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Before selecting a stock, there are a number of things that you need to consider in order to ensure that you are buying the stock of a high-quality company whose shares are poised to grow in value over time. Some of these concerns include what the company does, its competitive advantages, valuation, dividend payouts and sustainability, and earnings consistency.

Another important thing that you need to consider is the financial condition of the company in question. You want to know if the company is able to continue paying its bills, and how much debt it carries. The balance sheet is one of the most effective tools that you can use to evaluate a company's financial condition. In this article, I will discuss the balance sheets of McDonald's MCD and Yum Brands YUM, in order to get some clues as to how well these companies are doing.

I will go through the balance sheets of these two companies, reviewing the most important items, and seeing if there are any major differences between the two, making one a better investment than the other. Information that I used on McDonald's can be found here, and information on Yum Brands can be found at this link. Note that this article is not a comprehensive review as to whether either of these two stocks should be bought or sold, but rather, just an important piece of the puzzle when doing the proper due diligence.

This article might be a bit too basic for some and too long-winded for others, but I hope that some of you can derive benefit from it.

Background

As almost everyone knows, McDonald's is the world's largest hamburger chain, with trailing twelve-month sales of over $27B. It has 34,010 restaurants in 119 countries. 81% of these restaurants are owned by franchisees, who end up bearing much of the brunt from high commodity costs and capital investments. This is a big reason why Mickey D's is as profitable as it is.

Yum Brands is the world's largest restaurant chain in terms of the number of restaurants, with 38,000 of them spread out over 120 countries. Its restaurants include KFC, Taco Bell and Pizza Hut. It has a big presence in China, more so than McDonald's, where a big chunk of their operating profits come from. Also, about 75% of their restaurants are owned by franchisees, giving them many of the same advantages that McDonald's enjoys.

Cash and Cash Equivalents

The first line in the Assets column of the balance sheet is for the amount of cash and cash equivalents that the company has in its possession. Generally speaking, the more cash the better, as a company with a lot of cash can invest more in acquisitions, repurchase stock, and pay out dividends. Some people also value stocks according to their cash positions. Some of the larger and more mature companies tend not to carry a lot of cash on their balance sheets, as they might be more inclined to buy back stock with it, or pay out dividends.

McDonald's is one such company. McDonald's as of 9/30/2012 had about $2.2B in cash. While $2.2B is not a lot of money for a company with an approximate market capitalization of $95B, you should keep in mind that this company bought back over $2.6B in stock over its trailing twelve-month period and paid out about the same amount in dividends, which are well-supported by its free cash flows.

Yum Brands had $776M in cash as of the end of 2012. For a company with a $28.7B market cap, $776M isn't a lot of money, but it did buy back $965M worth of stock over 2012, as well as pay out $544M in dividends, which are well-supported by free cash flows.

The table below illustrates this information pretty clearly. From looking at this table, it would have been nicer if both of these companies had paid out more dividends instead of buying back stock, given the purchase prices compared with today's trading prices.

SymbolMarket Cap.Cash PositionDividend Payouts ((TTM))Buyback AmountAverage Buyback Share Price
MCD$94.9B$2.2B$2.6B$2.6B$94.96
YUM$28.7B$776M$544M$965M$66.00

Table 1: Cash Positions and What MCD and YUM Do With Their Cash

Net Receivables

Receivables constitute money that is owed to a company for products or services that have already been provided. Of course, the risk with having a lot of receivables is that some of your customers might end up not paying. For this reason, you usually like to see net receivables making up a relatively small percentage of the company's sales.

McDonald's had a total of $1.28B in net receivables on its balance sheet, which represents less than 5% of its trailing twelve-month sales of $27.4B. Yum Brands had $301M in net receivables, amounting to about 2.2% of its 2012 sales of $13.6B.

I don't see anything at all to worry about in this department for either company.

Current Ratio

Another factor that I like to look at is the current ratio. This helps to provide an idea as to whether or not the company can meet its short-term financial obligations in the event of a disruption of their operations. To calculate this ratio, you need the amount of current assets and the amount of current liabilities. Current assets are the assets of a company that are either cash or assets that can be converted into cash within the fiscal year. In addition to cash and short-term investments, some of these assets include inventory, accounts receivable, and prepaid expenses. Current liabilities are expenses that the company will have to pay within the fiscal year. These might include short-term debt and long-term debt that is maturing within the year, as well as accounts payable (money owed to suppliers and others in the normal course of business). Once you have these two figures, simply divide the amount of current assets by the amount of current liabilities to get your current ratio.

If a company's operations are disrupted due to a labor strike or a natural disaster, then the current assets will need to be used to pay for the current liabilities until the company's operations can get going again. For this reason, you generally like to see a current ratio of at least 1.0, although some like to see it as high as 1.5.

The current ratio of McDonald's is 1.01, while Yum Brands sports a current ratio of 0.87. McDonald's seems to be okay in this regard, while the current ratio of Yum Brands is less than ideal. However, I wouldn't worry too much about Yum Brands in this regard, because what are the odds that the entire operations of YUM come to a grinding halt? It is something to consider, nonetheless, but I would be a lot more concerned if I was dealing with a smaller and younger company with operations that are concentrated in just one or two places, as opposed to all over the world, like these two companies.

Property, Plant, and Equipment

The restaurant industry, like any other, requires a certain amount of capital expenditure. Land has to be bought, the restaurant has to be built, machinery has to be purchased, and so on. However, less may be more when it comes to outlays for property, plant, and equipment, as companies that constantly have to upgrade and change their facilities to keep up with competition may be at a bit of a disadvantage. As of late, McDonald's has been renovating some of its restaurants in order to lure customers away from its competition, particularly in the U.S. However, another way of looking at it is that large amounts of money invested in this area may present a large barrier to entry for competitors. Right now, McDonald's has $23.8B in property, plant, and equipment on its balance sheet, while Yum Brands has $4.25B on its balance sheet in this area. The good thing for both of these companies is that franchisees share a lot in this cost.

Intangible Assets

With both of these companies, the biggest intangible asset is goodwill. Goodwill is simply the price paid for an acquisition that's in excess of the acquired company's book value. The problem with a lot of goodwill on the balance sheet is that if the acquisition doesn't produce the value that was originally expected, then some of that goodwill might come off of the balance sheet, which could, in turn lead to the stock going downhill. Then again, acquisitions have to be judged on a case by case basis, as good companies are rarely purchased at or below book value. McDonald's has almost $2.74B of goodwill on its balance sheet, which is steady versus a year ago, while Yum Brands is carrying about $1.03B. Yum Brands also has about $690M tied up in other intangible assets.

Due to the problems with goodwill that I just spoke about, you generally don't like to see intangibles account for more than 20% of total assets, but in this case, intangible assets only account for about 8% of McDonald's total assets, while they account for about 19% of the assets of Yum Brands. You might want to keep an eye on Yum Brands over the next few quarters and monitor this figure relative to its asset totals.

SymbolTotal Intangible AssetsIntangible Percentage Of Total Assets
MCD$2.74B8%
YUM$1.72B19%

Table 2: Percentage of Total Assets That Are Intangible

Return on Assets

The return on assets is simply a measure of the efficiency in which management is using the company's assets. It tells you how much earnings management is generating for every dollar of assets at its disposal. For the most part, the higher, the better, although lower returns due to large asset totals can serve as effective barriers to entry for would-be competitors. The formula for calculating return on assets looks like this:

Return on Assets = (Net Income) / (Total Assets).

For McDonald's, the return on assets would be $5.61B in net income, divided by $33.8B in total assets. This gives a return on assets for the trailing twelve months of about 16.6%, which is very good. For Yum Brands, the return on assets is $1.54B (ex-items) in net income, divided by $9.01B in total assets, producing a return on assets of 17.1%. Both of these companies are doing great in this area.

SymbolReturn On Assets
MCD16.6%
YUM17.1%

Table 3: Great Returns On Assets From Both Companies

Short-Term Debt Versus Long-Term Debt

In general, you don't want to invest in a company that has a large amount of short-term debt when compared to the company's long-term debt. If the company in question has an exorbitant amount of debt due in the coming year, then there may be questions as to whether the company is prepared to handle it.

However, this is not a concern for either McDonald's or Yum Brands, as McDonald's carries just $512M in short-term debt, while Yum Brands carries just $10M.

Long-Term Debt

Long-term debt is debt that is due more than a year from now. However, an excessive amount of it can be crippling in some cases. For this reason, the less of it, the better. Companies that have sustainable competitive advantages in their fields usually don't need much debt in order to finance their operations. Their earnings are usually enough to take care of that. A company should generally be able to pay off its long-term debt with 3-4 years' worth of earnings.

Right now, McDonald's carries $12.8B of long-term debt, while Yum Brands carries $2.93B.

In determining how many years' worth of earnings it will take to pay off the long-term debt, I use the average of each company's earnings over the last 3 years. The average earnings of McDonald's over this period is $5.0B. The 3-year average for Yum Brands is $1.34B. When you divide the long-term debt by the average earnings of each company, here is what we find.

Years of Earnings to Pay off LT Debt = LT Debt / Average Earnings

For McDonald's, here is how it looks: $12.8B / $5.0B = 2.56 years

For Yum Brands, it looks like this: $2.93B / $1.34B = 2.19 years

This is fantastic for both companies. As long as they can continue to generate these kind of earnings, they should be able to manage their long-term debts without any major problems.

Treasury Stock

In the equity portion of the balance sheet, you will find the treasury stock. This figure represents the shares that the company in question has repurchased over the years, but has yet to cancel, giving the company the opportunity to re-issue them later on if the need arises. Even though treasury stock appears as a negative on the balance sheet, you generally want to see a lot of treasury stock, as strong, fundamentally-sound companies will often use their huge cash flows to buy back their stock. For this reason, I will usually exclude treasury stock from my calculations of return on equity and the debt-to-equity ratio in the case of historically-strong companies, as the negative effect of the treasury stock on the equity will make the company in question appear to be mediocre, or even severely distressed, when doing the debt-to-equity calculation, when in reality, it might be a very strong company.

McDonald's has a very impressive treasury stock figure of $30.3B. While Yum Brands has also been buying back stock, it doesn't show up on its balance sheet as treasury stock. I'm not sure why this is the case, but I believe that it's either because Yum Brands has canceled the stock, or it's illegal to keep treasury stock in the state where the company is headquartered. In the case of Yum Brands, that would be Kentucky, and I have not been able to find anything regarding their laws in this department.

Debt-To-Equity Ratio

The debt-to-equity ratio is simply the total liabilities divided by the amount of shareholder equity.The lower this number, the better. Companies with sustainable competitive advantages can finance most of their operations with their earnings power rather than by debt, giving many of them a lower debt-to-equity ratio. I usually like to see companies with this ratio below 1.0, although some raise the bar (or lower the bar if you're playing limbo) with a maximum of 0.8. Let's see how McDonald's and Yum Brands stack up here.

Debt To Equity Ratio = Total Liabilities / Shareholder Equity

For McDonald's, it looks like this: $19.9B / $13.9B = 1.43

And for Yum Brands: $6.7B / $2.25B = 2.98

A variation of this ratio that I like to use takes into account the presence of treasury stock on the balance sheets of very strong companies (like McDonald's). When there is over $30B of treasury stock on the balance sheet, the regular debt-to-equity ratio makes it look like Mickey D's is a severely distressed company, when we all know that it's not. Here, I add the treasury stock back in to the equity, as treasury stock can be re-issued at a later date if the need arises (although you hope that never happens). I call this ratio the adjusted debt-to-equity ratio. It's calculated like this.

Adjusted Debt To Equity Ratio = Total Liabilities / (Shareholder Equity + Treasury Stock)

For McDonald's, it looks like this: $19.9B / $44.2B = 0.45

For Yum Brands, this value is the same as the regular ratio due to there being no treasury stock on the balance sheet.

For the sake of comparison, I also calculated these ratios as of the end of 2011. Mickey D's had a debt-to-equity ratio of 1.29, while Yum Brands carried a ratio of 3.60. So, the debt-to-equity ratio for McDonald's has creped up a little bit, while Yum Brands has improved nicely. So, while the debt-to equity ratio isn't very good for Yum Brands in absolute terms, it is getting better.

Overall, I give McDonald's the edge in this department. The table below illustrates what I just discussed here.

Symbol2012 Debt/Equity Ratio2011 Debt/Equity Ratio
MCD1.431.29
YUM2.983.60

Table 4: Debt To Equity Ratios Of McDonald's And Yum Brands

Return On Equity

Like the return on assets, the return on equity helps to give you an idea as to how efficient management is with the assets that it has at its disposal. It is calculated by using this formula. Note that this is the adjusted form, which negates the negative impact of treasury stock on the equity.

Return On Equity = Net Income / (Shareholder Equity + Treasury Stock)

Generally speaking, the higher this figure, the better. However, it can be misleading, as management can juice this figure by taking on lots of debt, reducing the equity. This is why the return on equity should be used in conjunction with other metrics when determining whether a stock makes a good investment. Also, it should be mentioned that some companies are so profitable that they don't need to retain their earnings, so they buy back stock, reducing the equity, making the return on equity higher than it really should be. Some of these companies even have negative equity on account of buybacks. Once again, this is why I strip the negative effect of treasury stock from my calculations.

So, the return on equity for McDonald's is as follows:

$5.61B / ($13.9B + $30.3B) = 12.7%

For Yum Brands, it comes out as: $1.54B / ($2.25B) = 68.4%.

If you do the calculation like most and count the treasury stock as a negative to equity, then McDonald's would have an even higher return on equity of 40.3%.

I think that both of these returns on equity are impressive. However, I believe that the exceptionally high figure posted by Yum Brands has a lot to do with its relatively small equity position that comes from its debt. Hopefully, as the debt-to-equity ratio improves, we'll see the return on equity return to more reasonable levels.

Retained Earnings

Retained earnings are earnings that management chooses to reinvest into the company as opposed to paying it out to shareholders through dividends or buybacks. It is simply calculated as:

Retained Earnings = Net Income - Dividend Payments - Stock Buybacks

On the balance sheet, retained earnings is an accumulated number, as it adds up the retained earnings from every year. Growth in this area means that the net worth of the company is growing. You generally want to see a strong growth rate in this area, especially if you're dealing with a growth stock that doesn't pay much in dividends or buybacks. More mature companies, however, tend to have lower growth rates in this area, as they are more likely to pay out higher dividends.

McDonald's has $37.9B of retained earnings on its most recent balance sheet, while Yum Brands has $2.29B. Going back to the end of 2009, McDonald's had retained earnings of $31.3B, and Yum Brands had retained earnings of $996M.

In terms of retained earnings growth, Yum Brands takes the cake, as its cumulative retained earnings growth rate over the past three years was 130%! McDonald's comes in with a cumulative growth rate of what you would expect of a more mature and slower-growing company with 21%.

Conclusion

After reviewing the balance sheets of both McDonald's and Yum Brands, we see that both of these companies have several things in common. Some of these include small cash positions relative to their market capitalizations, generous buyback programs and dividend payouts, as well as good returns on assets and equity.

However, I just cannot put Yum Brands over McDonald's with that debt-to-equity ratio being as high as it is. It's great that this ratio is coming down for YUM, but we will need to see continued improvement in this area. Also, while very good, I do expect to see its retained earnings growth rate come down to more realistic levels as the company matures, and as it pays out more in dividends and buybacks.

With all of that said, I give the edge to McDonald's when it comes to which company is in better financial shape, but I think it'll be a lot closer in a couple of years if the debt-to-equity ratio of YUM continues to improve. I also like that McDonald's is paying out a better dividend yield at the moment.

Thanks for reading and I look forward to your comments!

Source: Which Is In Better Financial Shape? McDonald's Or Yum?