Alan Cring Productions in association with the Emergent Light Studio presents
the Illinois State Collegiate Compendium... Academic Lectures in Business and Economics.
This is Business Finance, FIL 341 for autumn semester 2024.
Today, ratio and common size analysis. This is the end of the lecture material. You have your
midterm exam next week. On Tuesday, we will review for it and then on Thursday you'll take the test,
the midterm exam. Now the Thursday class, the class after this one, I don't have a lot to do.
It's more technical just using the Excel sheet, using Excel to do as your basis for doing your
analytical tools. And of course, I strongly encourage you just as a heads up and I'll review
fully for the midterm exam on Tuesday of next week. But you are allowed to use your notes on
the exam. I have no problem with using and bring along that ratio formula sheet that I gave that I
is in your files. Financial ratios formulas or something like that. Do bring that one up
and have that one available for the midterm exam. I don't necessarily care so much about you being
able to accurately calculate ratios. You've got Excel to do that. What I do care about is your
interpretation, which is why I'm spending more than a couple of days looking at financial statements
and doing what is truly financial analysis. A lot of what we do in almost any area of finance,
well, is some kind of financial analysis. Looking at the financial statements and then shaking them
out. Today I'm going to do, as I said, the ratios, finish that up, do that all. And then I'm going to
do the common size financial statements. And then I'll probably just kill it at that point. And then
on Thursday, we'll do free cash flow. Now there are, it may be a little bit of pro forma, but
if our free cash flow goes, in the business there are several detailed meticulous ways to do free
cash flow. Then there's what we used to call dirty free cash flow. It was a faster way to get the free
cash flow of a company. It actually comes out with numbers that are very similar to what you would do
if you broke down and did all these weird things. And so I generally teach the dirty free cash flow
way and it gets you good results and it gets you just fine. You see in free cash flow,
free cash flow is very rarely close to zero. It's either a big fat positive number or a big fat
negative number. And you don't see much that's where, well, if we'd done this calculation a
little bit more accurately, it could have been positive instead of negative. It's not going to
work that way in real life. And we'll do a couple of financial statements. You'll see those on
Thursday where we run free cash flow analysis the dirty way. You'll see that it's either a big
positive number or a big negative number. And you could have done some little nuances in there.
It wouldn't have changed it. Here's the thing. If it's negative, that's bad. If it's positive,
that's good. There's no equivocation about it. And the more positive it is, the better, really.
Some ratios, and I'll bring this up and then I want to look at the numbers. Some ratios,
well, actually many ratios, there's not a good number. You can have a number that is near the
industry average. Well, yay for that. But what happens if you're in an industry that sucks?
All the other companies are terrible. Do you really want to be in the pack of that average?
So you have to think of each company on its own to a certain extent. Obviously, we want to look at
the industry averages, but at the same time, we also want to say to ourselves, well, maybe we're
different from the industry average, but maybe that's a good thing. Say your industry average
inventory turnover ratio is 4.5. Well, that's a pretty slow inventory turnover ratio in the
modern age. So we could say, well, we're above 4.5. That's a good thing. Or we're below 4.5,
and 4.5 really kind of sucks, so we're in a really bad position here. So ratio analysis does have
that judgment call in it, and that's what we do in here, and that's what I'm trying to empower you to
be able to do. Know enough so that your judgment actually means something. A judgment without
education and experience is nothing but another opinion on the internet.
So first of all, let's look at the numbers just for a little bit, and the numbers are actually not
very happy at all today. It is definitely a negative day, and the Dow is the least of our
problems today, of course, compared to the S&P 500. The Dow is down a little more than a half a
percent. Excuse me, the S&P 500 is down about 1.14 percent, and then you've got the NASDAQ.
Am I seeing that right? Is that 1.81 percent? Now that's kind of serious. We had some negative.
We had mixed data coming out today, and that's spooking the markets. It's really spooking them
because there's always that fear in the back of our minds that there's a recession right out there
around that corner waiting to kick us in the ass. Most of that fear comes from that inverted yield
curve. We've had an inverted yield curve for several years now. It is not just a normal inverted
yield curve, it is a yield inverted yield curve from hell, and it doesn't seem to have created a
recession yet, and yet we know that every recession has been preceded by an inverted yield curve.
So we're waiting for this to happen. We hope it won't happen. We're going to break the historical
trend, the historical reality, but we still are afraid, and every time we see some negative
numbers, well, we get spooked by what is happening. Now, crude oil has had a big jump, and if you are
watching the news or some of the more reputable sites on the internet, you can see that missiles
are raining down on Tel Aviv, this capital of Israel, and that from Iran, their ballistic missiles,
their mate, I don't know if I would call them Mark IVs, in other words, they couldn't reach Europe,
but they can certainly take a big swing across the sands of Arabian sands, and they're slamming into
Israel, and the Iron Dome isn't stopping them. If you watch the videos, lots of those missiles are
hitting pay dirt. Only a few are being intercepted. That's going to probably set Israel on a path
toward full-blown war, possibly with Iran. If we go to war with Iran, the price of crude oil could
go through the freaking roof. Here's why. Iran has wanted to be a respectable player on the international
stage, despite the fact that it is a highly ideological, violent theocracy, about everything bad
Westerners see in Iran, but if Iran is back to the wall, they could very well mine the Strait of
Hormuz. It's a very narrow channel that comes out of the Gulf and gets out to the Indian Ocean,
and if they mine it, that means that the ships going through it will blow up. They also have a
battery of old silkworm anti-ship missiles that can really tear up. We could probably, a modern
fleet of battle ships would have no problem with the silkworms. However, they also have Mach 5
sunburns, and those sunburns could probably get through, at least some of them could get through
even our Aegis systems on our ships. So that means that if things go sour sideways, the price of oil
is going to go to $100 a barrel, probably $125, and so that will send all the Western
economies into a recession right away. This is when you get to the point where you're doing
financial analysis. You notice that I'm talking about global events, politics, war, shipping,
and all of that. This is when what you may want to aspire to, it's when you know more than just the
textbooks and the typical news articles, and you begin to have an understanding of how the world
puts together and how those pieces can, when they break apart, what the domino effect is of those
things. This is our world. We're finance people, and so it all boils down to capital and money
and how it flows and what can stop it from flowing and what that can do to economies around the world.
So when I talk about this, I'm not just blowing information out of my butt. I'm telling you what
this is, how it's going to help, what you need to know to be better than the average, and thank God
you've got the best professor who ever walked the earth teaching you. Okay, or something like that.
Okay, look over here. We've got crude oil and look at gold, the gold bugs. Oh God, the apocalypse is
happening. Jesus is coming back. Buy gold. See it? So you see them freaking out today.
How much can you take? How seriously can you take them? Eh, you know, it is what it is. Now
interestingly, 10-year bonds have finally, the yields have turned the other way, which is good
news. They had been going up those yields had, despite the fact that interest rates, the Fed was
trying to bring down interest rates, but now the yields are finally settling back somewhat, which
is good news for us. That will help. They're still not down. They had gotten down to about, I think,
3.63% the yields had. They're still higher than they were a couple of weeks ago, but still we're
glad for anything that happens in this kind of a world. Now look, here's what could be going on.
This is a flight to quality. As the stock markets, as investors exit equities, they sell equities,
that freeze up funds, and so if they're looking for safe harbor, the next place they're going to
go is to bonds, which are safer than stocks in general. So that is what we're seeing here,
is investors are buying into the bonds, price of the bonds goes up, and yields go down. So this is
a classic flight to quality that we're seeing today. The equity markets over here, everyone's
getting the hell out, so what's happening is on this side over here, well that means that they're
getting out of risk, they're selling their equities, that freeze up funds, the funds, the safe
harbor is the bonds, and as the bonds are bought, that pushes the price of bonds, demand for bonds
goes up, price goes up, and yield goes down. Classic flight to quality. And the worrisome part is,
we see that gold going up, that is the second stage of a flight to quality, and that can be a
little concerning. I don't see gold, well let me look here again. Yeah, that's a little concerning,
that's more than a percent increase in the price of gold. So,
yeah, remember, flight to quality, stage one, from stocks to bonds, stage two, from bonds to gold,
stage three, from gold to bullets. We're not quite at the bullets yet, but maybe I should look at
some of the firearms manufacturers, see how their stocks are doing anyway. But anyway, there's what
you're seeing, this is no mystery to us. We're finance people. There are things that surprise
us, and you say WTF, and you've seen me do that a couple of times in this class, but in general,
the motion of the markets is a clock, the pieces fit together in a very clean fashion. It's just a
mystery and stuff for talking heads and conspiracy theorists outside of our realm, but in our realm,
we stick to the science, and we stick to the logic, and to the economics, and the finance.
Enough of that. Oh, what the heck was, oh look at that. The dollar is depreciating strongly against
the euro, and against the pound as well. So, I mean, look, I don't know what you can say about
that, other than that indicates weakening of the dollar, which is okay. If yields are going down,
the dollar should weaken against other currencies, the currencies of our trading partners. If our
yields are going down on our debt instruments faster than they are in Europe, Japan, Great Britain,
well, that tells us that the dollar is going to weaken, and that's what we're seeing here. Yields
are going down, dollars weakening against the major currencies, the euro and the pound. Japan,
I don't know what's going on there. You've got to see Japan here today. Japan, I was watching this
through the night, they had a very strong surge opening. Now, usually Japan's, the Tokyo
has had this weird pattern. Something big happens, and it surges up, or usually down,
right at the opening bell, and then it just sits there looking stupid. Today was a little bit
different, because it started up, and it kept going up for a while, and then there was a sell-off
there for a little while, and then it had another surge, and finally it just flattened out. But that
was somewhat unusual. Japan's been taking a number of days, more bear days than bull days,
recently. So this is good news. Now, if you look at the FTSE, it had a major drop-off a while ago.
Now, the FTSE is, London is still open. The bell hasn't rung yet. So this is something that happened
just about an hour ago. There was a major drop-off, and then it just went up, and then it
just recovered. There was a big sell-off, and then the bulls came in and just bought the hell out of
the bargains. It looks to me like it was bargain hunting. The market was dragged down, and everything
was dragged down with it, and then the bulls came in and found a whole bunch of bargains, and just
bought back in, and it came back from that big drop there very quickly. So here's what it is.
Now, going over here, just to look at a couple of stocks, I've been interested recently in the
bank stocks, and notice that they had a bad... the city has shed a lot of what it had gained over the
past week or so. If you look at the month, and I'll look at a monthly chart on this, remember that
these betas are heavy. They are risked, so you expect vol on them, but you see...
okay, the one month here. You see how... well, I shouldn't say that. It's still kept, at least
for today, it's still kept a lot of the gain that it has achieved over the last three weeks or so,
but it has been... I want you to look down here. Just look at the volume. Do you see that cyclical
waving pattern? There are these active, and then everyone backs off. Then active, then everyone
backs off. It's not a smooth vol from day to day, week to week, and that... you see that with some
stocks over a period of time that they have this... I hesitate to call it a pattern, but you will see
some stocks, vol is about the same every day, but then you see these ones like this. It's like there
are surges, and then everyone... no one trades, and then surges, then no one trades. Now these surges
could be buys, these surges could be sell. You see these surges right here? These were sell,
these were mostly sell. Then you see these little surge after surge after surge coming back up,
and then it dies back down, but then you see now we're going back into the little wavelets again,
and it looks like it's building for another one of those surges. You see how it seems to
be getting ready for another one of these out here, like this one, even like this one back here.
It looks like it's getting ready for a surge, which way? Don't ask me, I'm just a professor,
but it's right out there. So this is something to look for if you are into investments that,
like I said, some stocks you don't hardly ever see. It's very smooth vol from day to day,
but in other ones it has that kind of pattern. Now looking over here, just to see BAC real quick,
it's down too. Look at that spike right there, that's a sell spike. You see how it's a sell spike?
See how it's spiked and that just brought it down? But interestingly, you really didn't have any
signal and volatility when it started to turn around back here. So that's not as patterned,
for lack of a better term, as Citi is. And then going over to Wells Fargo, the other one I've
shown you before. That's down too. Now this one really doesn't pattern either the way Citi does.
Like I said, some you can see it, some it's just not really there. But in this case, notice that
Wells has a lower beta than Citi did. And you notice that volatility isn't nearly as strong
as it was. Well let me let me qualify that. It's got some volatility, but it's still not that
rocking stuff that Citi had there a while back. And another thing, when you're sitting around with
finance people, this is the kind of stuff that you talk about. You reinforce yourself by saying
yourself and each other through discussions about what's going on with these stocks.
Noticing patterns, trends, things like that in the stocks. This makes you more sophisticated
and it makes you more experienced for when you go out there and you have to do this in a live
fire exercise in the business world. But anyway, coming over here I was, what was I looking at? Oh,
our old friends TQQ. Look at that thing down hard today. TQQ is. That's a magnifier, that's a bull
magnifier. And when the bulls are in bad shape, it magnifies the downside too. So this would be put
territory. I don't know if I'd buy puts now. I think the mess is over with. However, look at its
evil twin, the SQQ. And of course, it's up. Bouts the same. So if you were a bear late last night,
you could have bought in the SQQ and you would have done really well. But if you were a bull
last night and you bought into TQQ, you would have been wrecked today. So these are the kinds where
you can take these if you have the courage of your convictions on bull or bear side.
These will magnify your convictions into money in a rather noticeable way. I'll show you one more
thing and I've probably shown you this a hundred times. I don't know if I have or not. The VIX.
This is the metric of volatility. Look at that. Hot damn, that thing went crazy.
Vol just spiked right in here. Well, I should say, well, the volatility, vol is volatility in this
case. Look at that. It was just calm, smooth waters, nice lake to paddle on. And then it turned into a
raging ocean right around at the beginning of trading today. Now remember, VIX is not a stock.
VIX is an index. There is a futures contract. And so this thing doing that, this thing has been
trading through the night and everything was nice and calm. And then right there, right before the
opening bell, all hell broke loose. This happened before the bell. The bell was about here and the
volatility index started the warning signs. This was going to be a really volatile day, probably
what, about 30 minutes maybe before the market opened the bell. So you see right here that that
was sort of like a quick, early, a very short fused early warning that it was going to be a fun, fun
day on the market. Now do you want to play volatility? Here's one. VIXX.
Whoops, didn't mean to do that. Let's try that again.
What the heck? Is it going to show me VIXX?
Well, no, VIXX. My bad. Geez. Oh, you would have done good on this today. You see that thing? And
yes, you can trade that. So if you want to play this, play volatility. If you want to play vol,
this is probably the best way to do it. And look at what you would have made. I mean, the options on
that were just insane today. Call options were. I mean, if I was lamenting that if I had thrown
a couple hundred dollars into call options out maybe two, three weeks near the money, just out
of the money on the top side, I would have made a lot of money today. And it looks like the excitement
is over with now. Let me look here. I don't know. It's still rocking in here, but it should calm
down as we come toward the bell. At least that's what I've seen this thing do before. There's just
all these traders just going crazy trading, and that reflects in volatility. And then as the
traders begin to step back and say, I'm done. That's it. Game over. Let's go out and have beer
or martinis or something. Then you see the vol begin to back down a little bit. I hope today.
If it keeps on going through the night, then you'll know that there is probably going to be another
really hard day tomorrow. But one warning. There's an old saying, down today, up tomorrow. And so you
might very well see a turnaround the other way tomorrow. Keep an eye on the volatility. If the
vol is still going crazy, that probably means it's going to be an upside day. If the vol starts going
cuckoo bananas, vix, with a little hat. If that's leading into tomorrow morning, and it's beginning
to show a lot of turbulence at the opening bell, that could very well mean that you've got the bulls
coming back, and they're going to start scooping up every bargain they can find in sight.
Enough of that. I've done what I can to talk about this. Now let me take you over here. And the first
thing we're going to do, I'm going to bring up the target worksheet. And I am uploading this
in your spreadsheets folder in Canvas. There's a subfolder, class examples, and this will all be
in there. But you still need to be keeping an eye on what I'm doing here, so that you know what I'm
doing and why I'm doing it. Now this is all, the first round of this is coming off the financial
analysis ratios. This sheet, it's in your Canvas file folders, financial analysis ratios, and this
is any ratio that I would care about that you would need to know. And there are even a few ratios in
here for at least one other class that I will be teaching as well, short-term financial management.
Specifically for short-term financial management, DSO, day sale outstanding, DIH, days inventory
held, and DPO, days payable outstanding. These are core ratios in short-term financial management.
And those three put together, you take DSO plus DIH minus DPO, and you get the holy grail of the
CCC, the cash conversion cycle, which is, it's just like one of those hugely important things
in short-term financial management. If you get into that kind of stuff, that's corporate,
not investments, but it also crosses into investments, short-term investments.
But anyway, these are the ones that I would care about. Some of those,
I mean some of them are really popular. They go in cycles. The ratios right now, EBITDA
is just a big thing, EBITDA or whatever they call it. And any ratio that has EBITDA in it
is important these days. And I'll show you right here where I'm looking at. Where the hell is it?
Where is EBITDA?
Don't tell me I don't have it in here somewhere.
Ha! I'll be darned. I gotta fix that. I need to fix that. I'm gonna have to put in another,
oh there it is. There it is. EBITDA coverage. That is a, technically that's debt management,
but it's also considered a liquidity ratio in some textbooks. That's why I was looking over there
around the liquidity and profitability. Essentially, EBITDA, operating income,
divided by interest expense is your times interest earned. So if I were to take
times interest earned,
and this is just in the book, so rather in my sheet, and it's in the book too,
so I'm not putting anything new on there. That's EBIT over interest expense. Now EBIT also is known
as operating income, or operating profit. Okay, that is a measure of how many times over you can
pay your interest expense. You do not ever want to have that below one because that means you're in
default on an interest payment. That's the end. That's end game. Chapter 11, protection. However,
the one that where you would put it as EBITDA, this part is your depreciation and amortization.
In other words, you're adding back the expenses that didn't happen. Those are accounting. They are
not real. You don't write a check to depreciation and amortization. Then you take that divided by
your interest expense, and that is a better measure of your coverage for your interest.
Because the EBIT is subtracting out something that doesn't exist. By putting it back into the
operating income, you are making it what really, how much funds do you have really to cover your
interest expense. That's why it's more popular now. The only downside of that is that some financial
statements, the companies do not report on the income statement the depreciation and amortization.
You're looking at this and you're saying, okay, is it still in there but they're just not putting
it on its own line or is it not in there at all? In which case, it's not EBIT, it's EBITDA is what
they're calling operating income. That's a mystery and it's something that's quite frustrating
to financial analysts now. You didn't put in, and a lot of companies do, you didn't put in a line
in your operating expenses, depreciation expense. Is it in there and you just buried it with SG&A
or is it not in there? What you're talking about as EBIT is actually EBITDA. The accounting
standards are basically silent on this issue. As far as I've looked and several others who are
bothered by this have said, we don't find any place in the general accepted accounting principles,
not standard principles, consistently applied. We don't find any guidance on whether or not you must
put depreciation and amortization into your operating expenses. We're in the dark. Is it in
there? Let me pull up something right here. I'm going to take this off the screen. I don't have
to do that, I can just minimize it. Let's look at target. This is target. Consolidated statement of
operations. Target is nice to us. They say, here it is. You can add it back in and you get EBITDA.
You take your operating income and add back depreciation and amortization. We know what to
do here. For that coverage ratio, we just add that back in. But there are a lot of companies,
there is no line there. You are just on your own trying to figure out what to do on that one.
Let me take this off to the side here just a second because it's going to get in the way here if I don't.
Now, as you recall from last time, where the hell was I? Oh, I got to get that over there and get
the financial statement up. Now, I was working my way through the ratios here and I had gotten down
to return on equity. Basic earning power, which you can look at, is EBIT over total assets. So,
the basic earnings power is equal to the, and if you want to follow along by all means, I will also
again upload this. Once I've put some things in here, I will upload it. But what I want to do here
is, what was I doing? Okay, total assets. Where the hell are my total assets?
Where the hell are my total assets? Oh, there it is. Total assets divided by the, no,
let me get off this. Basic earning power is EBIT over total assets equals EBIT over total assets.
So, what we'll do is we'll take the operating income, EBIT, right there, divided by the total assets.
Total assets, there it is. Okay.
Put 1031. So, essentially, that is your operating income as a, sort of like a percent of your total
assets. How much operating income did you generate from the total assets of the company?
If the total assets are a giant portfolio, and I've used this example, this way of explaining it
before, what operating income, that's your revenues minus your cost of goods sold, minus your operating
costs, what was your return on that portfolio? In this case, it was about 10.31. Now, I don't
know whether the book does it or not, but I would turn that into a percentage myself.
Now, the equity multiplier. Total assets over equity. So, that one would equal, you're going
to go to the balance sheet, and you're going to take your total assets divided by how much money
the owners have put into the company. That would be total shareholders investment, they call it.
So, in other words, how should I put this?
You've got that equity that you put, your shareholders put in money, they bought stock.
They also gave up dividends for the company to put that money back in to grow the company.
How much did that work? In this case, they turned that money that belongs to the shareholders,
they bought stock, they gave up dividends, that became a little more than four times as much
as they put in. That's the best way to explain that. And the name of it is indicative. How much
did they multiply what was put in there? Now, again, and I emphasize this over and over again,
is that these numbers are relative. Is this a good number? Is it a bad number? Well, it's pretty
obvious that if it's under one, that's bad. It actually deflated the owner's stake in the company.
But here we have, it's been multiplied by about four. What numbers do I see? Anywhere from, well,
I've seen under one, I saw a.7, I can't remember what it was last year, I hit a.7 on one company.
But in general, it's usually around four, yeah, seven, ten, hell, a few times I've run into things
like 30, 20, 30, where it really multiplied. The company was able to turn the shareholders' money
into 10, 20 times as much in terms of total assets of the company. Now, you obviously can notice that
this is highly sensitive to the leverage of the company. In other words, the more the company uses
debt, the more the equity multiplier will be because total equity will be lower and that means
that that will make the whole fraction larger. So that is, that gains to leverage in a ratio.
The more debt you're using, the more assets you're going to own. If you use only your own equity,
then you'll have a nice modest house on the outskirts of Decatur. But if you borrow tons of money,
you'll have a couple of nice houses in some reputable place in Schomburg, or something like
that, or Oakbrook. So that's what it is. Simply, the more debt you use, the bigger this multiplier
is going to be. So that's a warning. Yeah, bigger is better, but you're taking leverage and that
creates risk. The more debt you take on, the riskier your corporation is going to be simply
because you've got a bigger interest expense. So you have to have a bigger operating income to pay
that bigger interest expense. So your revenue, you don't want that to go up and down and up and down
because you could very well dip below the interest expense when you get to the operating income line.
That's why leverage does cause you to have gains, but it also is at the cost of more risk.
And let me do the dividend ratio. And this one, the dividend, I hope I can find it over here in
the statement of cash flows. Statement of cash flows. There it is. Okay, I've got to watch it here
because this is going to be a negative number and I really don't want it to be a negative number,
so I'll have to do an absolute value after I finish this. The dividends divided by the net income.
Where the hell is the net income? There we go. Net earnings. There we go. And that'll be a negative.
Let me fix that and make that a positive by doing an absolute value. ABS. Nope, don't want to do it there.
Want it one over. A absolute value of that top number. Well, I could do it at the bottom of the
whole thing if I wanted to. Okay, and then the plow back ratio is one minus that.
Well, try that again. Equals one minus the dividend ratio.
So, Target, this is Target, yeah. Target gave of what the owners claim, net income, Target gave
about 48.6% of it back to its shareholders. It kept 51% for itself, for the company to grow
the stockholders value. Now, let me do something here. These are generally considered,
and I don't know how your book puts it, but I don't recall, but usually a percentage. You notice that
Target gives a lot of its, what belongs to the shareholders, back to them. It is a very high
dividend company. It gives a lot back. Now, what does that mean? It could mean a couple of things.
Target is just generous with its shareholders. Another darker side of that is that Target
doesn't have really all that many positive net present values projects that it wants to pursue.
So, it says, here shareholders, you can do more with your money than we can. That's the
downside of giving big dividends away. It's almost a signal. Target doesn't have anything
it can do with that net income. So, it gives about half of it back to the shareholders
and keeps only about half of it to grow the company. That's a managerial, well, it's not
a managerial. It's a board of directors choice. Now, let me copy these and paste them over here.
And then we can get a clearer look. Basic earning power has jumped for this company. It really has.
And surprisingly though, the equity multiplier has eased back up a little bit.
That's a little odd, but you know, it is what it is. Now, notice that the dividend ratio has gone
down. They gave away in 2023, well, that's 2022-23, they gave back to the shareholders 66%
of what they made for them, keeping only about 34% for the company to grow. And apparently,
they definitely backed off that in this year quite a bit. But still, it's very big. And
you know, it is what it is. Clearly, they didn't want to share it. They shared a little bit too
aggressively. So now, let me go on here a little bit. I've done the liquidity and the profitability.
Now, I want to talk here a minute about the debt management ratios. Now, under debt management,
you have debt to total assets. Now, one thing about this, this is our most direct measure of
leverage. This is capital structure. Now, capital structure is a combination of debt and equity
that comprises total assets. Capital structure is a combination of debt and equity that comprises
total assets. The higher that number is, the more leveraged the company is. The lower that number is,
the less leveraged the company is. In general, the greater the leverage measured by debt to total
assets, the riskier the company is, just as a general rule. It's relying more and more on debt
and less and less on equity for its daily bread. And then, of course, you have the classic times
interest earned. And then, you have your EBITDA coverage. Now, going back up here, debt to total
assets. Now, when we do debt to total assets, generally speaking, and I think the book does this
too, you look only at your long-term debt and other borrowings. You don't bother the other ones.
For one thing, they're relatively minimal. And the other thing is, we're focusing only on the big
800-pound bondholders, those sons of bitches who can put us out of business if we don't make them
happy. So, in a case like this, we're going to take long-term debt divided by total assets.
This company has a capital structure that's 27% debt and therefore approximately 73% equity.
So, it is a relatively low-leveraged, unleveraged company. You see about 25.75 debt to equity.
That's your standard for a low-leveraged company. You get up there 50, 70, 30. That's high leverage.
But in this case, debt to total assets of.2695. Now, times interest earned, you're going to take
that operating income right there. Where the hell is it? Right there. And you're going to divide it
by your interest expense. 11 times. This is a relatively large number. You like this. You get
really fussy if it gets below four, three. At seven, you're okay. You're comfortable. Ten. Now, at 11,
things like this, and I've seen some of the big corporations are 20. They can pay their interest
expense more than 11 times over with the money that's available to pay interest expense.
Some would argue that that might be a little too high. They're obviously in no danger of default
whatsoever. But they could actually take on more debt in their capital structure and still be able
to pay their interest. And they'd have a stronger basic earning power and all that. Whatever. Their
managerial choice, their management and board of directors chooses to have a lot of distance
between them and default on any debt obligation. So now if we look at the EBITDA, we do the same
thing. But this time what we do is we take operating income. Where the heck? Oh, there it is.
And we add back the depreciation and amortization expense. Right there.
Okay. And then we divide that by your interest expense, net interest expense right there.
Net interest expense right there. And that's even healthier. That's big. So realistically they can
pay their interest expense every year 16 times over. 16 times over. So no pain there. And let
me copy those numbers over. Well, I'm going to put this as a percentage. It really doesn't matter.
But now let me copy these numbers over here. So you notice something interesting. One, a couple
of things. One, Target has become less leveraged. It has backed away from leverage. In other words,
it's paid off debt and it hasn't generated and it hasn't issued new debt. So it's
becoming safer. That should lower the beta for one thing. It lowers the risk of the company.
They're paying a big dividend. That should lower the risk of the company. So they have a lot of
factors that indicate a lower beta. And then if you look at times interest earned,
this makes sense because they lowered their debt load and so they have less interest to pay. So
their times interest earned has gone up. They are obviously pulling away from risk. Target is
becoming an old mature company and that's not that unusual. Back in my time, Target was new and wild,
a crazy thing. And now it's becoming one of the old men of the retail business. And it's doing a
good job. Now obviously EBITDA is going to follow suit on that. Now going over here to asset activity,
I have a few problems with asset activity. Here, that's going to drive me crazy, I think. Average
collection period. Now this is a problem for Target. Simply because if I look over here at their
balance sheet, I've got no accounts receivable to put in the formula. So that's Target's trick. They
have all their accounts receivable in a captive that is not being reported on their consolidated
financial statements. You would actually have to go into the 10K for God's sake to find the number.
It will be in item 7, management discussion and analysis of the results of operations. It's there,
but for God's sake, I mean, that's about the only place. Now I can go over here and check
in the statement of cash flows. God, it's not... Tell me if I'm not seeing it. Nope. They don't even
report it there. Son of a bitch. Okay, we can't do it. And that, you know, I mean, if I did that,
the SEC would make me some hard timers old lady at a federal facility, but apparently
they could get by with it, you know, whatever. Okay, enough of that. But I can do... Nope,
I can't do day sales outstanding either because that needs...
That needs it too. Whoops, I didn't mean to do that.
Day sales outstanding. I can't do that one either because I don't have their accounts receivable.
Okay, try something out. Oh, total asset turnover. Finally, total asset turnover. And the next one is
total fixed asset turnover. And then inventory turnover. And finally, day's inventory held.
And then day's payable outstanding.
At least I can get these down here. Total asset turnover. Now the total asset turnover is just
going to be your net sales divided by your total assets equals net sales divided by total assets.
Right, there it is. In other words, if you consider the total assets as being sellable,
you did it almost two times last year. Target did it almost two times last year. They sold their
company two times. That's basically what it's saying. They sold their company two times.
Now, what should that number be? I don't know. Total asset turnover. You can artificially
increase it by letting your not replacing equipment, property, plant and equipment,
letting it depreciate. In other words, letting total assets become smaller will increase your
total asset turnover ratio. It's not healthy. So if you see this as a big number, four, six,
you look at the pattern of how they are, of what's happening with their fixed assets. Now,
I'm going to look at their fixed asset turnover ratio right now. The fixed asset turnover is going
to be the same thing, net sales over net fixed assets equals in this case, your net sales
over your net fixed assets.
Who's this? Right here. Your property and equipment net.
Okay. Now, I'm dying. I'm sorry. I'm going to have to pull this over here. I want to see what happened.
Not much. Not much. See, if this number were to jump on me, I'd be worried. They're not replacing.
But in this case, it looks like they are having some capital investment. That's good news. Good
news there. Okay. So now, and it eroded a little bit on total assets. That was because fixed assets
increased. So the total asset turnover decreased. Now, inventory turnover. Now, the inventory
turnover ratio, you're just going to take your cost of goods sold equals cost of goods sold,
cost of sales divided by your inventory. Come back over here, divided by inventory.
They turned their, everything in their inventory, they wiped out and replaced a little more than
once every two months. 6.5 times a year. That would tell me that a little more than twice
every two months, a little less than twice a year. They completely rolled over their inventory.
Now, in that number is healthy. If it gets too low, you're holding a lot of inventory. If it gets too
high, you're probably going toward a just-in-time system. That's great, but it's not great if you
get a bottleneck in your supply chain. There was an obsession in the 2000s to get that inventory
turnover ratio up. Get the inventory in, get it on the shelves, get it sold, bring in more, do it again,
faster and faster. That turned into an absolute fiasco when the supply chain broke down in 2021
and 2022 because they were selling it out of the inventory as fast as they could get it on the
shelves and get it past the cash register. Then, okay, more toilet paper, more eggs, more everything.
The supplier said, don't got none. Wait, what? Yeah, you were selling, you had so short,
your inventory was so tight that when there was a breakdown in the supply chain, you had sold what
you had. You had small warehouses and so you sold everything in the warehouses thinking, well,
I'll just order more. We've got all these formulas for when you trigger the order inventory. That's
what I do in FIL 340. Knowing your trigger and you tighten them as much as you can,
bring in a little bit, set your trigger low so that you trigger with 100 units left and then you
order two days, you got your inventory full and then you sell it off. Well, that turned into an
absolute disaster when the supply chains broke down. That's why you had empty storage shelves
with toilet paper, other basic goods because they were rolling the inventory so fast,
they didn't have any backup in their inventory. There was none. Matter of fact, there was a joke
and I thought it was a joke, but it wasn't. There were actually toilet paper brokers who were
finding giant stashes of inventory and selling them to the highest bidding company to get it
onto their shelves. Days inventory held, let me do this, DIH. The days inventory held, you're
going to take your average inventory and you're going to divide that by your cost of goods sold.
Now, this one is a little bit tricky to do. Your average inventory. The way we do this
is I'm going to do it this way. I'm not sure. I'm going to take this year.
Whoops, let me back off here. I'm going to take equals the average
of the past two years
and divide that by the cost of goods sold.
I made a mistake there. I should have put, let me kill this. I'm going to have to do a
divide it by here. Let me delete that. Open parentheses. Cost of goods sold over 365. Cost
of sales. Well, cost of sales over 365 to make it a daily. 365 and then close the parentheses.
Almost 60 days they held inventory. That would be considered an embarrassingly high number by a lot
of companies these days. Where you see 20, 10, 5, certainly no more than 25. Target had inventory,
its average piece of inventory was sitting in a warehouse for two months. Now, the downside of
that is opportunity cost. You have to pay for the inventory space and all that for that two months
instead of for a couple of days. That creates its own cost, the inventory. You have big warehouses.
You have to have security on those. Heating, lights, all that kind of stuff. You have to have
security on those. You have to have security on those. So that's considered not a good idea.
Plus, holding that inventory that long, inventory held, is inventory not sold. That's an old thing.
Inventory held is inventory not sold. Most analysts would say this sucks. This is way too big.
But we'll see here in a minute. I can do this number, I think I can, but that other one,
well look at that. That looks like policy. That wasn't a fluke, that's policy. They don't move
inventory fast. If I see it for one year and then it's a big difference the next year or something
like that, you know that they saw a problem and they were fixing it. Here, they're not fixing any
problem at all. This is what they do. And DPO, let me do the DPO here real quick and then I'll finish.
We'll do the rest on Thursday. But DPO, days payable, average accounts payable divided by, so
this one equals the average of accounts payable. So I'll look for the accounts payable.
I said I'll look for the accounts payable. The average of those two, close the parenthesis,
divided by cost of goods sold over 365. So we go back over to cost of goods sold divided by 365.
Close the parenthesis and hope to God that it works. Well there we go. That's actually a very
large number. The golden number that you usually see is something around 30. 30 days.
Okay, because most vendors say 30 days net. You have to pay your bill within 30 days. So a lot of
companies you see it around 30 days. This is actually a good thing. They delay paying their
bills. That's a cash management strategy. And I'll finish you with this. This is from FIL 340.
The cash conversion cycle. You want this to be low. How fast you bring cash around back to you.
From ordering an inventory, through making the sale, getting paid for the sale, and then on the
other side the days payable outstanding. So this is your days of sale outstanding, DSO, plus days
inventory held, minus days payable outstanding. So you notice that the higher your days payable
outstanding, the lower your cash conversion cycle number is. So companies try. They try to make these
small and this one big. Ouch, God damn. Okay, that is most companies management strategy. Now the
ultimate in, I don't know how you would put it, in financial short-term spontaneous financing is
Walmart. Walmart has a negative cash conversion cycle, which means that their suppliers are
doing their short-term financing for them. And that's masterful. You want this number to be low,
but Walmart takes it to the extreme. They literally have a negative cash conversion. So that negative
is how much money their suppliers are financing them. How do they do it? They don't pay their
suppliers for 90 days about. The ultimate, well what if you're a supplier to Walmart and they say
well you know we'd like to have you pay in 30 days. Walmart says yeah you'll get a check in a few
months. That's how Walmart does it. So what are you going to do? Well Mr. Walmart you better pay us or
you're not going to be our customer anymore. Oh yeah sure you're going to do that. And they also,
their DSO is very, is pretty low because most of its cash retail sales and their days inventory
held. That's a relatively large number because they've got just insanely large warehouses they
hold things in. But overall that's what you're seeing here. Now I'm going to save this sheet
and then we'll finish it up with common size financial statements on Thursday. That's all I
have for you. I thank you.