory to customers, thereby creating
accounts receivable on the balance sheet and revenues on the income statement. Finally, our
company collects our money, and thus we have cash on the balance sheet. So, it all fits
together. The income statement tells us how much product was sold; the balance sheet shows
what resources were used to run the business; and the cash flow statement reveals the actual
inflows and outflows of cash.
Hey, Phil and I flew through this stuff, so if you have any questions at all, please ask on one of
the Rule Maker boards listed below.
One last note: If you're looking to air your thoughts on the millennium, check out how you can
get on The Motley Fool Radio Show.
Have a great night, and Fool On!
- Matt Richey