Liquidity and Bankruptcy

As investors have learned, like any other investment, cryptocurrency is subject to volatility. The recent bankruptcy filing of crypto exchange FTX shows, this volatility can be extreme. For example, the Ontario Teachers' Pension plan wrote down $95 million due to the collapse. As you probably know, bankruptcy occurs when liabilities are greater than assets. However, bankruptcy can result from a finer distinction between liabilities and assets, namely liquidity. In the case of FTX, the company had $8.9 billion in liabilities and $9.6 billion in assets. So was the company forced to declare bankruptcy? Liquidity. When you look at the balance sheet, FTX had $900 million in liquid assets, $5.5 billion in less-liquid assets, and $3.2 billion in illiquid assets. Think about it like way: You owe $10,000 at the end of the week but your only asset is a $100,000 house. Yes, your assets are greater than liabilities, but you likely won't be able to sell the house and receive the cash for the sale by the end of the week, so you could be forced into bankruptcy. But FTX had other problems as well. John Ray, who was appointed to oversee the FTX bankruptcy and has overseen other large bankruptcies such as Enron, stated "Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here."

Inventory Spikes

During 2021, much of the talk concerning inventory surrounded shortages due to a variety of factors. In response, many companies increased production and orders to combat supply chain disruptions and increased consumer demand coming out of COVID-19 lockdowns. Now, it appears that companies have overshot demand as inventories have surged. For example, inventories for global manufacturing companies reached a record $1.87 trillion. As a result, inventory turnover for manufacturers increased to 81.1 days. And retailers are no different: Inventory for Macy's, Target, Walmart and other large retailers has increased from 17 to 45 percent compared to last year. This increased inventory is a boon for off-price retailers like Ross and TJ Maxx, which have a larger supply from big retailers offloading inventory. For many corporations, the excess inventory will likely negatively impact the bottom line. 

TIE Increases

As we discussed in the textbook, in general, there is no absolute number that is best for a particular financial ratio. However, when the economy is bad or uncertain, it is better if leverage ratios are more conservative to help avoid financial distress. During the COVID lockdowns, this is exactly what happened to the times interest earned (TIE) ratio for most companies. The median TIE increased from 6.1X prior to the pandemic to 8.6X during the pandemic. This was true even for below investment grade companies, which showed an increase in the TIE from 2.8X to 4.1X. Given that the cost of borrowing is beginning to rise, this bodes well for companies.

Kia's Home Run

When Kia debuted the Telluride, the company set production capacity at 60,000 units. Demand was so high that the company upped production to 100,000 units, but one couple has already waited 9 months for their SUV and they were told to expect another 5-6 month wait. A production shutdown due to COVID-19 has slowed delivery and once production restarted, a parts shortage still limited manufacturing. Obviously, sales of the Telluride is a best-case scenario for Kia, although production difficulties means the best-case has been limited to date. One other thing we want you to note is terminology. The article states that the turn rate was 11 days for most of the year, but it is currently at 0 days. The turn rate is the same as the days' sales in inventory ratio we discussed in the textbook.

Total Cost To Reward And Retain Employees

As we mentioned in the textbook, there are numerous other ratios that can be calculated and analyzed. The American Productivity & Control Center (APQC) is advocating a new ratio, the total cost to reward and retain employees (TCRRE). This ratio is calculated by summing costs for compensation, benefits, payroll processing, award/incentive administration, and employee assistance, divided by sales. In using this ratio, APQC argues that a low TCRRE ratio may indicate that a company may be spending too little on employees, which can result in lower morale or employee satisfaction. However, as with most other ratios, there is no absolute measure for this ratio. In this case, the ratio is determined in large part due to the company's size, culture, internal reward, and retention practices.

McDonald's Negative McEquity

A negative book value of equity is generally a bad sign as it often indicates a company has accumulated losses that have exceeded shareholder capital contributed. However, as with any other accounting number, it must not be taken at face value. For example, hamburger giant McDonald's has an interesting shareholder equity that indicates something entirely different. If you take a look, McDonald's Treasury stock has exceeded its retained earnings since 2016, which indicates that the company has repurchased more of its stock than it has reinvested from earnings. While this is a good thing for investors, it does create a problem when evaluating the company's financial ratios. For example, the ROE as calculated is negative, which is generally not good, but the 28 percent profit margin in 2018 is a very good sign.

Corporate Projections

A question often asked by students is how to get projections for a particular company. One way is to listen to what the company itself says, and the analyst call is a good place to start. Publicly traded companies have analyst calls to disclose management's opinions on the current state and future of the company. You can actually listen to many calls online, and the information on the call is reported online if you can't listen live. For example, Chevron recently held its analyst call. A lot of information is available If you look at the Corporate Overview link, you will find, for example, that Chevron expects its capital expenditures to be $20 billion in 2019, $18-$20 billion in 2020, and $19-$22 billion per year for 2021, 2022, and 2023. The company also reports that it has the lowest breakeven oil price in the industry. In short, the company itself is an excellent place to start for projections. However, we should advise you that these projections are not set in stone, but a only a good place to begin your analysis.

The (Partial) Effects Of Tax Reform

With the U.S. corporate tax rate being among the highest among developed economies, there is discussion of corporate tax reform that would reduce the corporate tax rate from 35 percent to 20 percent, as well as the possibility of eliminating the deduction of interest expense entirely. So how would this affect corporate finance? A cut in the corporate tax rate on interest would reduce the attractiveness of debt as a form of financing, thereby reducing the amount of debt in the optimal corporate capital structure. One estimate is that the U.S. average debt-to-EBITDA ratio would drop from 4.1 to about 3 times, which would also affect the other financial leverage ratios. And the non-deductibility of interest expense would affect the calculation of the weighted average cost of capital. And, finally, at least for now, the decline in corporate debt will likely increase the credit rating for the remaining debt, driving the yield down on debt that does remain. All in all, major changes to U.S. based corporations.

PE Ratio Math

As we mentioned in the textbook, when you are examining ratios, it is important to not only learn if a ratio has changed, but why it has changed. A recent article about the PE ratio highlights our discussion. Most people believe that an increasing PE is due to an increasing stock price, but as with any fraction, a change can also occur due to a change in the denominator. Currently, the PE ratio of the S&P 500 is about 19, above the 5-year and 10-year averages of about 16. As a result, many market analysts are predicting a declining stock market. However, even with a falling PE ratio, stock prices can still increase as long as earnings per share increase at a faster rate than stock prices. While we are not predicting the stock market, the article does note there are many periods in stock market history that earnings growth exceeded stock price growth, PE multiples declined, yet the bull market continued.

Ratios And Lease Accounting

Beginning December 15, 2018, new FASB accounting standards will require public companies to include both capital and operating leases on balance sheets. Currently, only operating leases are reported. The effect of this new standard will be an increase in the reported value of assets and liabilities, which will result in an apparent overnight jump in the book value of many companies. According to one estimate, over $1 trillion will be added to balance sheets. Because of this increase in assets, several commonly ratios such as return on assets and the equity multiplier will be dramatically changed for companies that use lease financing. Of course, trained analysts have already been adjusting balance sheets for estimated lease liabilities. Although not mentioned in the article, there could be unintended consequences. For example, if a company has bonds containing a covenant that prohibit the company from exceeding a specific debt-equity ratio, the increase in liabilities could potentially cause a breach of that covenant.

Inventory Shortage Costs

What is the optimal days' sales in inventory? It depends! Too much in inventory will result in large opportunity costs. In other words, a company has cash tied up in inventory that costs the company money and does not earn a return. However, too little inventory can be problematic as the company can experience shortage costs. In this article, the costs of inventory shortages are explained. For example, although just-in-time delivery is popular, it does create problems in supply chain management. Not only does a company need to monitor its suppliers to ensure they will be able to meet obligations, but a company must also monitor the supplier of the company's supplier. A disruption at any point in the supply chain can result in an inventory shortage. So, how much does an supply chain disruption affect a company's value? One study indicates that supply chain disruption can reduce a company's value by up to 7 percent.

Russell 2000 Facts And Figures

A recent article about the Russell 2000 has some interesting facts and figures about the index. In case you don't know, the Russell 3000 index consists of the largest 3,000 stocks by market capitalization in the U.S. The Russell 2000 consists of the smallest 2,000 stocks in the Russell 3000 index. So, the Russell 2000 is a small cap index. The largest company in the index has a market cap of $5 billion and the median market cap is about $528 million. What we found interesting in the article was several ratios. For example, the current PE ratio for the Russell 2000 index is 22.7, higher than the historical average of 16.2. And, the current price-sales ratio is 1.6, 67 percent higher than its historical average. As for sales, while only 64.3 percent of the sales for all S&P 500 companies comes from within the U.S., 81.3 percent of the total sales for Russell 2000 companies come from within the U.S.

Months' Payables Oustanding

Days' payables outstanding is frequently used to determine if a company pays its bills slowly, yet for for some companies, months' payables outstanding may be a better measure. CFO recently discussed 45 publicly traded companies that had an average days' payables outstanding of 212.3 days. The longest had a days' payable of 585.9 days, or almost 20 months!  Although the article touts a long payables period as beneficial because "the company is able to deploy cash to other uses," it is also forcing the company's suppliers to finance part of the company's operations.

Tesla's EFN

Few companies publicly announce EFN numbers. However, today Goldman Sachs announced that Tesla will likely need to raise at least $6 billion between 2017 and 2025. Tesla has currently raised $2.3 billion toward its $5 billion gigawatt plant in Nevada. This outlay, combined with other projects that the company has announced, indicate that Tesla will need to raise significant capital over the next several years.

Capital Expenditures Slow

Capital expenditures fell by three percent in the first quarter of 2014, to an annualized value of $1.8 trillion. With the lower capital expenditures, the financing gap (think external financing needed) was a negative $77.4 billion, the 21st consecutive negative quarter. U.S. nonfinancial companies issued $4.873 trillion in new debt during the quarter and spent about one-half of that repurchasing equity.

GE's Profit Rises On Negative Taxes

GE had promised an increase in its profit margin and an increase in overall profits for 2013. The company did increase its profit margin, although it did not meet its target increase, but profits were aided by a tax gain of $1 billion. During the 4th quarter of 2013, GE Capital sold its Swiss operations, which generated the $1 billion tax credit. During 2013, GE Capital's tax rate was negative 14 percent. While we like the idea of negative taxes, the only way to achieve this dubious distinction is to lose money, which GE did on the sale of its Swiss operations.

Exxon's Performance

While we don't often discuss an analyst's report, a recent report on Exxon caught our eye. One way to create a positive NPV project is to have economic moats. An economic moat can be a competitive advantage over others in the same industry, or barriers to entry. The article discusses several concepts that we think should interest you after what you have learned in this class so you can see how key concepts are applied in other areas of finance. For example, the article discusses Exxon's low cost of capital (Why would Exxon have a lower cost of capital than its competitors?), as well as economic rents. You can think of economic rents as a positive NPV. The article also discusses Exxon's lower F&D (finding and development) costs in relation to its peers, as well as a lower cost structure, which is the application of ratio analysis.

#TwitterIPO

About three weeks ago, Twitter announced that it had filed for an IPO, although the filing was confidential at the time. Today, Twitter made its S-1 filing public, an indication that the company hopes to go public sooner rather than later. The disclosures reveal that the company's revenue for 2012 was $317 million, with a net loss of $79 million. There are 250 million active users on the service, with 100 million daily users. One million shares are expected to be sold in the IPO. With a valuation of $10 billion, the company will have a P/S ratio of about 31 and, of course, no reportable P/E.

Notes Payable: Operating Or Financing Cash Flows?

A common question posed to us is the treatment of notes payable. Are notes payable part of total debt, or is it something else? You should note that there is an unavoidable inconsistency in dealing with notes payable and cash flow from assets. The same thing occurs when calculate EFN. In both contexts, NWC is essentially treated as an asset, which means that notes payable have been netted out (treated as a contra-asset). On the other hand, interest paid shows up in cash flow to creditors, but not repayments of note principal (which show up in the change in NWC). Interestingly, a similar inconsistency shows up in the standard statement of cash flows, where interest paid is treated as an operating cost.

Some argue that it would be more consistent to define net operating working capital (NOWC), which is just NWC with notes payable left out.

In our view, this issue runs much deeper. First, notes payable are operating liabilities for many businesses. Any company, such as a car dealer, that uses bank borrowing to floor plan inventory is using notes as operating liabilities. In this case, the interest paid actually is an operating cost. Very commonly, companies with seasonal sales use revolvers (a form of notes payable) to crank up inventory. Same story. Making matters more complicated, accounts payable is the single most important form of business financing (not just operating financing) for small businesses. The distinction between accounts payable and notes payable is pretty artificial in these cases. Both are debts, just different creditors. However, long-term secured debt maturing in the current year is clearly not an operating flow.

But wait, there is more.

Large corporations are increasingly holding huge amounts of cash, far more than needed for operations. This excess cash is properly viewed as a short-term investment portfolio. If we are trying to be very rigorous in our definitions of operating assets and liabilities, then we have to somehow separate out the operating cash (this is why we subtract cash in calculating enterprise value, but that’s also wrong because some of the cash is needed for operations).

So, in light of all this, we made the decision to follow common business practice and call NWC the difference between current assets and current liabilities. The cash flow to shareholders comes out correctly, EFN comes out correctly, and in capital budgeting, none of these issues exist. As you go out in the world and use what we have taught you, you may run into these issues. Hopefully, for your company, you should have more information available which will allow you to separate cash and notes payable into separate operating and financing cash flows.

S&P 500 PE Rises

According to a recent report, the PE ratio of the S&P 500 has risen to 16, a 14 percent increase relative to earnings over the last 12 months. The last time the PE ratio has risen this fast was 1999, just prior to the dot com crash. The S&P 500 PE has averaged 17.4 during bull markets since 1957, and have typically reached a high of 20.2 at the top of the market, with a high of 31 times  in March 2000.