Financials Demystified: Current Liabilities & What They Tell You About Cash Flow

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2:58There isn't a lot of alignment from company to company to company. And so unfortunately, sometimes when you're looking at different businesses, you think, oh, this is going to be easy. You know, the things I know should all be here. Sometimes they are, sometimes they aren't. I love this podcast because it crushes your dreams of getting rich quick. They actually got me into reading stats for anything. You're tuned in to the Investing for Beginners podcast. Led by Andrew Sather and Dave Ahern. Step-by-step premium investing guidance for beginners. Your path to financial freedom starts now. Starts now.

3:37All right, folks. Welcome to Investing for Beginners podcast. Today, we're going to do another Financials Demystified, and we're going to continue our analysis and discussion of balance sheets. So today, we're going to talk about current liabilities. In the past, we've talked about current assets and total assets. We're going to continue moving down the balance sheet, and we're going to talk about current liabilities. So with that, let's go ahead and dive in. So I guess we'll start with the easy one. Andrew, what are current liabilities? Yeah, current liabilities, just like current assets, it's going to be those liabilities that apply in the next 12 months.

4:19Anything longer than that, it becomes a long-term liability, same as the long-term assets on the balance sheet. So most balance sheets are organized in those four sections, which make it easy to memorize, give us that little backbone, that structure. so current assets at the top, long-term assets below, and then you have another section, current liabilities on the top of that section, and long-term liabilities on the bottom. So that would be the four big pieces to the balance sheet. And the current liabilities can tell us a lot. What kinds of things do they tell you? uh they can tell you uh they can tell you a lot of things for example uh they can tell you kind of how they're financing their business so things like uh accounts payable which is money that they owe to vendors if that can tell you how they are financing buying their inventory for example, or how they're buying maybe products that they use to make their products.

5:30So for example, if you're buying copper wiring for a company that makes wires for electrical companies, then that's an expense that the company has. And typically they will buy it from their vendor and they'll have some sort of terms depending on how that is organized 15 30 45 60 days 90 days however that's organized which means that they have that amount of time to pay the vendor back and depending on how they do that can impact their cash flow of their business because the longer they can negotiate terms the more they can try to generate revenue on the thing that they bought and maybe air quote double dip and pay more, generate more revenue before they have to pay their vendors back.

6:20That's one of the things that Amazon does with their vendors. So things like that are things that I can look for with current liabilities. And so it can tell you a lot how the company is managed and how it manages its cash flow. Yeah, time is money, right? So anytime companies can make a little extra change, They're going to find a way to do it. And to your point about accounts payable, that can be a way to leverage your working capital to free up some free cash flow. A company like Paychex or ADP comes to mind because if you look at their balance sheet, they have cash that they hold for their clients when clients do payroll and then they hold some funds.

7:08We'll see what happens with all the fintech that's going on, if that's still going to be a thing for them. But up to now, it has been. And companies do do that just in general. They manage their working capital, which is current assets and current liabilities. And they do that to free up cash flow, which allows them to invest and generate more revenue and grow and all those things. Yeah, exactly. So maybe we could talk about a few of the, air quote, more common line items that people might see. As you mentioned off-air, every company, it can be a little bit different. So some companies will not have all the same exact structure or format.

7:49So maybe we could talk about a few of the, I guess, the general ones. So we mentioned accounts payable. What would be a couple other ones that we could throw out there? Well, let's do a boring real-life business like a Campbell's company. We all, I think, know about Campbell's Soup. Did you get your soup in today? I did not today, but I've had plenty of Campbell's soup in my lifetime. That's for sure. Well, it's not Sunday football, so we're excused for not having our Campbell's. Right. A mature company like a Campbell's will have something like short-term borrowings, short-term debt, which is that debt that is coming due.

8:32And that's something I think to keep an eye on. And I started with something super, super boring. I know it's not as fun as talking about soup, but short-term borrowings and dividends payable. Those are two bigger line items here for Campbell's Soup on their balance sheet. And those are things, you know, the blocking and tackling that businesses do, the types of things that they need to do as public companies. And if you see short-term borrowings ballooning, that could be a potential red flag to look at. A huge dividends payable, that usually shows up in other metrics, but can also show up on the balance sheet.

9:14All things you can monitor just from a glance because the numbers will tell you, all right, borrowings are big, dividends are small. Okay, then now I can start to dive deeper. But those are the things for Campbell's Soup. Of course, they have accounts payable, like you mentioned, and then accrued income taxes, which is another blocking and tackling. And then they also have accrued liabilities, but I like to talk about other companies when I mention that line on them. All right. Well, maybe we could segue to one that has some of those. Yeah. Let's do accrued liabilities. I pulled up Adobe just because it was easy because they have an A, Go Team A.

9:58They're at the top. and then they break out their accrued expenses as things like, and there's a whole table in the footnotes, so if you want to dive in, it's fascinating reading, but things like accrued compensation, accrued corporate marketing, sales and use taxes, a lot of the things, I don't know, this bucket, I guess, if we were to talk about levels of significance would be less in my mind versus something like an accounts payable. Because a lot of times as investors who want to dive into the accounting, a lot of investors look at how is a company managing its working capital and things like that.

10:41I don't hear a lot of measuring what's the accrued compensation costs and what's the metric behind that. So there's not a lot of that, but I think it's still helpful to understand what these numbers mean because you just never know where a big red flag will pop up. It could pop up anywhere. So it's helpful to know what you're looking at even if what you're looking at, you don't necessarily care too much. You're just kind of trusting that the company is going to manage what it's supposed to do, but it helps to know when something looks out of the line. accrued expenses and other current liabilities for Adobe being some of those things that are, I guess, just part of running the business, doing the blocking and tackling.

11:34I noticed in Adobe's balance sheet that deferred revenue is by far the largest line item for their current liability. So what is deferred revenue and how does that apply to a company like Adobe? Deferred revenue is huge. And it's one of those current assets that's not a real... I'm sorry, one of those current liabilities that's not a real liability. What I mean by that is if a company has short-term debt, that's going to be cash coming out of their account. Deferred revenue is not like that. And so if you understand how Adobe's business works, let's just take their creative cloud, which is easier to understand and it makes up a big part of their business.

12:20If I'm a small business owner and I'm subscribed to Adobe's creative cloud, I am paying them 50, 60 bucks a month, whatever the number is. And I'm getting access to 10, 20 different softwares, whatever it is, again, depending on when and where we're talking about. Let's say I want to save some money and I subscribe to their annual option. So we all know how subscriptions work. Customers are sick of them. But you subscribe to the annual option, you save some money, you're giving that company money up front. And so you're giving them, let's say it's$300. You're giving a company$300, but they still have to, they can't book the entire$300 as revenue right away.

13:09they're booking the part that they can book and then the rest of the money is going to be booked as revenue as it comes along. So let's say I did it in November. I subscribed in November and I gave them an annual fee for November. So they could record revenue for November, December and then January, February, March, April they're not going to record revenue until those quarters happen. And so that deferred revenue, so they mark all the cash they took in for me as either revenue or deferred revenue. And then that deferred revenue converts to revenue once that period that I paid for passes. That's kind of my layman's understanding of deferred revenue.

13:58The way I, and I think that's perfect. I think the way I try to look at it is this is money that they will earn in the future. if they execute on what they promise to do. And so even though, like you said, even though it's listed under a liability, I understand why it's listed as a liability because they have to do their work to earn the revenue. But you could also say that this is money that Adobe is going to earn if they do what they say they're going to do. So it's actually to benefit of the business, even though they haven't, you know, they've received the money. They just haven't, you know, done, they haven't provided the service that they promised yet.

14:42And when they do, then that's, you know, that's, that's good stuff for the company. Yeah. I found a weird tidbit. Are you curious? I am curious. So Netflix, obviously big subscription business. In their latest 10Q, they said their deferred revenue, is membership fees that are billed that are expected to be recognized as revenue within the next month. So they're not... They're deferred revenue. Because I was shocked. I was like, why is their deferred revenue so low? They're saying it's only expected to be revenue in the next month. I thought that was different. That is different. That's very different.

15:29Okay. Yeah, the fun part about accounting is that there can be lots of interpretations and there isn't always a lot of, what's the word I'm looking for? There isn't a lot of alignment from company to company to company. And so unfortunately, sometimes when you're looking at different businesses, you think, oh, this is going to be easy. The things I know should all be here. Sometimes they are, Sometimes they aren't. Sometimes they may allude to it in the balance sheet, but you have to look at the footnotes to get deeper detail to understand exactly what that number is. It just may say other current liabilities, but you don't know what those are.

16:15And it may be a big number. If you look at it as a percentage of the current liabilities, sometimes it could be 30%, 40%, 50 % of the current liabilities. Well, it kind of behooves you to understand what's hidden in that generic line item. We're looking at Adobe right now and operating lease liabilities as peanuts compared to the rest of what the company does. And so it's important to know, but it's not critical to know. So yeah, that's my thought. I guess a couple other ones that I'm curious about. Income tax is payable. What does that indicate? Is it exactly what it sounds like? Yeah, pretty much.

17:05Okay. All right. And then I mentioned operating lease liabilities. What does that entail? People miss meetings and emails and lunches, which reminds me, I've got to call him back. But my task routing agent never does. With Notion's new AI-powered custom agents, my task routing agent automatically imports meeting notes, emails, and other chats that I want and clearly lists out tasks assigned by team member and forwards them a list. No more missed lunches, I mean meetings, anymore. Notion is an AI-powered connected workspace for teams. Notion brings all your notes, docs, and projects into one space that just works.

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19:18Go to quince.com slash beginners for free shipping and 365-day returns. Quince.com slash beginners. I just made a new stock the third largest position in my portfolio. And I actually just finished the deep dive report on it called the Newtonian Compounder, How 60 % Returns Power an Unstoppable Machine. It's available for our Value Spotlight members. If you want to see the thesis, we're doing a 60 % discount for now, but I'm pulling the deal once the stock hits$45. Check it out at einvestingforbeginners.com. Yeah, I pulled up GameStop just because I reported this week, and their operating lease liabilities was$94 million.

20:04So not huge. It was like 10 % of their current liabilities. But basically, if you have a store like GameStop has their different kiosks in the malls and things like that, they're going to have to pay. Either you own the property or you lease it. if you're leasing it, you are going to pay that over time, but the current portion is the portion you're paying this year. Okay. All right. That makes sense. That makes sense. So if you look at GameStop's other current liabilities, you said that was about 10%. Do they have other ones that are a bigger percentage of the current liabilities? Yeah, so accounts payable is a big one.

20:56And so I think this would be a good time to talk about how you would measure accounts payable. Is it the cash conversion cycle? I'm blanking on the formula. We could probably pull it up, but you compare the two. You're going to do that right now, yeah. I'm sure one of us have written on it. but you compare the two and when you see the trend the number going in the direction you don't want to go that can sometimes be an indicator of like a forward-looking indicator of a company that is slowing down the classic example was under armor in the book called financial shenanigans which if you love nerding out into this accounting stuff is a wonderful, wonderful book that dives into day sales outstanding, day sales and inventory.

21:54A lot of these deep, deep accounting topics that we've been mentioning, they use Under Armour as an example of when the Under Armour was not selling through its inventory. That was a forward indicator that the sales were slowing down. and so the demand was not meeting what management had thought. And then they showed how the stock price took a hit later on as that started to materialize. You can do a similar thing for accounts payable versus accounts receivable, and that can tell you when a company

22:41doesn't have the negotiation power. I don't know how to explain how to say it properly, but the power dynamics between companies, suppliers, and their customers, that relationship can be seen in the relationship between accounts payable and accounts receivable. I know there's a much better business-y way of phrasing all of that, but that's just kind of the way I think about it is game theory, negotiation, who has the upper hand, that kind of thing. Yeah, for sure. So days payable outstanding, the formula is accounts payable divided by cost of goods sold. And then you multiply that by the number of days, which is 365.

23:30And so what that tells us is kind of what I was alluding to earlier, where it basically tells you on average how long it takes a company to pay its suppliers and its vendors. So to give an example, let's say that GameStop has a days payable outstanding of 45 days. It means that GameStop is taking on average around 45 days to pay their suppliers. and like we were talking about earlier the longer the higher the dpo or the higher the days payable outstanding the longer a company is holding on to its cash and because it can and that's a good thing for the company because it helps improve cash flow and it gives them more working capital to use in the business to do other things sometimes there's a fine line though like anything Too much of a good thing can be a bad thing.

24:28So if it's really high or if it's trending higher, that could indicate that the company is struggling with cash or maybe they're pushing their suppliers too hard because maybe their business is struggling. And so they're pushing back on their suppliers to get longer term so they can improve their cash flow. So it's something to kind of keep in mind. This is all part of the cash conversion cycle. And so it's something to... Basically what that means is it shows how the company is managing its cash flow between its accounts receivable, the money it collects, and the inventory that it buys and the suppliers that they pay.

25:13And so it's kind of all connected with that. I know that fiscal.ai, that's one of the metrics that they track. and so it is something you can see. I created an infographic many years ago that we can put in the show notes, Stephen, to, I can give that to you, that we can, that people, you can look at and easily see how this all kind of works and whatnot. Two famous companies, we talked about them in the past when we talked about balance sheets are Walmart and Amazon and Costco all have, this is something that you would want to track if you're investing in those businesses because it will have an impact on the cash flow for a company like Costco.

25:58How quickly do they pay their vendors? How quickly do they turn their inventory? How quickly do they receive accounts receivable from people that owe them money? Kind of thing. So it is important to track. Yeah, perfect. Another one, I'll throw a log on there. This is from a blog post you did, which we can also put in the show notes, but you can also just search on our blog accounts receivable versus accounts payable and the working capital cycle. Pick your favorite words in that phrase. But the other formula is working capital cycle equals inventory days plus receivable days minus payable days.

26:43And so putting that full circle, pun intended, you get the working capital cycle. And you did a good example here where you used Intel. So they had 91 for inventory, 33 for receivable, and 51 for payable. So when you add the two and then subtract the payable, it's 73 days. That means Intel is only out-of-pocket cash for 73 days before receiving full payment for its chips. And that's a really cool way to understand, to put this formula with all these random metrics and to say it very succinctly and clearly, how long is the company out of pocket for the cash before they receive full payment for their chips?

27:31This is older data, and I'm going to put that on my list to update for our blog since I've been doing that with a lot of our posts lately. but I thought these numbers were kind of fascinating. Intuit, Spotify, and Salesforce, and Netflix all have negative days working capital cycles, which basically means they're getting paid before they're having to do these services. Salesforce had the biggest minus 160 days, so they're getting a lot of cash up front. Walmart was 0.8 days and Cisco was 15 days. So just to kind of give you an idea of where some of these companies lie. And it's not to say that a company is good or bad based on how many days their working capital cycle is.

28:25But you can do things like compare inside of an industry. Is one company really managing their working capital way better than another company? And does that signal that they are a stronger business or that their goods and services are more valuable than competitors, things like that? And you can also track these things over time, like I said, as forward indicators. So all, I think, good, valid information to understand. Yeah, for sure. If I was looking at particular industries, this is something that would be included on my air quote checklist to look at and see how the company is doing in these particular metrics over a longer period of time.

29:14And then absolutely comparing it to competitors in their industry to see how your company is doing compared to its brethren. And hopefully the better it's doing, the better it can be. This also can be an indicator of how well management has a pulse on its business. And so as one of the air quotes, soft, squishy skills of trying to analyze management, you can look at something like the cash conversion cycle or the working capital cycle. and that can give you some insights into how well the company is, you know, management is managing the business, the cashflow of the business. Because the better they manage that, obviously the better they're going to do because they have more money available to them to do the things that they want to do.