Paul Fischer Transcript — Sept. 16, 2025

Kevin Johnson/NPF (00:00:01):

This is a session and we’re so happy to have Professor Fischer here from the Wharton School to lead this discussion or class. It’s going to, we’re go about this as sort of a classroom type of format. So raising hands questions throughout are welcomed. Don’t hold back until the end because there will be no end. So you’ll have to get your questions in as we go. And this is focused on analyzing financial statements and good business coverage begins with solid training and the basics, and many of you are familiar with this, maybe some not so much. I’m not at all. So I’m happy to be here to pick up the expertise. And Paul Fischer is the Samuel Harrell professor at the University of Pennsylvania’s Wharton School of Business. He’s here. His research spans two areas of interest, the acquisition and dissemination of information in capital markets and the design of incentive systems within and between firms. His capital market research has considered the impact of accounting disclosures on security prices, manager disclosure, behavior investor information gathering strategies, pricing bubbles, and other related forces. Lucky for us, the professor has a soft spot for reporters. He is part of Wharton’s annual seminars for journalist program in partnership with NPF, and we’re thrilled to have him here. So please welcome Professor Fischer.

Paul Fischer/Wharton School of Business (00:01:48):

Alrighty, thanks for having me. I was asking, well, what else are they doing this week? And they started describing who you’re talking to or whatever, and I said, well, I guess you brought an accounting guy in to make everybody else look better. So I’m pleased to be here. I didn’t exactly know what the target market was here in terms of what people know. And so they said, well just kind of assume nothing about accounting. And so we’re going to do a little bit of a brief introduction before I start. Do you think an hour and a half is going to be sufficient?

(00:02:25):

Probably not. So this is going to be an introduction, going to touch a few bases, illustrate a few things. If you’re going to get serious, I would recommend an introductory financial accounting class anywhere the community college. Try to find somebody who’s pretty good at it in terms of leading the class. That can be useful in terms of your own, using the internet to help you. AI’s pretty good now in terms of you type a question, it’ll usually give you a reasonable answer. The problem is sometimes it doesn’t and you don’t know it, and that’s the problem. So that can work in terms of vocabulary. There’s so much jargon out there. Students ask me questions all the time and they’ll use some acronym and I go, what does that mean? Because there’s lots of, just like any other discipline, there’s lots of acronyms and jargon and slang and a good website to sort of get quickie definitions of those things is Investopedia does a pretty good job of defining terms.

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So when you hear terms, it’ll give you some various definitions for those terms and I find that’s pretty helpful for students. So let’s get started. So what am I going to do? First thing is I’m going to give you basically a quick little financial accounting primer and to illustrate sort of the two financial statements that have been around for hundreds and hundreds of years. A balance sheet and income statement. And then you might have seen or heard of the term financial ratios. We’re going to talk a little bit about ratios. Those are used in financial statement analysts to give you an idea of why do people divide one number by another. Third, we’re going to talk about cash flows a little bit because earnings and cash flows are not the same thing. What gets into earnings isn’t always correspond to what the cash flow is that that earnings will ultimately generate.

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Then I’m going to talk a little bit about multiples because many of you’ll be excused to, they’re saying, well, that’s trading at x times earnings. Well, what does that mean and where does that come from? Talk a little bit about that. And finally, if we have time, I’ll talk a little bit about accounting analysis, which is basically how do companies use the language of accounting? It’s not a boilerplate thing that everybody just sort of plugs something in and it spits something out. So we’ll talk a little bit about that. Okay, so here’s a financial accounting primer. Many of you should have received an email with just recently that’ll have some of the handouts we’re going to do. And one we’re going to do now is called Simple Co. And I know that some in the back are going to have a hard time seeing the screen I suspect, but we’re going to use that as our illustration.

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So what is financial accounting? Financial accounting has evolved basically to a mechanism for communicating a firm’s current standing in past performance. That’s kind of two outside parties, parties outside the firm, and all of these communication mechanisms. There are some rules for mapping from what one observes to what gets reported. So in that sense, it’s like a language. And the rules for financial accounting are called generally accepted accounting principles. And there are two sets of generally accepted accounting principles. There’s US Gap, generally accepted accounting principles, and then there’s the International Financial Reporting Standards. In the us, almost all companies use US Gap. Some multinational companies outside the US will use international financial reporting standards. They’re close enough for the level of what we’re going to do. And all communications systems, it’s imperfect. So it doesn’t what somebody sees and what ultimately ends up in those financial statements sometimes doesn’t perfectly align.

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Okay, so here’s our little example to illustrate just kind of how this basic thing started in it, how it works. We’re going to have this firm starts in year zero and it starts in year zero by raising some equity capital. It sells some equity shares to the outstanding public and they get a hundred dollars. And then we’re going to have, during the year, we’re only going to have five transactions. They raise some debt financing, so they get a hundred dollars by issuing some 10% debt. They buy some assets like buildings and inventory. They operate those assets and in the process of operating those assets, they get sales revenue of 400 or operating revenue and they have $375 in operating expenses. They pay interest on that debt that they issued of $10 and they pay their shareholders dividends of $5. And that’s going to give us enough to get an idea of how the accounting system works.

(00:07:38):

So how does the accounting system work? I dunno if many of her assets equals liabilities plus owners equity. That is the accounting system right there in one equation. So basically it says, well, think of a firm. It has claims on things, it has claims on cash, it has inventory, maybe it has some receivables from people they sold stuff to. Those are assets. Well, the assets have to equal the liabilities, the claims on the firm. So there are the liabilities and the equity. So there’s accountants cut up what I’m going to call the right hand side of the balance sheet into two components, liabilities and equity. But they’re both representing claims on the firm. We can think about liabilities as kind of debt like claims. And then equity is representing equity like claims, like common shares, common shareholders. And so all this accounting equation is saying is the claims of the firm equal the claims on the firm. So it’s pretty easy peasy.

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And then the insight that happened long, long ago was, well, we can sort of use this equation and we can create a bookkeeping system and when we record every transaction, if that accounting equation is satisfied, then our system will hang together. So that’s the double entry bookkeeping rule is the accounting equation always has to be satisfied. So there’s going to always be double, right? There’s going to be a left hand side and a right hand side or maybe two left-hand side, but there’s always going to be in and the yang to every transaction how it gets recorded. And why has that endured the test of time? Well, it sort of has a built in control in there. If somebody takes $10 out of the till, they’re going to have to reduce cash by $10. They got to record the other side. Well, where’d the $10 go? And so it kind of creates a natural control and it also sort of naturally just makes it easy to prepare balance sheets and income statements at the end because of how we’ve tracked things through.

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So where did this come from? Actually the typical sort of Western textbook will tell you that it comes from at least 14th century Venice merchants. And it was formalized, what was it formalized in just before 1500 by this guy named Luko Oli. And he was a monk and a mathematician. So sort of just perfect for an accountant. And apparently he was really good buddies with Leonardo da Vinci. They hung out. And so he came up with this system, which many people in disciplines that we would consider a lot more intellectual have said There’s a lot of elegant beauty in this system that we’re going to talk about. Now, do we know that Luca’s the one who put it all together and got it right? There’s disputes, I didn’t know this, but there’s actually people who study accounting history and they argue about this.

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It’s a pretty harmless thing to argue about, but it’s been traced back to the Middle East, 11th century, Cairo bankers, 10th century India. So some form of this has been around for a long time and probably evolved in a lot of places. So I’m going to get us started. So we have our first little bookkeeping entry in that simple call, which is they raise equity capital. And so what do they have? Well, they got a hundred dollars cash. So cash is an asset, so I’m going to increase cash by a hundred dollars, but there’s, these shareholders now have a hundred dollars claim on our firm, so I’m going to increase equity by a hundred dollars. Easy peasy. And so now we have an end of the year balance, a hundred equals a hundred. So we started with zero equals zero, now is a hundred equals a hundred. And so now we can prepare a little balance sheet at the end of that year. We have assets of a hundred, we have no liabilities, equity and our total liability and equity is a hundred. Our accounting equation satisfied.

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So that’s what we’re going to do for each of our transactions. So now that you guys, so if you hopefully have that am going to load this up. And so let’s go to the next thing in our list. The next thing in our list was that this company issues some debt for a hundred dollars. So how do we think we would record the issue of debt? What kind of accounts would be affecting Yes, if you don’t mind. What do you mean by issue? Debt? Have you ever taken a loan, you’ve issued debt? Debt is just a loan. So a company, so that’s a debt claim is a loan and you are the debtor and your banker is the creditor. So in this case, simple CO is the debtor and somebody that loaned them the money is the creditor. Good question. Yes.

Speaker 3 (00:13:02):

When I started covering this, I had a

Speaker 4 (00:13:04):

Plug with the word issue. It’s just very confusing,

Paul Fischer/Wharton School of Business (00:13:08):

But it’s just taking on debt. Yeah, and typically you can think about issue is selling your debt. It’s basically I’m selling you a promise to pay you something in the future. Give me some cash that’s issuing debt. And the same thing with issuing equity is I’m selling you an equity claim, which is a promise to pay you excess cashflow in the term form of dividends in exchange for you giving me something. So it’s basically just selling a claim on your entity. Other questions? So they’re going to sell this debt to somebody outside or take out a loan from a bank. How would they record that? Yes, that be a liability because now you owe the bank a hundred dollars. Okay, so that would be a liability.

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So now, so we’d have a hundred dollars here and we have an asset because we got cash from the bank and the spreadsheet I threw together probably, I guess it didn’t quite format. Well, I’m going to pull a miles Davis on you and turn my back to you, which I know is bad. There we go. Okay. Okay. So we’ve issued debt, we got a hundred dollars in cash, our assets go up, we owe somebody a hundred dollars, we buy some assets, we buy some plants and equipment, we buy some inventory for cash. And that was I guess 190. How would we record that? So we exchanged some cash and we got some equipment.

(00:15:19):

Well what about giving up the cash? What is that? That is, we’ve given up an asset. So our assets go down, but what did we get? Equity? Did we get equity? We got a piece of equipment. So what do you think your car is to you? An asset besides a money sink? What do you think your car is to you? It’s an asset. So we basically gave up one asset cash in exchange for another asset. Okay? So we’d have a one 90 in one 90 out here. We’re going to have assets go up by one 90 because we got some equipment, but they’re going to go down by one 90 as well. Notice that our accounting equation is still satisfied. Okay. Yes. I wanted to go back for a second to the issue that,

Speaker 5 (00:16:21):

So this step, so shouldn’t the equation be 200 equals 100

Paul Fischer/Wharton School of Business (00:16:27):

Plus 100? We only issued the debt for a hundred, right? So where did you get the 200 from? Because now we have coming from this, okay, so we’re just recording each individual transaction and then we’ll sum stuff up at the end. At the end we’re going to sum stuff up. Okay? Okay, so we’re just recording each transaction. So we sold some stuff for $400. How do you want to think about that? Well, what did we get? We got $4 in cash. So that means the cash is what to you asset. Okay, but you’re close. When you said equity, so we got $400 in cash, but who’s ultimately going to be entitled to the cash? Shareholders? Shareholders, which are equity? There we go. Okay, so that gets that part. But now we said we sold some stuff to somebody. We probably had to give them something in exchange. So let’s say we gave them some inventory in exchange. So we took some stuff out of inventory and they took it home and got to consume it and that inventory had cost us 3 75. What do we want to do there?

(00:18:03):

Expense. That’s going to be an expense that was a cost of getting this revenue. So we’re going to put 3 75 here. We have inventory going up, going down because we sold it and we’re not to expenses yet, but who’s ultimately going to bear the brunt of this shareholders. So we’re going to reduce equity by 3 75. So we basically kind of cut that thing into two pieces. We have sort of our sale and we have our cost of what it cost us for the thing we sold. Yes, I’m so sorry. I should be doing the apologizing.

Speaker 6 (00:18:51):

I think a lot of journalists on these majors, the revenue and expenses

Paul Fischer/Wharton School of Business (00:18:56):

We’re not there yet.

Speaker 6 (00:18:57):

Okay?

Paul Fischer/Wharton School of Business (00:18:58):

So don’t even worry about revenue expenses. You got your two slides ahead of me. So all we’re just trying to track is flows of assets, liabilities, and equities.

Speaker 6 (00:19:07):

And I think that was my question. So when we put things in those columns, do those count as assets? Should I just wait?

Paul Fischer/Wharton School of Business (00:19:14):

I reduce their total assets.

Speaker 6 (00:19:16):

Some

Paul Fischer/Wharton School of Business (00:19:16):

Inventory disappeared from the warehouse.

Speaker 6 (00:19:18):

So both of those are,

Paul Fischer/Wharton School of Business (00:19:19):

And the equity holders bear the brunt of that.

Speaker 6 (00:19:21):

Okay?

Paul Fischer/Wharton School of Business (00:19:22):

Yes.

Speaker 3 (00:19:23):

Expense.

Paul Fischer/Wharton School of Business (00:19:24):

There’s no liabilities on p and ls. It’s an expense, but we’re going to learn where do expenses, who ultimately gets the income at the bottom of the p and l shareholder shareholders. That’s why we’re going to hit equity.

Kevin Johnson/NPF (00:19:39):

If I could interrupt, if I could interrupt just a minute before you ask a question, just raise your hand, we’ll get a microphone to you.

Paul Fischer/Wharton School of Business (00:19:48):

What’s the p and l? I don’t know. You asked him. He’s the one who used it. It’s the income statement, profit and loss. So just hold off on that.

Speaker 3 (00:19:56):

So right now, hang on just a minute.

Speaker 7 (00:20:00):

Right now you’re just trying to keep, we just talked about this. I’m sorry. So right now we are just marking down the general expenses that we are doing. We’re not combining anything and because it’s all just exchanging money back and forth, that is oh,

Paul Fischer/Wharton School of Business (00:20:11):

Exchanging money for stuff here for

Speaker 7 (00:20:13):

Stuff. But that’s why it’s an asset because it’s all about that total. We’re just messing with that number

Paul Fischer/Wharton School of Business (00:20:18):

Right now. Yeah, we gave up the asset, somebody walked out with our inventory and that’s why it’s reducing our equity. Now what did they give us? They gave us an asset and so we could net these two things together if you want to and think about it that way. And that’s the effect on equity. I had my little lemonade stand and I sold it for 400 and it cost me 3 75. What do I get at the end? 25. So on net we’ve got 25, I’m keeping them tracked separately. Kind of how bookkeeping’s done. Yes,

Speaker 4 (00:20:49):

Is liability always just going to be debt or,

Paul Fischer/Wharton School of Business (00:20:56):

But it has different names like an account’s payable is kind of like really short-term debt.

Speaker 4 (00:21:02):

An account’s payable. Yeah,

Paul Fischer/Wharton School of Business (00:21:03):

That’s like you owe your suppliers, they gave you some goods and you promised to pay them later. That would be an accounts payable.

Speaker 4 (00:21:12):

Okay, thank

Paul Fischer/Wharton School of Business (00:21:12):

You. Okay, so it has different names, but you can kind of think about they’re all debt like claims. We pay some interest to our banker, $10. This one’s kind of a little dicey. What do you want to do there? We pay them some interest. Well first of all, we pay them some interest. What do we pay with? We give them some cash, which is, so we’re going to reduce our cash balance by 10. 10. Okay, so I’m going to take this down by 10. So let’s start with that. So the cash goes down by 10, our assets go down by 10. Now some of you, what do you want to do with the liabilities?

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Have we paid them back a hundred? No, we’ve only paid the interest. So who’s paying the interest? In some sense, the equity holders. So we’re going to reduce the equity balance by 10 because the liability hasn’t gone away. We still owe them a hundred. We just paid the interest on the hundred. Okay, the next one we’re going to pay it $5 dividend to our shareholders. So we can kind of think of that. Dividend payment is analogous for the equity is analogous to the interest payment for the debt. So it’s kind of analogous to that. It’s basically giving them some cashflow in exchange for the fact that they basically gave us some money.

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So what are we going to give them? We’re going to give them some cash. Cash. So that’s going to be, assets are going to go down by five. And what else? Some celebration. Equity’s going to go down by five. We’ve basically given them their cash. So we’re going to reduce their claim on us of buy five because that money is actually, the money is left the firm and gone to the equity holders. So from an equity holder perspective, it’s kind of basically moved the money from one pocket to another, their firm pocket to their own pocket.

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Okay, so let me go back to my slides here. So I’m going to summarize all this what we did. And so we just summed up everything and now Lucia, we’re getting to what you want at the end, we basically summed up all these things, but notice at the end, what did we end up with? Assets equals liabilities plus equity. And then this’ll be our ending of the end of the year balance sheet. So we can think about, we have a beginning of the year balance sheet here and an end of the year balance sheet. Okay, questions? Yes.

Speaker 4 (00:24:29):

With the dividends, was that just the, could you re-explain that

Paul Fischer/Wharton School of Business (00:24:33):

What a dividend is?

Speaker 4 (00:24:34):

Well, yeah, are we, go ahead.

Paul Fischer/Wharton School of Business (00:24:36):

Sorry. So if you buy a share of stock, are you just going to give the firm your money and expect nothing in return ever? I just turned 65. So why? Sure. And heck hope not because that’s my retirement, but you anticipate that in the future this firm is going to pay some dividends to the shareholders. And so that’s why the dividend is sort of analogous to the payment of interest to debt holders. It’s sort of payment because you basically gave your resources to the firm to use in exchange you expect to get some resources in the future.

Speaker 4 (00:25:21):

So we paid the shareholders. So we paid the shareholders $5 when they technically covered our debt, our interest payment.

Paul Fischer/Wharton School of Business (00:25:31):

No, they didn’t.

Speaker 4 (00:25:32):

Okay,

Paul Fischer/Wharton School of Business (00:25:33):

So first of all, who owns the firm? Shareholders. Shareholders. They have an ownership claim. And so what we can think about this is the owners decided they wanted to pull some cash out. They want to send little Jimmy to college or something, so they’re going to pull some cash out. Well, that’s what the dividend is, is the shareholders pulling cash out of the firm. And that’s all we’re trying to reflect is the shareholders pulled some cash out of the firm, but it’s analogous to why did shareholders invest in the firm in the first place? They want a rate of return. Those cash pullouts are parts of their rates of return, just like the banker needs a rate of return if they give you a loan. That’s the interest.

Speaker 8 (00:26:19):

Okay, thank you. So in a similar fashion, so why did it go down by five? In the equity column, they gaining five,

Paul Fischer/Wharton School of Business (00:26:29):

Their claim on the firm is reduced by five because

Speaker 8 (00:26:33):

We paid out a bit. So they’re technically a little bit less.

Paul Fischer/Wharton School of Business (00:26:37):

If you’re thinking about I am the shareholder and the firm paid me a $5 dividend. In

(00:26:42):

Theory, that should be awash to me basically just moving cash from one pocket to another. But we’re doing this from, we do our bookkeeping at the level of a firm. So we’re not technically, but we treat the shareholders as the residual claimants or the owners of the firm in our bookkeeping. So this is basically shareholders just distributing some cash to themselves so they can use it for whatever they want. So here’s our balance sheet. So we started here, we ended up here. And notice I’ve done the columns like this and structured it like this because that’s kind of what a real balance sheet looks like. So this is whatever, the 2021 and 2020 balance sheets for Tesla. So this would’ve been in Tesla’s financial statements, which they have to file with the SEC and the 10 k report includes their financial statements. And so here’s the assets part of their balance sheet.

(00:27:42):

Now they have a lot of stuff here. They have different kinds of assets. They have cash, they have some marketable securities, they have some inventory, they have some property planting equipment. So they have all sorts of different kinds of assets that have different labels, but it’s the same basic idea that we just ran through. And they come down to their total. So they have 62 billion in assets and then we go to the liability side of their balance sheet. And so they have different kinds of liabilities, but they’re all kind of debt like claims. So there’s accounts payable, which we just talked about. There’s some customer deposits in there. The customers gave them the cash, but they haven’t yet delivered a car.

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So they have different kinds of liabilities here. And then we go to the equity section and they have sort of different classifications of equity, but it’s all just kind of representing equity claims on the firm. So this balance sheet, then what is it really representing? It represents stocks, not like a share of stock, but like a grain stock, a pile. So it represents piles of assets, liabilities and equities at a point in time for the firm. And what are the things that are called assets? Those are claims or resources that are controlled by the firm, like their cash and their inventory. What are the liabilities? Those are certain kinds of claims on the firm, their payables and debt. And then the equities are the residual claims on the firm. So the common stockholders claims on the firm and the book value of a firm. When people refer to an accounting book value, they’re referring in many cases to the book value of equity. So in that a hundred that we came up with is going to be a frequently stated statistic. So if somebody says the book value of this firm’s 200, what that means is their total equity balance is 200 at a point in time.

(00:29:46):

And it’s the accountants measure of assets minus liabilities. Yes.

Speaker 9 (00:29:52):

In your first example, you stated it in cash basis. The second example for Tesla use you, I guess it looked like it was accrual basis because you had accounts receivable in there. Yeah,

Paul Fischer/Wharton School of Business (00:30:03):

We’re not there yet.

Speaker 9 (00:30:04):

Okay.

Paul Fischer/Wharton School of Business (00:30:08):

Okay. So we’ve got these balance sheets. Just think if that’s all a company gave to you is their balance sheet at the beginning and end of the year. What question are you going to ask? How’d you get from one to the other? That’s what the purpose of the income statement basically is, tells you how the company ended up from one spot to another or at least partially tells that story. And so an income statement is just going to be grabbing these things that somebody said, oh, those are revenues and expenses, those flows, those inflows of assets and those outflows of assets due to your activities during the year.

(00:30:51):

And so I’m going to pop up the income statement, then we’d have revenues of 400, expenses of 3 75. We come down to a 25 here, we take away the interest, we’re left with net income of 15. I left something off here. There was another flow. The very last one we did the dividend. How come the dividend isn’t a reduction in income? Shareholders? We’re paying it to shareholders and we’re doing our bookkeeping from the perspective of shareholders. So shareholders can’t have income from paying themselves a dividend from their firm. So the net income is net income for shareholders. Some it gets reinvested into the firm effectively in retained earnings and some gets paid out in dividends. And that’s the reduction in equity, the reduction in earnings in equities.

(00:31:49):

So now we’ve got this flow and that sort of tells us how we got from the beginning to the ending. And so we can look at Tesla’s income statements. And when these companies file their financial statements, they always give two years of balance sheets, two dates of balance sheets beginning and end. And then they give three years of income statements. Because once you have three data points, that makes a trend, I guess. So that’s why we do three. And so now they have all different sources of revenue and they have all different sources of expenses, but it’s the same idea as what we have.

(00:32:25):

So the income statement is just representing flows of net assets into and out of the firm during the period. It adopts an equity holder perspective. So the net income is net income for equity holders and that net income ultimately is going to land in the equity account called retained earnings on the balance sheet. So the income that the firm has accumulated to date that hasn’t been paid out as dividends is what the balance of retained earnings is. And finally, just keep in mind, dividends aren’t an expense. They’re just a distribution to the owners of the firm.

(00:33:12):

You guys are all experts in financial accounting now. So hopefully you have an idea of what a balance sheet is. It’s just telling you sort of the piles of stuff a firm has at a given point in time. That accounting equation is the assets should be equal to the liabilities and equities claims of the firm should be the claims on the firm. And then we have an income statement, which is basically providing you information of why you got from one balance sheet to another. Okay, so we’re going to turn now to sort of financial statement analysis, which is going to be using the data from financial statements to do something. So we’re going to do something with that data and to think about the whole process is firms communicate via these financial statements to outside parties who use that information to make decisions that are often relevant to the firm. So equity investors are going to use that information to maybe decide how much they want to value the stock in the marketplace, whether they think the shares are priced too high or priced too low, should I buy or should I sell? Creditors might use those financial statements to assess should we give these guys a loan or should we not?

(00:34:33):

Outside shareholders or activist investors might look at these financial teams to assess should we get rid of top management or should we not? Are they doing a good job or aren’t they? So they’re used for all sorts of different reasons to assess different decisions. And the analysis that they do doesn’t tell them what decision to make. It just informs the decision. It provides sort of the data and the information upon which they’re going to build their narrative that leads to their decision. So what do they do with the data? Well, oftentimes what they want to do is they want to benchmark one firm against another or against their peers. How you doing relative to your peers or how you do in relative to how you’ve done in the past? Are you getting better or worse?

(00:35:30):

And so it’s kind of all relative, and that’s where we get to this benchmarking problem. So you’re going to read this simple example. So Ed and Mary gave their two daughters, Barb and Betty, some startup funds for their new business ventures. One year later, Barb returned home with $110 and Betty returned home with $210, which daughter made Marian Ed most proud? Talk to your neighbor about that. Then I’m going to give you 30 seconds to come up with an answer. So how many of you think Barb did better? How many people thought Barb did better? Just two. I thought journalists were. How many thought Betty did better? A handful. Oh, the classic journalist response. We need more information. What information do you need? Yes. Me? Yeah.

Speaker 4 (00:36:40):

Oh, how much? Hold on, sorry. Well, now I don’t even know if this is a good question. I was just

Paul Fischer/Wharton School of Business (00:36:45):

Excited. I think it’s going to be a great answer. Not a good question.

Speaker 4 (00:36:48):

How much were the startup funds, right?

Paul Fischer/Wharton School of Business (00:36:51):

Yeah, that seems pretty important, doesn’t it?

Speaker 4 (00:36:54):

Yes.

Paul Fischer/Wharton School of Business (00:36:54):

Yes. Because if they gave Barb and nickel and Betty $200, they like her better. Well, I could have replaced Barb and Betty by Mark and Paul because my parents are Ed Mary and my older brother’s, mark, and they always liked him better. So it depended on how much they intuitively said. It depends what they started with. Now, some of you might’ve drawn your conclusion by saying, by adopting an assumption that we love our shoulder, and equally they must have started with the same stuff. But that’s just an assumption. Yes.

Speaker 10 (00:37:38):

Would it also be depending on how much debt they’re in, if the one who came home with lower money has $400 in debt, but the one who came home with more money has less debt, wouldn’t that factor into who’s doing better?

Paul Fischer/Wharton School of Business (00:37:51):

I didn’t know about your parents, but my parents said, you take on debt, that’s your problem, not mine.

Speaker 10 (00:37:55):

So is this money that they came back with putting debt? This is just what

Paul Fischer/Wharton School of Business (00:37:58):

They said. Here’s what I got Mom and dad. That’s it. There’s debt. Yeah. Yeah. They didn’t pass on any debt claims. Let’s not make it harder than it’s so astutely said, well, it depends on how much they were given to begin with. And then you said, well, if we think about, well, if one got twice as much funds as the other, that’s going to change how he thinks. Because if you start with more, you should end with more. So that’s the scale issue. And so to deal with that comparability issue, we scale things in accounting when we do financial analysis. That’s the whole point of a lot of ratios is just to scale, to pick up for size.

(00:38:39):

And it also, think about it, what we did so far, we just added and subtracted. Now we get to divide. So we get to do the whole thing. And these scale adjustments are going to allow us to compare firms that are of different sizes. And it allows us to compare a firm with itself over time because a firm will probably grow over time if it’s successful and it will shrink over time if it’s being less successful. So that’s why you’re going to see financial ratios in most, not all cases, but in many cases it’s just to scale.

(00:39:14):

Now is it a perfect scaler? I don’t know. Okay. So we’re going to do quick two illustrations on sort of ratios. There’s a million ratios out there before we go forward. There’s kind of generally accepted accounting principles to how to define inventory or how to define cash. And there’s a gap income number. So there’s some commonality in how gap net income numbers get computed. Are there any generally accepted standards for ratios? No. You could talk to two analysts. They’ll use exactly the same words for the same construct, they think, but they define it differently. And so they compute it differently. So if somebody says their blah, blah, blah, blah is this, it’s a reasonable question to ask is how are you defining their blah, blah, blah, blah. Particularly if you have two analysts who disagree with each other, you want to make sure they’re starting with the same computation before you start hearing their story about whether it’s good or bad. So we’re going to do one that’s sort of capturing an accounting measure of returns to capital providers. And then we’re going to do a couple on profitability ratios. They’re trying to assess profitability and efficiency. So two 50,000 foot ratios to provide a quick measure of returns that are being generated for providers of capital. As we can think, if we want to focus just on equity holders, there’s something called return on equity, which is net income divided by equity. I’m going to define it that way.

(00:40:55):

And then there’s return on assets, which is trying to get at sort of a measure of performance that’s independent of how you financed your firm. So we’ll talk about that in a few minutes. So this is trying to get at some notion of a rate of return on the invested capital. I’m going to define it as simply as possible, is just net income divided by assets. Oftentimes in this ratio, people are going to add back the interest on the debt. So it’s totally independent of the financing choice. So we’ve got those two high level ratios, return on equity and return on assets.

(00:41:37):

And so I’m going to sort of compare and contrast these firms. So we have some measure of returns to just equity holders, net income divided by equity or average equity balance. And then we have net income divided by average asset balance. So we’re going to have two firms target, and I’m going to call the other one comm. So target’s kind of the one we’re focused on. And target has an ROE of 30% spectacular, and their return on assets is 15%, pretty tacular. And then the comps, the people we’re comparing them to, they have ROEs of 16 and two thirds percent, and they also have an ROA of 15%. Which management teams is the target management team doing better then the comms team. So talk to your neighbor about that. What’s the data we have? So yeah, we can think about that. Debt income is the measure of returns to equity holders during the year and you’re dividing it by the amount they gave you. That’s the rate of returns. Who do we think is doing better? Yes.

Speaker 11 (00:43:02):

A before question. What’s the difference I guess between the equity and the assets? I feel like, okay, so

Paul Fischer/Wharton School of Business (00:43:09):

We know assets equals cash. No assets equals all the claims. The firm has cash inventory receivables, that’s property plan equipment equals all the claims on those assets, which are not just equity claims, but also liability, liability claims.

(00:43:30):

But you’re kind of niggling around why things can be different here in terms of these rankings or how we think about it. So one, you might’ve asked the question, answered the question with a question reporters. So you would’ve said, I’m going to answer the question with the question and say, well superior for if we wanted to say who did better just for their equity holders, would we say target that period did better for their equity holders? If we wanted to say who’s done better, regardless of how they financed, there are operations. Can we say one did better than the other? No, they did equally well.

(00:44:21):

Okay, so how can I do better by my equity holders than comms, but just do equally well for the rest? Well, we can actually link these things up. So now you’re going to start saying, oh my God, I’m having seventh grade algebra flashbacks. So we’re basically take these definitions. This member was net income divided by equity. This was net income divided by assets. Well, if I take this ratio and multiply it by this thing, I get that thing. But I can sort of say, well, what is this thing? Well, we could sort of cut this thing into this is basically this plus this.

(00:45:02):

So algebraically, we can sort of connect these two things up. Well, these are things people would call these measures of leverage. So if we take the liability, the equity, that’s how much leverage or we take the assets divided by equity. That’s a measure of leverage. Why? Because we know assets equals liabilities plus equities. And so what this is basically capturing is if this number’s really big, it’s saying a lot of our assets were not financed with equity. They were financed with liabilities. So when people talk about a firm being more levered, they just mean more debt financing relative to equity financing. So more levered means more debt financed. So we can connect them up. Yes. Hold on.

Speaker 11 (00:45:58):

Which one is a better measurement for the health of the company?

Paul Fischer/Wharton School of Business (00:46:05):

Oh, let’s see if I can hedge this one. What do you mean by health of the company? The future sustainability of the company. You mean just survivability? Yeah, future survivability probably. I wouldn’t use either of these because I’d really want to know. Tell me how levered they are. If you just say, because of the more leverage you are, there’s going to be all else sequel, higher probability that you will go bankrupt in the future. You won’t be able to pay your claims. And then the equity holders in theory are going to end up with almost nothing if you go bankrupt. So if that’s kind of what you’re getting at is default risk or likelihood of going bankrupt. I wouldn’t use these. I use a measure of leverage. Hang on. A high measure of leverage would be an indicator of a company that is all else equal more likely to go bankrupt. But you’d want to look for changes in that leverage measure year over year. Because some industries naturally have a higher leverage than others because they have debt financings more efficient for them. They have assets that can serve as collateral, so they can get debt financing cheap. They have very stable cash flows. They’ll be naturally more leveraged because debt is a cheaper cost of capital typically than equity for firms.

Speaker 12 (00:47:31):

Can you explain what you mean by leverage in another way? Obviously you just did it right there, but can you explain it in a different way? What do you mean by leverage? Leverage to gain more debt, leverage to pay off their debt and give money back to stakeholders

Paul Fischer/Wharton School of Business (00:47:49):

Leverages the amount of debt that you take on relative to the amount of equity. So more debt relative to equity means. So it’s at a point in time means more levered. And then we’re going to see how leverage can affect performance in and of itself. So the choice of how you finance yourselves is going to affect how you perform? Yes.

Speaker 5 (00:48:12):

From a purely linguistically standpoint. Why does leverage, why does it mean depth? Where does it come from?

Paul Fischer/Wharton School of Business (00:48:19):

The word leverage? Yes. So if you think about, I’m winging it here, but if you’re thinking about physics is we have more leverage, we can lift a bigger weight at the end of the board. So it’s the same idea as think about equity holders. They have to decide how much debt they want to take on

Speaker 3 (00:48:39):

And

Paul Fischer/Wharton School of Business (00:48:40):

If they take on more debt, we’re going to see they can do really well under certain circumstances. They’re leveraging their equity, getting a bigger board, but managing a bigger board is more challenging and there’s potentially some downside. Okay, so let’s do this little example. So we’ve got two firms. They’re going to be identical in every respect except for the one thing we’re going to tweak, which is how they finance themselves. So we have two firms, the high leverage firm and the low leverage firm. The high leverage firm has, its a hundred dollars in assets, 75 of that was financed by debt and the equity holders just kicked in 25 in the low levered firm. The equity holders kicked in 75 and financed 25 with debt. Does every kind of make sense? So they’re all identical, it’s just how did they finance their operations? We’re going to assume that the interest rate on debt’s 10%, there’s no taxes to make our lives easy.

(00:49:42):

And then we’re going to have three return on asset scenarios. So there’s three states of the economy. There’s the good state where they get a 15% return on their assets then comes higher. There’s the middle state where they get a 10% return on their assets, and then there’s a not so good state where they only get a 5% return on their assets. Everybody understand the facts? So here’s our facts. So now we’re going to think about, okay, what do they have here? Here’s our three scenarios, 15, 10, and five, and then we’re going to look at the returns to equity holders in those three scenarios across the two firms. Does this one look a little familiar? That’s the one we just did. So in this case, the return on equity for target’s going to going to be 30%. The return on the comps was only 60 and two thirds. And then we go down here, we have 10 and then we have five. So I want you to just look for the patterns here and then say, and we’re looking at this from the perspective of equity holders, under what conditions does leverage not matter for the return on equity holders?

(00:50:48):

What financing choice is going to give the greatest variation in outcomes for equity holders? And then you can try to answer the last question, which is what financing strategy is best? So you have three questions to answer. I’m going to give you a minute. This is harder in jeopardy. Okay. So under what condition did the leverage choice not matter when the return on assets was 10%? Why do you think that’s the case? In this example? What was the interest charge on the debt? 10%. 10%. You think that’s coincidence? No. No. He wouldn’t ask the question if he didn’t. It was not a coincidence. So intuitively think about it. I’m a shareholder and if I take on a dollar of debt and I generate 10% return on that dollar, what do I have just enough for? I just have enough to pay the interest on the debt and I am not impacted. So yes.

Speaker 6 (00:52:02):

And to make that more of a general rule, would that be that leverage doesn’t matter if the interest on the debt is equal to the ROA?

Paul Fischer/Wharton School of Business (00:52:12):

Yes.

Speaker 6 (00:52:12):

Okay.

Paul Fischer/Wharton School of Business (00:52:12):

As an approximation, yes. That’s what I’m, because it basically capturing the idea that yeah, you can take on another dollar of debt, you’re going to get 10%, it’s not going to do anything for equity holders. You’re going to generate just enough to pay the interest on the debt. That’s what it’s trying to capture. What’s that? From a company’s perspective? From the company’s shareholder’s perspective,

Speaker 3 (00:52:39):

Right?

Paul Fischer/Wharton School of Business (00:52:39):

Yeah. Yeah. Okay. Which financing strategy will result in having the most variable outcomes for equity holders? So if you look at the which, where variable means the biggest possible spread. So we could think about, let’s say we have a 20% chance of this outcome, a 20% chance of this outcome and a 60% chance of this outcome, which one’s going to have the biggest spread and possible outcomes and biggest spread or biggest variance? If you’ve had statistics and outcomes where the outcomes are going to be further apart,

Speaker 7 (00:53:19):

Would it be 5% because they’re at the negative? And the higher end would be the third.

Paul Fischer/Wharton School of Business (00:53:22):

Which strategy? The high or low? So it’s high or low leverage is going to give you the more variable outcomes. For equity holders, it looks like the high ones, this is more extreme good than this, and this is more extreme bad than this. You kind of get it. So it gives you a bigger spread in outcomes. So leverage is really great if you can take every dollar you get from those debt holders and generate a rate of return in excess of the interest. But if you don’t, your equity holders are going to get slammed. Can you say that again? Sorry, could you say that one more time? So taking on leverage is good for equity holders if you earn more than the interest charges on the debt with those dollars borrowed because it leaves more for you in the end, but if you don’t, it’s going to mean you’re going to regret having taken on that debt.

Speaker 7 (00:54:26):

So the high financing strategy has the greatest equity performance volatility, the high strategy has the greatest equity performance volatility because of all that potential?

Paul Fischer/Wharton School of Business (00:54:35):

Yes. Yes, because it could. But there are certainly people like on Wall Street, they live for leverage because they always think they’re going to get the higher outcomes because they project, we’re going to get a higher outcome, we’re going to leverage this firm and we’re going to extract some great returns for us. And when does that not work out? When things don’t work out as they hoped they had and then they end up in bankruptcy court. So

Speaker 11 (00:55:09):

Can we Yes. Random, really random question. Who’s setting these interest rates and how do we know going into this? Maybe that’s kind of outside the

Paul Fischer/Wharton School of Business (00:55:18):

Scope. There’s that guy at 600 Pennsylvania Avenue, he’s playing to take it over, I think. But nobody sets interest rates. It’s a market outcome. It’s like asking who sets the price of oranges in the grocery store?

(00:55:30):

Nobody, right? In some sense it’s a market outcome. So it’s always going to be very variable. Interest rates, day-to-day interest rates, they move by the minute and then they’re tied to the risk of the claim, but they move up and down. Yes. Okay. Can we say exon before the fact which financing strategy is best? No, no. I mean, if we figure we can’t guess what’s going to happen in the world any better than anybody else, we probably can’t say which one’s necessarily best. We can say which one is just riskier from an equity holder perspective and therefore if it’s you’re probably going to offer a greater average return because otherwise they wouldn’t engage in that strategy. But we can’t say what’s best. It depends upon your risk preferences, depends upon what you think is going to happen.

(00:56:27):

So it depends on what you think is going to happen and your risk tolerance. If you’re more tolerant of risk, you’ll probably take on more leverage, take on more debt. If you’re less tolerant, you’ll take on less debt. Okay. So why did I point that out? Because sometimes when the economy’s great firms who are levered are going to do great, should we assume they’re always going to do great? No. If the economy goes in the dumper, they’re going to get hit harder than the other firms because they took on that risk. So just because somebody’s done well in the past, don’t assume it’s going to continue on forever. And they may be doing exceptionally well, not necessarily because they’re operating their firm all that much better than everybody else. It’s just they’ve chosen a different capital strategy, capital structure strategy, different financing strategy. So being able to manage people and all that stuff is different than being able to raise debt. Those are two different things. And some people might do well just because they’re good at raising debt. Yes.

Speaker 13 (00:57:32):

Yeah. Sorry, my question is just about the risk and the tolerance for risk in companies because you could take on high leverage, but then you can go to bankruptcy. Is it fair to say you go to bankruptcy faster with that

Paul Fischer/Wharton School of Business (00:57:46):

Probabilistically? If you take on more debt, there’s a higher probability that you will default. And default is what drives you into bankruptcy.

Speaker 13 (00:57:54):

Okay. And then as, would you be able to give examples of what companies are more prone to that or what industries?

Paul Fischer/Wharton School of Business (00:58:02):

So one is we can’t say one industry is this and that what industry in the United States is our most levered industry? What do you think

Speaker 3 (00:58:12):

Military. Military,

Paul Fischer/Wharton School of Business (00:58:13):

Like an industry like tech, automotive, some other manufacturing grocery stores, who do you think is most levered? Defense banks are the most levered because what do banks have? They have deposits. And what do banks live by? They live by between the spread, they pay their depositors and the simple banks spread between your depositors and spread on your loans. They are the most levered entities in our economy because of the nature of their industry and the nature of FDIC insurance probably helps that along a little bit too. So they’re the most levered. And then what are some of the least levered firms do you think? Agricul? I have no idea on the ag, even though I come from an ag state, I should know the answer, but I don’t.

Speaker 3 (00:59:08):

So I guess

Paul Fischer/Wharton School of Business (00:59:09):

So you’re a startup biotech firm, A lot of leverage. Yeah,

Speaker 3 (00:59:19):

They’re

Paul Fischer/Wharton School of Business (00:59:19):

Not giving you debt because you’re starting up. You’ve got basically an idea. You’re going to develop that idea. You don’t know exactly how long it’s going to take to develop it if it works out. And a banker’s going to say, well, what kind of loan am I going to give you? Because bankers don’t, bankruptcy is an inefficient outcome. A lot of money gets lost. To whom in bankruptcy? The banks. Well, you got the bankrupt party and you have the claims on the bankrupt party who’s between them? The bankruptcy court and who handles bankruptcy court for the parties, lawyers and bankers. And what do lawyers and bankers get paid money fees. And where’s that come out of? The pile of stuff the firm had to begin with. So it’s not an efficient outcome. So banks don’t want to make loans that have a high probability of default. So those startup firms are going to use equity? Yes.

Speaker 6 (01:00:21):

Oh, sorry. Does the amount of subsidies in industry or a firm gets alter this scenario or does this scenario stay the same and then just maybe the impact is differed by

Paul Fischer/Wharton School of Business (01:00:36):

Subsidies?

Speaker 6 (01:00:37):

Well, so for governmental subsidies, so if I have a big, I don’t know, dairy company and I leverage a lot, and this is all hypothetical, I don’t really know these things, but I know that the government subsidizes the dairy industry

Paul Fischer/Wharton School of Business (01:00:54):

Pretty subsidizes that industry

Speaker 6 (01:00:56):

To death. So then would this scenario, if I had high leverage and something went wrong and I went to bankruptcy, would the impact not really matter as much because

Paul Fischer/Wharton School of Business (01:01:07):

Subsidies

Speaker 6 (01:01:08):

Are not once,

Paul Fischer/Wharton School of Business (01:01:08):

You’re probably not going to matter, but it might matter to what your capital structure choice is. If the subsidy is certain you’re going to get it, then it can allow you to

Speaker 6 (01:01:20):

Be riskier,

Paul Fischer/Wharton School of Business (01:01:21):

Take more leverage because your cash flows are more secure, which is the case in the ag industry is those subsidies help farmers get the credit they need to do to sort of buy the stuff they’re going to put in the ground. Okay, let’s go to the next one, which is a notion of profitability and efficiency. So just as we sort of decomposed ROE, we can decompose return on assets into a return on sales number and asset turnover. So return on sales, just net income over sales, asset turnovers, sales over assets. And this is thought to be a measure of profitability. And this is thought to be a measure of some sort of operating efficiency measure. And so I’m going to give you return on sales here. So to start with, we’re talking about return on sales profitability. So in our little example, this would be the return on sales, 5%. It’s 5% of their total sales ended up hitting the bottom line. And so it’s a measure of profitability for every dollar you sell. What do you take away at the end after you pay your employees and pay for the products that you sold?

(01:02:33):

And so that’s a measure of profitability, but people will work their way up. The income statement. Now I’ve given this thing a name gross profit. And so sales minus cost of goods sold is often referred to as gross profit. And what does that represent? You got a dollar in sale, how much did, what’s a measure of the cost of the stuff you sold? And then everything that falls below that, that’s like selling general administrative, right? It’s marketing expenses and paying the suits, paying the accountants to add up the numbers. That’s below this. But this is kind of the cost of the product. So if you’re a manufacturing firm, what’s in cost of sales is basically a measure of, well, you paid the people who worked in the factory, but the raw materials that you took into the factory, some depreciation on all of the equipment and stuff in the factory.

(01:03:25):

So that’s what’s going to be embedded in the cost of sales. If you’re a retailer, it’s what the goods you bought cost you. Okay? But we can start and say, well, for every dollar, they may take it in revenue and they have a 5% goes to the bottom line. But we can push our way up and focus on this gross profit. And gross profit margin is something that a lot of analysts will look at, which is how much of each dollar of sales is eaten up just by the cost to buy or produce the goods sold. So that’s what that’s trying to capture. Okay, so now we’re going to see if you can get some intuition for this. So we have three. Everybody’s familiar with these. Three retailers rank from the highest to lowest. Who do you think has the biggest gross margin ratios on average? So who has the biggest wedge between the dollar? They sell a good for the cost of sales to get that dollar. Think about their selling strategies. Okay, so what do we think? Who’s going to have the highest margins? Yes. So tell us what your reasoning. Okay, so what’s value proposition to people?

Speaker 7 (01:05:20):

Walmart’s kind of like the cheaper store, but they sell a ton of stuff and they don’t play their employees very well.

Paul Fischer/Wharton School of Business (01:05:24):

Okay, so Walmart, but what do they, customers go to Walmart because they’re going to get a

Speaker 7 (01:05:31):

Deal, they’re

Paul Fischer/Wharton School of Business (01:05:32):

Going to get a lower price. So if they sell for a lower price, the same stuff from Proctor and Gamble that Target does, do you think they’re going to have a higher margin on Target? No, you’re right. Okay. So we can sort of say Walmart’s going to be sort of the value for the customer’s proposition. You might guess that they should have lower margins, but they’re going to make up for it. They sell a lot of stuff given that logic. So I’m going to say that Walmart does have the lowest gross margin on average.

Speaker 7 (01:06:04):

Okay? We were thinking Nordstrom because the stuff that they’re buying probably costs cheap to produce, but then they’re selling it for so much money. So

Paul Fischer/Wharton School of Business (01:06:11):

That’s going to give them a high margin and lo and behold, and how do they get away with that? Because they’re offering a luxury, a better buying experience, more unique goods, all that stuff, but they have the highest margins and then who’s going to sit in the middle target? But it kind of goes with their selling strategy, right? They’re a little bit more stylish and stuff than Walmart, but they’re not a Nordstrom. They still say they offer a value proposition. That’s better. Okay, another question back. I’m sorry. Yes.

Speaker 4 (01:06:45):

Could you, just going back, could you re-explain what the gross profit margin represents?

Paul Fischer/Wharton School of Business (01:06:52):

So it’s basically the thought experiment is I sell a good for a dollar. How much is left of that dollar after I pay whoever sold me the good to put an inventory?

Speaker 4 (01:07:04):

Okay. So then if for example, with Walmart, if they have a low gross profit margin, how do they make up? Is it just because they remember this is a percentage, right?

Paul Fischer/Wharton School of Business (01:07:14):

So it’s just a percentage. So the question is how do they make money? How do they make money? They don’t pay people. Well, they don’t pay their people. That’s fine. Although they sell a lot to a lot of, they sell a lot. So they have a lower margin, but they sell a lot more stuff. So they push more stuff in and out of their stores. Nordstrom, stays, it stays on the shelf a shorter period of time. Yes. I

Kevin Johnson/NPF (01:07:47):

Just want to discuss, hang on just a minute. Walmart does have lower prices, but

Speaker 13 (01:07:50):

They offer a lot of opportunities for their employees to rise up in the managerial ranks that you can make a hundred, $125,000 working at Walmart.

Paul Fischer/Wharton School of Business (01:08:03):

Oh no. All I will say is having lived in the Philadelphia area and central Pennsylvania for long stretches, yeah, the views on these things depend a lot on where you live.

Speaker 14 (01:08:21):

You have a question, could you have the expected gross margin be better for Walmart? But then they might have other expenses. So your return on sale would be,

Paul Fischer/Wharton School of Business (01:08:31):

That’s possible because there’s stuff below the line, right? They’re selling general administrative, which going to include marketing expenses, advertising and all of that stuff.

Speaker 14 (01:08:39):

Why do analysts focus then on the gross profit instead of, because then it feels like there’s a big chunk you’re not taking into account,

Paul Fischer/Wharton School of Business (01:08:51):

It’s only one piece of their analysis. So they’ll be looking at return on sales, but I think the idea is the cost structure, what you’re managing above the gross profit is quite different than what you’re managing below.

(01:09:05):

And so to think about where firms can save and if you’re in a business where you’re primarily a price taker, whatever the market gives you get, and when you buy your stuff, you’re a price taker. And when you sell your stuff, you’re a price taker. There’s not a lot you can do about margins, but what you can do a lot about potentially is the stuff below the line. Okay, so let’s talk about efficiency. So these measures of efficiency are like turnover ratios. And so the asset turnover was the big one we looked at, which is sales over assets basically says for your asset base, how many sales are you pushing out the door? And you’re deemed to be more efficient if you’re taking a smaller asset base and driving more sales. And there are other similar type of turnover ratios that are used. So sales over accounts are siebels trying to get at how quickly if you sort of think about all their sales, and this is really only relevant to firms who sell a lot on credit, how quickly do they get paid if you don’t get paid in a very quick fashion, that costs you a lot.

(01:10:17):

And then another one that’s really important in the retail sector is inventory, turnover and in some manufacturing sectors as well is how quickly does a firm get its product sold? So that’s cost of sales divided by average inventory for the period, kind of basically capturing how many times does your inventory turnover every year and why do they people focus on that? Funds tied up in inventory are earning nothing. They’re just sitting on the shelf, it’s just money on the shelf. And so that’s not a good rate of return. But if you don’t have products on your shelf, what happens when your customers come in and they want, I want the green Schwinn bike and you don’t have it, they’re going to go somewhere else. So there’s the balancing act of how much inventory you want to have around. You don’t want to lose customers, but you also don’t want to have money just sitting on the shelf earning no return. Okay, so we’re going to do the same question, which is highest to lowest the firms that you think have the highest inventory turnover ratios,

Speaker 7 (01:11:24):

I’m not saying nothing about.

Paul Fischer/Wharton School of Business (01:11:27):

Well, they’re on the list.

(01:12:02):

Okay, highest to lowest. Which firms do you think have the greatest inventory? Which one do you think has the highest inventory turnover? Walmart, because they live on volume, which one do you think has the lowest nor Nordstrom’s? And so that’s what you’ll see in the data. So these ratios are going to be tied distinctly to companies strategies. Okay, so I gave you a couple ratios. There’s some other standard textbook ratios you can look up on Investopedia. But another thing to keep in mind is there are a lot of industry specific ratios as well. So in retail, common metrics are same store sales or sales per square foot. And those are used because people want to distinguish sales growth. That happens because you build more stores versus sales growth. That means you’re driving more customers in and out of your stores because the latter one’s viewed as better than the former because if you build a new store, you’re going to get some new sales. Yes.

Speaker 9 (01:13:01):

Could you go back to slides? That one? Okay, so my question is that when you get the number, what does the number stand for and how does it perform? Are you comparing that to comps or how

Paul Fischer/Wharton School of Business (01:13:18):

You could be comparing it to comps or you could be comparing it to the firm over time and looking for trends.

Speaker 9 (01:13:24):

Okay, so example would be is that okay, I’ve got a hundred thousand dollars in sales, but my inventory was 300,000,

Paul Fischer/Wharton School of Business (01:13:34):

But this isn’t, remember this is cost of sales. So you have 300,000 in sales and inventory of a hundred. That would give you an inventory turn of three.

Speaker 9 (01:13:48):

I’m in the wrong slide. I think it’s the one before that.

Speaker 9 (01:14:08):

Well, we could use almost any notes you were calculating. You’re going back too far. Keep going, keep going there. Okay, so I guess the question is that when you arrive at the ratio, what does the ratio mean? It’s a meaningless number for me at the moment. How do you use that number in order to establish profitability and how good is your profitability? Make

Paul Fischer/Wharton School of Business (01:14:37):

Sense? So if you’re taking a firm relative to itself, if you see that this gross profit margins growing, what would that suggest to you that you’re doing well? That you’re doing well? Because the spread between what you sell stuff for and what you paid for it is getting bigger, right? Right. Okay. So that growth in margins is viewed as all its equal, a positive thing. So

Speaker 9 (01:15:05):

Are there industry standards on what a

Paul Fischer/Wharton School of Business (01:15:08):

Now you should think about? Now you’re going to compare them to comps, it can differ from comps and you can say this firm is more profitable per dollar of sale than that firm. But that difference might not say that this firm is better than that firm because Walmart is pretty successful in Nordstrom. I don’t even know where they are now, but at one time they were successful as well and the wedge in their ratios was driven by completely different strategies.

Speaker 9 (01:15:38):

I guess that’s my question is, is there industry standards poor per the ratios that are used for comps for across?

Paul Fischer/Wharton School of Business (01:15:47):

So typically you want to find the ideal comp is somebody who’s doing exactly what you’re doing, right? Right? Yep. That’s never the case. But you’ll find firms that are sort of in the same business, they might be doing different strategies. You can get some idea of maybe which ones, which strategy seems to be panning out. But this is one nugget in a narrative that an analyst would build, right? This is a supporting fact in the story. They’re going to tell

Speaker 12 (01:16:25):

In your opinion, what’s the leverage? Some of these metrics tell the story of some businesses as you just alluded to.

Paul Fischer/Wharton School of Business (01:16:33):

So what typically people will do is they’ll be looking at the behavior of a firm’s metric over time. Just like my doctor tracks my cholesterol over time, and if they see a blip, they don’t freak out immediately, they just say, well let’s go run another one to see if we’re picking up a change or just a blip. I think. So thinking about firm over time can be pretty useful. Now comparing one firm to another, you have to be careful there because any individual metric might naturally be different because they’re doing different strategies. And so in that sense you want to be careful how you compare.

Speaker 12 (01:17:15):

So it’s a lot more beneficial or a lot less messy to focus on one firm over a set period of time versus trying to, yeah, because

Paul Fischer/Wharton School of Business (01:17:24):

You’re kind of comparing that firm with itself. And if you want to compare that firm with other firms and say, this one’s better than that one. Well you can say this one. You need more context to understand why is it management’s making poor decisions or they’re doing a different strategy.

Speaker 4 (01:17:41):

Quick question. You guys were talking about comms. Could you remind me what stands

Paul Fischer/Wharton School of Business (01:17:46):

For people talk about comms comparable. So it’s who do I benchmark myself against? So we’re in school and you’re in a class and you get graded. Who are your comparables? Okay, so there’s all these industry specific metrics I’ve thrown up. So I have some ones that relate to the hospitality industry or the blue ones. The purple ones relate to the airline industry. The red ones relate to the financial services industry and the green one related to just the generic service industry. So you can see all sorts of ratios and if somebody references a ratio, it’s just useful to look it up to say, okay, what exactly is it trying to capture? What does it capture? Okay, we’re going to skip these in the interest of time. So these are just little exercise. I’m going to jump to the next thing. So I’m going to conclude the ratio analysis with one note of caution related to the question that Marlin just asked. And this one’s motivated by something I heard on NPR like driving my kid to soccer a long time ago.

(01:18:53):

So there was this law professor who had written a book and stuff and he was being interviewed on NPR, and I’m not going to tell you, well it’s some university on the Charles River, but nonetheless, there was this law professor and he was in the area of antitrust law and he was making the argument that pharmaceutical companies have had so much protection that they kind of have these monopolies that allow them to generate egregiously excessive rents. Which may be perfectly true or may have been perfectly true, may be perfectly true, but the statistic they used was return on assets. They said if you compare pharmaceutical industries return on assets to some other industries like manufacturing or retail, their return on assets are way better than these other guys. So therefore the conclusion was these guys are earning excessive monopoly rents.

(01:19:51):

So I can’t speak to the antitrust issues, but when I heard return on assets, I said, well, I’m not so sure. So is that true? Can we compare a pharmaceutical industry return on assets and a manufacturing company’s return on assets and say, this one’s much bigger than that one historically, so therefore these guys are earning monopoly rent. What’s the biggest asset for pharmaceutical companies? What’s their biggest asset? They they’re patents like their drugs, right? The drug patents they have, how much is on their balance sheet for their drug patents and assets? Almost zero. Why? Because all research and development expenditures under accounting rules get expensed right away. So they’re not on the balance sheet as an asset. What’s a manufacturing entity’s? Biggest assets? The machinery, the property plant equipment under accounting rules that sits on the asset balance sheet and gets brought down over time. So that denominator is vastly different between the two. So can you make that conclusion? No, that was not a good statistic to pick. Okay. So generally people don’t use financial analysis to pair one industry with another because there’s differences in the nature of the assets and liabilities and how they get accounted for.

(01:21:19):

Okay, I’m going to spend a minute on cash flows. So financial statements are generally in conformative with this gap and they’re audited so people have to adhere to the gap. The auditors try to make sure they adhere to gap. And gap is, this was brought up much earlier, requires something called accrual accounting. And under accrual accounting, the intuition is we’re going to record revenues when they’re earned, which is generally when we deliver the product we might get paid later, we might’ve been paid before. So the cash flows don’t dictate when to recognize the revenue when you earn them is going to dictate when you recognize them. And then expenses are going to be recorded when the associated revenues they drive are recorded. And that’s sort of this matching convention. And the idea here is that this accrual accounting is intended to provide more useful summary measures. So hoping to give you a quick example. So we have a real estate company and they own a building and they lease it to X Corp for 10 years, but to attract X Corp, they actually give them a four year rent holiday and then they back load the rent and then it’s 200 per year thereafter. So that’s the nature of the lease has this rental holiday, we’re in the first year of the lease, how much revenue should they record? So talk to your neighbor about that. What do you think?

Speaker 3 (01:22:51):

Yeah,

Paul Fischer/Wharton School of Business (01:23:09):

And I’m going to finish up after this. I’ll finish up after the cashflow thing. Is that okay? Okay. So what do you think? So let’s get some ideas. We got to vote for zero because they haven’t gotten paid anything. Is that your view? Okay, other views? What’s that? Was there an initial payment? Nope. 0 0 0 0 0 200 200. 200. 200. 200. 202.

Speaker 15 (01:23:42):

1200.

Paul Fischer/Wharton School of Business (01:23:43):

Oh god.

Speaker 15 (01:23:44):

$1,200.

Paul Fischer/Wharton School of Business (01:23:46):

So you want to do 1200, basically you want to basically record the full 1200 that you’re going to collect over 10 years.

Speaker 15 (01:23:54):

Maybe it’s just but that

Paul Fischer/Wharton School of Business (01:23:58):

So or do you want some rata portion of the 1200?

Speaker 15 (01:24:02):

I mean maybe just for the year 20 x one it would be 200, but over the course of the six years with the four year rent holiday, that’s just the math that I did.

Paul Fischer/Wharton School of Business (01:24:10):

Okay, so you know that over the entire lease, how much is going to get paid is 1200. Question is when are we going to recognize that 1200? How much of it is going to be recognized in 2000 x one? And so we had to vote for zero because you haven’t gotten paid. You kind of want to record something, but I’m not sure.

Speaker 15 (01:24:29):

$200 for 20 x one then and then $200 per year thereafter. Well

Paul Fischer/Wharton School of Business (01:24:32):

That’s going to get you to more than 1200. So I think you want to prorated it. So you want 120 because we have 1200 over 10 years.

Speaker 15 (01:24:40):

Yes,

Paul Fischer/Wharton School of Business (01:24:41):

That’s 120. That’s your accountant speaking. So it’d be 120 per year for each year over 10 years if you want to make it nice and smooth. Okay. Okay. Not the 200 because you’re not going to get 200, you’re not going to get 200 per year.

Speaker 15 (01:24:55):

That makes sense.

Paul Fischer/Wharton School of Business (01:24:56):

So we could do 1200, we could do zero. Anybody want to do anything else? We could do the first 120 or zero. We could do the full 1200. That’s an option. They’re in the building, but you’re kind of uncomfortable with that. Okay, so which one do you think it is? It’s one 20. So gap is going to be one 20, but it’s valid because basically you’re going to get a promise to pay. It’s valid, but you might not get paid for. You might not get paid at all and you’re recording something, you might never get any money, but that’s what gap is. So for reasons like this, people often find accounting a little wanting and so they turn to other measures. So they’ll turn to what we’re going to call cashflow measures and then people come up with other non GAAP earnings numbers that they use as well.

(01:25:51):

And firms sometimes disclose non-gap earnings numbers. So there’s all sorts of measures out there that they’ll come up with because they don’t like the gap measures. Okay? The cashflow measure driven by, if you don’t bring in cash, it doesn’t matter what pot of gold is at the end of the rainbow, you’re never going to get there. So liquidity is critical. And so to inform people about liquidity, your ability to generate cash, we prepare a cashflow statement and provide some useful metrics out there. So cashflow statement’s going to have three sections. Cash you generate or use in operations cash you generate use in investing activities and cash user generate in financing activities. So there’ll be three sections of this thing and they’ll reconcile from the beginning to the ending cash balance. Yes. Yes.

Speaker 11 (01:26:41):

To go back to that rent holiday example, would you on your statement say that there is a four year rent holiday so that there’s a known that okay, I’m expecting this one 20 but I don’t really actually have it. They

Paul Fischer/Wharton School of Business (01:26:56):

Would have instead of they wouldn’t have the cash obviously. So when they record the revenue increase equity, they’re going to record an asset lease receivable and then they’ll describe what those lease receivables are.

Speaker 11 (01:27:08):

And in that description it would say,

Paul Fischer/Wharton School of Business (01:27:10):

Well, but they probably have a thousand leases, right? They’re not going to give you the detail on a thousand, but they’ll describe kind of when those receivables are likely to be paid and stuff like that.

Speaker 11 (01:27:19):

As I’m asking more. So for a transparency thing, right? Yes. So if I’m looking at the statements and I’m trying to notice a red flag, if we’re giving a hundred people these rent holidays, you don’t have any money, which

Paul Fischer/Wharton School of Business (01:27:33):

Means there’s going to be a big wedge between your net income and your operating cash flows.

(01:27:38):

And that’s kind of the red flag people look for. So we have these three sections and then this is what the Tesla ones look like and what do people focus on? They’ll focus on the total operating cash flows. And for a typical healthy company, those things should kind of be moving in tandem. There shouldn’t be a huge, if income’s going up, you would think operating cashflow should be going up and vice versa. There shouldn’t be a huge wedge. Sometimes there is, but when you see that wedge, that’s a red flag and then people say, okay, something’s going on. Interesting. With the accrual accounting, I got to dig deeper into the notes of the financial statements to figure out exactly what’s driving that and it might be a good story for what’s driving it and it might be a bad story, but that’s the red flag.

(01:28:24):

Cash flows from operations income should generally moving together. And another thing people will look at is free cash flow, which is basically operating cash flows minus investing cash flows is a rough thing they use. Other people have different ways they define that, but this would be sort of a pure accounting way and they just look at that difference and that’s kind of the excess cash that’s thrown off to your claimants. And so people will look at that measure as well. Okay, so what I’m going to tell you if we’d had time to do this is this statement of cash flows is just largely rearranging the accounting furniture. It takes what’s in the income statement and balance sheet and just rearranges it. So you can kind of rough out what the cashflow statement would look like with an income statement and a balance sheet. Maybe not exactly, but get really close. So why do you think firms have to provide it? If you can kind of rough it out anyways? Because there didn’t used to be a cashflow statement 30 years ago. No, maybe more now. Maybe 50 years ago there was no cashflow statement.

Speaker 8 (01:29:26):

Isn’t it kind, seeing where the investments are going, if they’re reinvesting,

Paul Fischer/Wharton School of Business (01:29:30):

It kind of is used, it provides a different perspective, it’s the same data but it’s providing a different perspective. It’s like we’re going to show you that. I always think of this, I think of there was a blazing Saddles a movie and the conclusion of the movie is the bad guys all riding into the town, but the people that built a fake town like a movie set town. And so from one side it looked like a real town, but if you walked around and look at it from the other side, you got a totally different perspective. And so this is going to offer a different perspective. So that’s one reason. And the other reason is if everybody wants to do this, it’s much more efficient for the firm to just do it for everybody than for everybody to do it on their own. And so that’s another argument in favor of sort of this uniformity.

(01:30:13):

Now why not just focus on the cash? Some of you love cash, we like the cash. The idea here is accruals often sort of better reflect the underlying economics of what’s going on. That’s the argument in favor of accrual accounting. And most analysts focus on metrics or earnings metrics that sort of land between pure cash flows and pure accrual accounting. So they’ll use something, this is an acronym here, ebitda, which is basically they focus on earnings before interest, taxes, depreciation and amortization. And some people literally call that cash flows. It’s not literally cash flows, but it’s somewhere between earnings and cash flows. Yes.

Speaker 12 (01:30:52):

What’s a common mistake that you see reporters make? What’s a common mistake that you see reporters make when analyzing income statements and balance?

Paul Fischer/Wharton School of Business (01:31:04):

Okay, so we’re not going to get there, but I’m going to give you the answer. I have to quit now, but we’re not going to get there. But the common mistake is, but what’s their true earnings? That is a common mistake. What is their true earnings? There is no true earnings or if it is, none of us know exactly what it is. There are measures of earnings and earnings measures are trying to capture how well the company has done during the year in terms of having more inflows than outflows, but there’s no notion of true. So I think when people say true earnings, that’s a problem. And I think that throws your readers off what’s true earnings. You can argue about how a company measures its earnings, how they would account for their leases. We were going to have some ones in there if you get the other slides about how they would account for their contracts. But that’s just a different way to compute earnings. It’s not saying one is true and the other’s false. And then there’s the other issue of people say true earnings. I think is it consistent with gap? We didn’t get to the end. A lot of approaches can be consistent with gap and give different metrics. Yes. Questions going on

Speaker 10 (01:32:23):

Asking hope not. Hang on, hang

Speaker 4 (01:32:25):

On. That’s boring. But do you feel like there’s something companies ever do in making announcements or news releases that’s misleading when they’re reporting their own wins so to speak? The point is we put our best foot forward when we’re in front of the public, right? Certain public anyways. Do you think companies will behave any differently?

Speaker 4 (01:33:00):

No. But is there something I can watch out for?

Paul Fischer/Wharton School of Business (01:33:03):

So there are issues of what are they? So we can say, okay, everybody’s going to put their best foot forward, but then there’s are they trying to mislead you of how good their best foot is? That’s kind of what you’re looking for. And so one is to think about motive. What are their motives? So people’s beliefs are changing constantly in the marketplace. So if a company is managers really care about what people believe now, that’s more likely when they’re going to try to distort things to get a better viewpoint. So think about what their incentives are so that when are they going to really care what people believe? Now if they just went public, if they’re going to go public or if they’re going to issue shares because they want to get a good price for those shares, if managers have a lot of stock options that are coming due that they’re going to want to liquidate, that’s more likely when they’re going to have an incentive to try and want to look good management that’s under fire and they get fired, that’s when they’re going to try to want to change perceptions and look good.

(01:34:14):

So those are the cases when you would think, okay, that’s when firms are going to do bad stuff.

Speaker 4 (01:34:22):

But is there something they might say I guess or something they might like a measure might we did good? Because look at this figure. Is there something they might use that is like when you mentioned the law professor who used the ROA and you’re like that’s a bad

Paul Fischer/Wharton School of Business (01:34:36):

Statistic. So if they focus on one metric and other metrics that are sort of picking up a similar construct are vastly different, that would be a red flag because generally we think these metrics should be moving together. And if they’re not, that’s a red flag. So you could look then that’s the operating cash flows versus earnings. Another one is you guys are familiar with transparency, right? So you’re 19 years old, you go home, you go out at night and you come back at some ungodly hour in the morning and you get up the next day and your mom asks you, so what’d you do last night? What’d you say? Nothing. Nothing.

(01:35:22):

What is your mom now that I’m old enough, what did your mom actually think? The boys were doing some bad stuff last night. Same for companies. There was no rule that says they can’t disclose stuff. So if they don’t disclose stuff when they could and people are asking for it, that’s usually not a good sign. And so that would be another case if they get asked a question and there’s a clear place and they can provide data or an answer and they evade providing that answer, what should you assume the answer is bad. Is there ever a reason

Speaker 3 (01:36:00):

They might a legitimate

Paul Fischer/Wharton School of Business (01:36:02):

Why they will disclose it

Speaker 4 (01:36:04):

Or a legitimate reason I guess to delay reporting something like for example, I had a company I was writing about a few weeks ago that’s restructuring and they had a really large operating loss last year and they had put out a press release I think in June saying we cannot report our first quarter results yet because we’re still trying to figure out what our debt means or trying to work with our debtors. We just can’t do it yet.

Paul Fischer/Wharton School of Business (01:36:33):

What do you think? Bad news?

Speaker 4 (01:36:35):

I thought it was probably bad, but I was like,

Paul Fischer/Wharton School of Business (01:36:37):

They just do that. It’s news. Yeah, it’s kind of bad news.

(01:36:40):

So when companies don’t file on if it’s a public company, if they’re not filing by their filing when they’re supposed to, that’s generally perceived as a bad news. And actually companies are really persnickety if they are always accustomed to releasing their earnings on the third Friday after the quarter end or whatever, if you’re working on the audit of that company, you’re going to get done by the third Friday. They know if they miss, people will panic and say it’s bad news. Particularly like financial institutions are terrified of this. They generally always report on the same day every year.

Speaker 4 (01:37:15):

I swear. Last question, is there anyone that’s going to, I feel like I could look this up, but is there anyone that’s going to come for them, like a public company if they keep delaying, is there some sort of,

Paul Fischer/Wharton School of Business (01:37:25):

They have to file in so many days within 45 days of quarter end now? I think in 90 days, no, it’s shrunk even. It’s gotten tighter. So they have to file within their actual financial statements at the SEC within pretty short time after quarters and a pretty short time now after annual. So they have to file and if they don’t file then the SE C’s going to say, okay, what’s going on?

Kevin Johnson/NPF (01:37:51):

I hate to be the grim reaper here, but I think we’re done. I think we’re going to have to close it down. The final question though is one that I get where can they pick up their Wharton degrees now that for Amir

Paul Fischer/Wharton School of Business (01:38:07):

X thousand dollars and two years of your life, you can get one.

Kevin Johnson/NPF (01:38:12):

Please join me in thanking him.

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