If you’ve been investing for a reasonable amount of time sure you’ve realised how important it is to analyse the working capital management of a company. If like me you are always looking for shortcuts to evaluate companies (in this case how to use the flow ratio) this article will be especially useful to you.
It is a shortcut that I’ve come across that helps you evaluate the working capital investment of a company quickly and very effectively I’m sure you are aware of the normal ratios used to evaluate working capital.
Here they are:
- The current ratio (current assets / current liabilities) as a general rule a value greater than 1.5 is good
- The quick ratio also called the acid test ratio ((current assets – inventory) / current liabilities) a value greater than 1 is good
- Days inventory on hand ((inventory / cost of goods sold) * 365) Compare this number to competitors to see if it is good or bad. Be careful if it keeps deteriorating.
- Days of accounts receivable ((accounts receivable / sales) * 365) Again, compare this number to competitors to see if it is good or bad and be careful if it keeps deteriorating
To this I would like to add this very innovative way of evaluating working capital that you may not have heard of. It is a ratio that I discovered when reading old articles from the Motley Fool, more specifically an article written in 1999 by a friend and hedge fund manager Zeke Ashton.
You can find the whole article here The Early Warning Flow In spite of the article being written in 1999, just like all good advice, it is as relevant today as it was then. Before I tell you how to calculate the ratio let me start at the end and explain what the ratio tells you.
The lower the better
A low flow ratio tells you if a company has an asset light business model or if it manages its working capital well. A low ration means the company either has a low amount of current assets or it is able to finance current assets entirely with low or no cost current liabilities (like accounts receivable).
A high flow ratio means that the company has to invest a substantial amount of money in working capital assets or that the company is really bad at managing its working capital.
Bad working capital management would be having too much inventory or collecting accounts receivable very slowly.
A ratio of less than 1.5 is really good.
Should the ratio go over three, it’s a warning sign for you to find out why it is so high or to be very careful before investing in the company.
How is the flow ratio calculated
So how is the flow ratio calculated?
It is calculated as follows:
Flow Ratio = (Current Assets – (Cash + Short-term Investments)) / (Current Liabilities – Short-term Debt)
The first or top part of the flow ratio or the numerator. The ratio finds “bad” current assets by subtracting the good current assets which are cash and short-term investments.
Bad current assets are mainly accounts receivable and inventory.
Accounts receivable are sales for which the company hasn’t received payment yet. The longer it takes to collect accounts receivable the more likely it becomes that they may not be collected.
Inventory is goods purchased waiting to be sold, and like accounts receivable, the longer goods take to be sold the less valuable they become.
They may thus become outdated or obsolete.
In the second or bottom part of the ratio you calculate the good current liabilities. Good current liabilities are those that don’t cost the company anything.
Current liabilities contain short term liabilities a company has to pay. These consist mainly of accounts payable, which are services and goods the company has received but hasn’t paid for and short term debt.
Because debt costs interest it is deducted from total current liabilities.
What the ratio REALLY does
So what the Flow Ratio does is it shows you the ratio of bad current assets to good current liabilities.
It shows you to what extent a company is able to finance its bad current assets with current liabilities that do not cost any interest.
Thus the lower the Flow Ratio, the better the company is at maximizing the value of its cash flow.
But that is not all
As mentioned a low Flow Ratio also tells you that the company has an asset light business model and/or excellent working capital management.
Keep in mind a rising Flow Ratio shows a deterioration of these qualities.