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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 sheet of Cisco Systems CSCO, in order to get some clues as to how well this company is doing.

I will go through the balance sheet, reviewing the most important items, in order to assess Cisco's financial condition. The information that I am using for this article comes from Cisco's website here. Note that this article is not a comprehensive review as to whether Cisco 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

Cisco Systems is a technology company that designs, manufactures, and markets Internet protocol-based networking and other products that are related to the information technology and communications industry. In addition to selling these products, it also offer services that are related to its products. Its products are used to transport voice, data, and video from one place to another, whether it be within the same building, or on the other side of the world, in order to help people connect and collaborate. Its products are used by businesses, government agencies, personal residences, and telecommunications companies.

Cisco has a market capitalization of $114B and has recorded over $47B in sales over the last 12 months. 59% of its sales over the last 6 months came from the Americas, while 25% of its sales came from Europe, the Middle East, and Africa, and 16% of its sales came from the Asia-Pacific region.

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, pay down debt, and pay out dividends. Some people also value stocks according to its cash positions. Some of the larger and more mature companies tend not to carry a lot of cash on its balance sheets, as it might be more inclined to buy back stock with it, or pay out dividends.

As of Jan. 26, 2013, Cisco had $46.4B in cash and short-term investments, which can be easily converted into cash. This is a lot of cash for a company that has a market cap of $114B. This means that the company is trading for less than three times its cash position, which can be very attractive for value-oriented investors. Over the last 12 months, Cisco Systems repurchased $1.6B worth of stock, and paid out $2.35B in dividends. These activities are both well-supported by its trailing 12-month free cash flow of $10.8B.

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.

Cisco had a total of $8.35B in net receivables on its balance sheet, which represents 17.7% of its trailing 12-month sales of $47.3B. On July 28, 2012, 17.4% of its sales over the trailing 12 months were booked as receivables, while that percentage was at 18.1% for the twelve months ending on July 28, 2011.

While 17.7% might be considered a relatively high percentage for receivables, it appears to be pretty consistent with the company's history over the last couple of years, so I'm not too worried about this.

Inventory

With manufacturing companies like the one we're reviewing today, I like to keep an eye on inventory levels. I usually like to see inventory levels stable or slightly rising from one year to the next. If I see inventory levels rising, then I want to see revenues rising as well, to indicate higher demand for the company's products. I don't like to see rapidly fluctuating inventory levels that are indicative of boom and bust cycles. In some instances, if inventory ramps up without increases in volumes or revenues, then it may indicate that some of the company's products are going obsolete.

Cisco had $1.57B worth of inventory on its most recent balance sheet. This is slightly down from the $1.66B that it reported six months before, and the $1.59B that it reported 12 months before. During this stretch, revenues have risen by 5% over the last 12 months versus the same 12-month period one year before, so I don't see anything that indicates any kind of distress here.

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 its 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 Cisco is 3.37, which is outstanding.

Quick Ratio

With companies that have significant amounts of inventory, I like to consider another ratio that is known as the quick ratio. While inventory is generally regarded as a current asset that can be converted into cash within a year, what if it can't be converted for some reason or another? The quick ratio takes this uncertainty into account. When calculating the quick ratio, just subtract the inventory from the current assets, and then divide the rest by the current liabilities. Ideally, you like to see this ratio at 1.0 or above.

For Cisco Systems, the quick ratio comes out to 3.29, which is also outstanding. With current and quick ratios north of 3, Cisco Systems shouldn't have any problems at all in meeting its short-term financial obligations, even in the event of a disruption to its operations.

Property, Plant, and Equipment

Manufacturing, like any other industry, requires a certain amount of capital expenditure. Land has to be bought, factories have 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 its facilities to keep up with competition may be at a bit of a disadvantage.

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, Cisco has $3.4B worth of property, plant, and equipment on its balance sheet. This figure matches what the company reported 6 months ago, and is fairly consistent with what it reported 12 months ago. The majority of this figure for Cisco comes from land, buildings, and production and engineering equipment.

Given the consistency of its position here, I don't see anything to be concerned about.

Goodwill

Goodwill is 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.

Cisco Systems has $21.4B worth of goodwill on its most recent balance sheet, which is significantly higher than the $17.0B worth of goodwill that it reported 6 months prior. Of this $4.4B increase in goodwill, $3.44B of it came from its acquisition of video software company NDS Group for $5.0B last July.

According to Cisco's most recent 10-Q filing, NDS Group is "a provider of video software and content security solutions that enable service providers and media companies to securely deliver and monetize new video entertainment experiences. The acquisition of NDS is expected to complement and accelerate the delivery of Cisco Videoscape, the Company's comprehensive content delivery platform that enables service providers and media companies to deliver next-generation entertainment experiences." The goal of this acquisition is to expand Cisco's reach into emerging markets like China and India, where NDS already has an established customer presence.

Another $920M worth of goodwill came from seven smaller acquisitions that the company made over the last six months, for a total of $1.2B. In Cisco's 10-Q filing, management said that the $4.4B increase in goodwill versus six months prior is "related to expected synergies." $4.4B seems like a lot of goodwill for a little over $6B worth of acquisitions. Synergies can be rather hard to quantify, especially at the time of acquisition, so I guess that time will have to tell.

Overall, goodwill accounts for 22% of Cisco Systems' total assets of $96.4B. Usually, I don't like to see goodwill account for more than 20% of a company's total assets for the reason that I discussed above. However, I don't yet see the need to panic here. We'll just need to monitor it for now.

Intangible Assets

Intangible assets that are listed on the balance sheet include items such as licensed technology, patents, brand names, copyrights, and trademarks that have been purchased from someone else. They are listed on the balance sheet at its fair market values. Internally-developed intangible assets do not go on the balance sheet in order to keep companies from artificially inflating its net worth by slapping any old fantasy valuation onto its assets. Many intangible assets like patents have finite lives, over which its values are amortized. This amortization goes as annual subtractions to assets on the balance sheet and as charges to the income statement. If the company that you are researching has intangible assets, with finite lives, that represent a very large part of its total asset base, then you need to be aware that with time, those assets are going to go away, resulting in a reduction in net worth, which may result in a reduction in share price, unless those intangible assets are replaced with other assets.

Cisco Systems currently has $3.54B worth of intangible assets on its balance sheet. This is quite a jump from the $1.96B that it had 6 months prior. This increase is mostly due to the $1.75B in intangible assets that it got in its acquisition of NDS Group. Of its $3.54B of intangible assets, virtually all of them have finite lives that will be amortized over time. $2.25B of these assets are from licensed technology and $1.23B are from customer relationships.

This amount of intangible assets here is no cause for concern to me at the moment, as they account for less than 4% of its total assets.

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 Cisco Systems, the return on assets would be $10.4B in core earnings over the last 12 months, divided by $96.4B in total assets. This gives a return on assets for the trailing twelve months of about 10.8%, which isn't bad, especially when considering that a huge asset base of $96.4B serves as a good barrier to entry. I also calculated Cisco's returns on assets over fiscal years 2012, 2011, and 2010 for comparative purposes. This can be seen in the table below.

Symbolttm201220112010
CSCO10.8%10.9%10.3%11.6%

Table 1: Nice Returns On Assets From Cisco Systems

These are pretty good and consistent returns on assets for Cisco.

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, Cisco doesn't have much to worry about here, as it reported just $37M of short-term debt on its most recent balance sheet. And, as I discussed earlier, Cisco has more than enough current assets on hand to meet this, along with other current obligations.

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 its fields usually don't need much debt in order to finance its operations. Its 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, Cisco Systems carries $16.3B of long-term debt.

In determining how many years' worth of earnings it will take to pay off the long-term debt, I use the average of the company's core earnings over the last 3 fiscal years. The average core earnings of Cisco over this period is $9.47B. When you divide the long-term debt by the average earnings of the company, here is what we find.

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

For Cisco, here is how it looks: $16.3B / $9.47B = 1.72 years

This is fantastic for Cisco, in that it can pay off its long-term debt with less than two years worth of earnings. If it wanted to, it could also dip into its cash to pay it off. Before I leave this section, I should mention that more than half of its long-term debt won't be coming due until at least 2019, so I don't see the company getting into a pinch here anytime soon.

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 its operations with its 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 Cisco Systems stacks up here.

Debt-To-Equity Ratio = Total Liabilities / Shareholder Equity

For Cisco, it looks like this: $40.9B / $55.5B = 0.74

Cisco's debt-to-equity ratio also looks pretty decent. To see how this figure has changed over time, I have included it from the ends of the last three fiscal years in the table below.

Symbol1/26/13201220112010
CSCO0.740.790.840.83

Table 2: Debt-To-Equity Ratios Of Cisco Systems

From the looks of this table, the debt-to-equity ratio of Cisco is slowly moving in the right direction, and it has been consistently good. So, from a debt-to-equity standpoint, I don't see anything to be worried about at the moment.

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.

Return On Equity = Net Income / Shareholder Equity

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 it doesn't need to retain its earnings, so it buys 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. However, Cisco is not one of these companies.

So, the return on equity for Cisco is as follows:

$10.4B / $55.5B = 18.7%

This is a pretty solid return on equity. In the table below, you can see how the return on equity has fared over the past three years.

Symbolttm201220112010
CSCO18.7%19.5%19.0%21.0%

Table 3: Returns On Equity At Cisco Systems

It looks like the return on equity at Cisco has been consistently good over the past three years, although it has been creeping lower over the time in question, due to the company's equity growing at a faster rate than its core earnings (which are also rising), which isn't necessarily a bad thing.

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.

Cisco, once again, does really well here. It currently has $14.6B of retained earnings on its balance sheet versus just $5.09B at the same time three years ago. This translates into a cumulative growth rate of 187% over just three years. This is outstanding. In the table below, you can see how the retained earnings have grown over the last three years.

SymbolQ2 2013Q2 2012Q2 2011Q2 2010
CSCO$14.6B$9.49B$6.36B$5.09B

Table 4: Retained Earnings At Cisco Systems

Conclusion

After reviewing the most recent balance sheet, it can be concluded that there is much to like about the financial condition of Cisco Systems. It has a large amount of cash and short-term investments that can be used for acquisitions, debt retirement, dividends, and share repurchases, in addition to a strong level of free cash flow. Excellent current and quick ratios show that the company can meet its short-term financial obligations, even in the event of an unlikely disruption of its operations. Cisco's short and long-term debt positions are easily managed by its large cash position and earnings power. The company has also shown very good returns on assets and returns on equity, along with very good growth in retained earnings that the company can invest for future growth.

The only potential weakness that I see with Cisco's balance sheet is its sizeable amount of goodwill, which accounts for just over 20% of its total assets. While management claims that a lot of the goodwill is related to expected synergies from recent acquisitions, investors should pay attention to see if those synergies materialize.

While this is not a comprehensive review as to whether Cisco should be bought or sold, it can certainly be said that Cisco Systems is in excellent financial condition.

To learn more about how I analyze financial statements, please visit my new website at this link. It's a new site that I created just for fun, as well as for the purpose of helping others make good financial decisions.

Thanks for reading and I look forward to your comments!

Source: How Is The Balance Sheet Looking At Cisco Systems?