Accounting Lecture Transcript

If I was going to ask you which document has total assets and total liabilities, you would say?

BALANCE SHEET

Grab your balance sheet. Now, go ahead and see if you can spot on your balance sheet – Total Assets. You will pass by current assets, which you don’t want. Head on down and you will see total assets. Remember that you are probably dealing with thousands, millions, or in some cases, billions.

Then, follow down and see if you can spot total liabilities. Not current liabilities, total liabilities. If you end it with a number exactly the same number that you had above, it is the wrong number.

What we are going to do now is calculate the debt ratio. If you think about this, what you have in the denominator is total assets, which is everything that can be owned. The numerator is the part that you owe. It will work out to be the fraction of the firm that is owned by the bank, or somebody else who is not the owner. The number will generally be between zero and one. Occasionally you will find a number greater than one, but that is generally the grace period before they vanish. What that means is what they owe money greater than their assets.

Tell me the firm, what they do and the number:
• Johnson and Johnson .40
• Starbucks .56
• Exxon .50
• AT%T .63
• United Health .62
• McGraw Hill .79
• Apple .46
• Costco .55
• B of A .55
• Ebay .29
• Coke .90
• Verizon .79
• Rite-Aid .85
• Ford .97

Across industries, you will find that there is a normal debt ratio to have. For every one of these firms, you are going to have some net income which is flying out and things that they can go ahead and distribute. Sometimes, net income for a firm is steady and will be the same every quarter, every year, and every business cycle. You like it when things are predictable, and if you are going to have predictable terms, you will pay a bit of a premium for them. This means that if you are buying stock in that firm, it will be more expensive than for a firm that bounces around.

Contrast that with a bond payment. If you lend money to a firm, you get interest, interest, interest, interest, then boom… you get your money back all at once. Firms that have stable net incomes find it very easy to sell stock. People love to buy stock from those kind of companies. When people love to buy stock, they don’t have to sell bonds. If you have industries that have very stable income over years, over quarters, what you will find is very low debt ratios, because that is a cheap way to raise new money.

If you look at an industry where net income bounces around a lot, if they have seasonality, if they move drastically over the business cycle, those are firms that find it cheaper to go ahead and selling bonds. So, a lot of the debt ratios that you see have to do with the nature of sales in an industry. It is not comparing them with each other, it is just how variable net incomes are. As net incomes get more variable, you tend to see more debt. As net incomes get less variable, you tend to see less debt.

Any time you go into a recession, these numbers kind of collapse.

There is another way of thinking about these numbers, and that is to put it into a personal finance context. Think about buying a house and picture the liabilities being the loan that you are going to take out. Frequently, what you are aiming for is what fraction of that housing purchase is going to be financed by the loan? It is the loan to value ratio.

Put yourself in the place of a borrower and think about looking at the debt ratio from the loan to value ratio. As the lender, would you prefer to have a high debt ratio or a low debt ratio? Think about just making sure that you are going to get your cash back. What do you think you should have? LOW! If you have a $200 house, and the person only borrowed $10K on it, your chance of getting the $10K back is very good. If that person borrowed $250K, the chances are not so good that you will get your money back.

You can think of this as a measure of risk, with the risk being the probability that the lender can recover the principal. High numbers mean high probability, low numbers mean low probability. Note that that what that ratio maps in terms of probability will depend on the industry. What is considered a low ratio in some industries will be considered a high ratio in others. It is industry specific and you need to know about the variability of net incomes.

If you are glancing through on the aggregators, eventually you will spot a place where these accounting ratios will show up. Besides giving you the specific ratio for that firm, they will show you some of the other firms from within the industry so you can see if the firm has a high or low debt ratio, if they are leveraged more than others, or are they leveraged less. The important information is usually cross-referenced and is not found within a single individual document.

Let’s look at the time-interest-earned ratio. This compared the flow with the flow. You will find earnings before interest and taxes and interest expense on which document?

The INCOME STATEMENT!

Knowing where stuff going to be very important for your final exam, and would also make an excellent quiz later on. Good fodder for exams is anytime you see a closed list, know it!

Go ahead and haul out your income statement. Look for something that says interest expense. Remember that negative numbers in parenthesis means that they had interest income during that period and made money off of interest. If you have a consolidated income statement, you might have difficulty finding it. If you have a dash, it probably means missing because the aggregators have difficulty picking up interest expense. Check and see if they have liabilities, because if they do that means that they most likely have interest expense.

Next thing to spot is earnings before interest and taxes, or earnings before interest, taxes, and depreciation, or an acronym that says EBIT or EBITDA. There should be a variety on what you can actually pluck out. The personal finance analogy is that is your gross income. Go ahead and try calculating earnings before interest, taxes, and depreciation. You are seeing how many times over you can make the payments. The numerator is your gross income, and the denominator is the payment. In general, they should be numbers larger than one.

• Apple 10.4
• Coke 1.44 (Seriously? Ouch!)
• Microsoft – undefined (zero in denominator)
• Ebay – 272 (Not a lot of debt there, huh!)
• J & J 39.9
• Rite-Aid 2.55 (a little on the dangerous side)
• Boeing 20.7 (but they were upside down on the balance sheet – huh)
• AT&T 6.8 ( I wonder what they did wrong recently)

All over the map. Think about these from a personal finance point of view and dealing with the house. How big of a loan vs the house that you are trying to buy, and the other thing is how big are the payments vs your income. Your income is in the numerator; your payments are in the denominator. This is a little different than how they do it for personal finance, because banks are looking at your percentage of income, which goes toward your payment. This way is the inverse of that. It gives you the likelihood that you are going to make your payments on time. The risk that you are seeing is going to be the probability that payments will be made on time. Look at that ratio and put yourself in the lenders shoes. You would like to see a BIG number. If your income is $1M and your payments are $1, the payment is going to be made. Just like if you are looking at a personal finance context, if someone has a mortgage payment of $2000/mo and their income is $2500/month, you would think they are going to be late some of the time.

Remember, time interest earned ratios are going to be industry specific, but there is probably a good chance that this 1.44 isn’t very good. Lending money to Coke is probably not so hot right now. Lending cash to Ebay means you will probably get your payments on time.

If you have a mortgage payment that is 25% of your income, is that good? That is pretty much the target they are aiming for. Turn that upside down, and please not that 25% would be a times-interest-earned ratio of 4. Look at the firms up there, and they are pretty much all bigger than 4. So, 4 is a good ratio for a person, but maybe not so much for an industry. The number depends on the circumstances which surround it.

How would you know for an undefined company?

Undefined means that they don’t have an interest expense, they have earnings. Microsoft has lots of interest earnings, not expense.

Is there a way to compare companies?

Go to one of the aggregators, which will set you down in an industry and have comparisons. A lot of finance is not geared toward people who want to look at a lot of information at once, it is geared toward people who want to see information on a number, instead of putting it in context with statistics.

Let’s work on interpretation. These two things represent two different kinds of being well off. There is wealth rich and income rich, and you do not necessarily get to be both at the same time. Let’s look the top right box using a personal finance interpretation and visualize. Get the story on how the person got there. Each box will have a bright side and a dark side. Tell a story about the person with a high debt ratio and a low times-interest earned ratio. Put constraints on it: the person is male, and must involve a mullet, a Camero, and cigarettes.

• Why does he have a high debt ratio and what does that mean? (High debt ratio means you own a lot of stuff but you owe a lot of people for it)
• What kind of assets does he have that he owes all of this money on? (Line it up with a low times-interest-earned ratio, which means that if you get a paycheck, a big fraction of it goes toward paying it off)

This would actually be like Bernie Madoff. How’s that? He borrowed a bunch of money from people and invested it, then frittered it away and collected a little off of the flow. The story I was trying to get, which is why I set you up with a mullet and Camero, is remember that guy you went to high school with who looked exactly the same after 4-5 years, still driving that Camero, still working at Taco Bell or Quickie Mart? It’s JEREMY! They guy who had is credit cards fueled up and maxed out? It will remind you what not to do.

Next – high debt ratio and high times-interest earned ratio box. Make this you in three years. This is a workaholic you. A high debt ratio means lots of assets or lots of liabilities? A high debt ratio means that the bottom number has to be a small number relative to the top. What you are looking at with the high debt ratio is that a large portion of the assets you own, you owe money on. Interpret a high times interest owned ratio: Big numerator (lots of gross income) small denominator (tiny payments). It is a good situation. Has some assets and owes a lot on those assets. If you look at income, it is high relative to the payments that are there. Can you think of how you could have got into this situation? You owe a lot of money, but you are making money hand over fist and can make your loan payments out of pocket change. That first year out, you actually make $1M. You have put your nose to the grindstone and your income skyrockets. You don’t have a car or a house yet… You can think of this as an ideal after college story.

Low debt ratio and high times interest earned ratio: Suzie wears sweatpants all of the time, lives in a tiny apartment and has 8 cats. She was raised in a poor family and taught to work hard. She went to MIT on scholarship, then made lots of money and doesn’t spend anything because she grew up poor. Low debt ratio means you don’t owe people money. This is a financial ideal – what you could be aiming for. I added the cats because I thought you were going dark on me, because this is also besides the MIT story, it is also the crazy guy down the street with all of the pets. The one that steals your cans in the middle of the night, or gets the bad meat at the grocery store, and when he died left $12M to the humane society. It is financial frugality.

This last one is kind of fun, and it is someone we know. (not me!) These people have gray hair. One (or both) may be bald. Low debt ratio means you owe a low fraction of your income. So, you may have $100K of assets but you only owe $5K. Low times-interest earned means that payments are high relative to your income. Lots of assets relative to your debt and their debt payments are actually high relative to their income. RETIRED PEOPLE! Grandparents own their car, house, and have built up a retirement fund. They just retired so are on a fixed income, and may be making their last few house payments. That doesn’t stop them from spending three months in Croatia or a cruise to Antarctica. You are seeing a big distinction between being income rich and wealth rich.

CURRENT AND QUICK RATIO
These have to do with working capital, which are current assets less current liabilities. You can think of it as the amount of money you keep in the bank to make sure you don’t accidentally get overdrawn. It is the money you keep in there so that it doesn’t matter that your income didn’t come in when the bill did.

How much do you keep in your checking account for working capital?

Take a look at current assets v current liabilities with your companies. Chant out a number when you get there:
• Rite-Aid $2M

What I am eventually going to get to is that you can’t just deal with absolute values and need to look at it with the ratios. We will do that on Wednesday!

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