The Chicks' 12 Steps to Picking a Stock

STEP 9  Flow Ration

Note: This article focuses on Step 9 of the Chicks' Dozen. For articles focusing on other Steps, see the links listed at the bottom of the page.

Last night I had the hardest time trying to put my three year old to bed. She wasn't going to go to sleep for anything. I tried singing to her, telling her a story and even tickling her back. Nada. Miss Bright Eyes and Bushy Tail wanted to watch T.V. She won, as she always does. How can you say no to "Pwwweeeeeeeese, Mommy"?

Anyway, as I was blankly staring at Ariel's new baby I realized that I wasn't using my management skills very well. Here I was watching The Little Mermaid II for the fifth time when I should have been writing this article and my daughter should have been sleeping. I'm not a very good manager (or bedtime Mom). Thankfully, I am not a company to invest in. But, as Chicks, we need to take notice of how well a business manages itself. We are especially concerned with how the company manages their cash and inventory. (Similar to children and parenting.) How are they at handling the incoming and outgoing of its dollar bills, and how does this relate to their inventory? This would be called the Flow Ratio, and is Chicks Dozen step # 9.

The Chicks first learned about the Flow Ratio from our Foolish neighbors at www.fool.com. (Really smart people over there.) Aside from Buying What We Know, and Keeping It Simple, our Chicks Dozen has a few numbers to compute, and more importantly... understand. The Flow Ratio is the most difficult to compute of our Dozen, and I think, the most difficult to understand. You might have to print this article, take it to bed with you, lay it under your pillow, and by morning... VOILA... complete comprehension.

Here is the formula:

       Current Assets - Cash*         
Current Liabilities -Short Term Debt

(* Includes marketable securities and cash equivalents)

What the top part of the equation focuses on is the part of a company's assets that are not liquid. If you take their Current Assets and subtract the Cash, what you have left is pretty much inventory... or stuff they hope to sell within the next year. For example, let's look at The Gap. You're more than welcome to look at the real Gap's Balance Sheet as we go along.

The Gap lists their Current Assets at almost three billion dollars! Sounds good. But what if 75% of those Current Assets were last year's Tech Vests? I mean seriously, who is wearing Tech Vests this year? Let's take a closer look:

Current Assets (in thousands)

The numerator (top part of the equation) is figured like this. (Total Current Assets = $2,783,729) minus (Cash = $327,860). The Cash figure includes any monies that are liquid. Marketable securities such as stocks and bonds are liquid, so we include those in the cash figure. Here is our numerator:

Current Assets - Cash = Unloaded Inventory
$2,783,729 - $327,860 = $2,455,869

Wow... looks like they have a lot of tech vests and even some unsold cargo pants sitting in the back room. This should make investors nervous. We would like A LOT of cash, and hardly any unsold inventory.

Now for the denominator (bottom part of the equation). Let's go back to the Gap's Balance Sheet again.

Current Liabilities (in thousands)

Stay with me here... it's getting tricky. What our denominator is focusing on are the "good" liabilities or the "profitable" liabilities. By "profitable" liabilities I mean, it's cost-effective to hold the people you owe off, as long as you can. Why pay them Tuesday when you could wait three months? This way, you are able to keep the money in your pocket or in your interest earning money market account. You are earning interest on the money you owe up to the last second. But, some of the Current Liabilities include short-term debt. We need to filter that out.

Short-term debt refers to short-term loans, or borrowed money that a company will be paying back within the next year. Loans carry interest. Short Term debt is not a "profitable liability" because you are paying interest on that money. We want our companies to keep money in their hands any way they can, but NOT pay interest for holding it. So, we must subtract that number out of our Total Current Liabilities to find out which of our liabilities are "profitable" liabilities.

Now, only to confuse us more, someone at the Gap has changed the language. Don't let these accountants frustrate you. As Chick Cheryl always says, you say ta-may-toe, I say ta-mah-toe. They all use different lingo for the same thing. If it doesn't say Short-Term Debt, it might be worded, Notes Payable. Notes Payable = Short Term Debt. The Gap's accountant chooses Notes. Does anyone know his name?

Here is the Denominator:

Current Liabilities - Short Term Debt (or Notes Payable) = Profitable Liabilities
$2,400,099 - $859,448 = 1,540,651

Now we can actually figure our Flow Ratio since we have both our numerator and denominator.

The best-case scenario has the bottom being larger than the top. Let's do the Gap:

Uh-oh... looks like the Gap needs to tighten up the pants. The Chicks would like this number to be 1.5 or under. This would mean that they are getting things off the shelves quickly while holding off the people they owe. This would be a well-balanced liabilities to inventory Flow Ratio. It takes a special company to be able to create a flowing balance between these two. It also takes a special parent to create a balance between TV and bedtime. Maybe the people at the Gap are watching more Little Mermaid than me.

Chick Karin