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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 Johnson & Johnson (NYSE:JNJ) 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 the financial condition of Johnson & Johnson. The information that I am using for this article comes from J&J's website here. Note that this article is not a comprehensive review as to whether Johnson & Johnson 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

Johnson & Johnson is a company whose products and services are familiar to just about everyone. The company's operations are split into three segments. Their Consumer division offers baby care, wound care, oral care, and skin care products, along with over-the-counter medications. Notable brands include Johnson's, Aveeno, Band-Aid, Listerine, and Tylenol. This segment accounts for 21% of the company's sales. The Pharmaceuticals segment produces prescription drugs for a wide variety of purposes, such as treating infections, gastrointestinal problems, dermatological issues, and contraception. This segment currently accounts for 38% of J&J's sales. Their Medical Devices and Diagnostics division produces everything from blood glucose monitoring and insulin delivery products to orthopedic joint reconstruction to disposable contact lenses. This segment contributed 41% of the company's sales in 2012.

Johnson & Johnson has a market capitalization of $211B and has recorded over $67B in sales over the last 12 months. 56% of the company's sales came from outside the United States.

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 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.

As of Dec. 31, 2012, Johnson & Johnson had $21.1B 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 $211B. This means that the company is trading for just ten times its cash position, which may be very attractive for value-oriented investors. Over the last 12 months, J&J paid out $6.61B in dividends, which are well-supported by the company's free cash flow of $12.5B.

While the company does have over $21B in cash and short-term investments, this is significantly less than the $32.2B that it reported one year before. This is due to the company's decision to repurchase $12.9B worth of stock in order to finance its acquisition of orthopedic device manufacturer, Synthes, in June 2012.

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.

Johnson & Johnson had a total of $11.3B in net receivables on its balance sheet, which represents 16.8% of its 2012 sales of $67.2B. For 2011, 16.3% of its sales were booked as receivables, while that percentage was at 15.9% for 2010.

While 16.8% 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.

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 Johnson & Johnson is 1.90, which is outstanding.

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, Johnson & Johnson has $16.1B worth of property, plant, and equipment on its balance sheet. This figure is higher than the $14.7B that it reported at the end of 2011. In its 10-K filing, the company said that most of that money is in buildings, machinery, and equipment.

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.

Johnson & Johnson has $22.4B worth of goodwill on its most recent balance sheet, which is significantly higher than the $16.1B that the company reported at the end of 2011. Of this $6.3B increase in goodwill, $6.0B comes from the company's purchase of Synthes for $20.2B. The company says that this goodwill is for expected synergies that will result from the merger.

Overall, goodwill accounts for about 18.5% of J&J's total assets of $121B. This is a jump from the 14% of assets that were goodwill at the end of 2011. 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. Since Johnson & Johnson is below that threshold at this time, I don't see much need to panic here, but we need to monitor this in the years and quarters to come.

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 their fair market values. Internally-developed intangible assets do not go on the balance sheet in order to keep companies from artificially inflating their net worth by slapping any old fantasy valuation onto their assets. Many intangible assets like patents have finite lives, over which their values are amortized. This amortization goes as annual subtractions from 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.

Johnson & Johnson currently has $28.8B worth of intangible assets on its balance sheet. This is a huge jump from the $18.1B that it had 12 months prior. This increase is due to the $12.9B of intangible assets that were acquired with the purchase of Synthes. Of the $12.9B involved here, $11.4B represent intangible assets that have finite lives, with a weighted average life of 21 years. $9.9B of these assets come from acquired customer relationships.

Of the total $28.8B of intangibles, half of it comes from customer relationships, while 30% comes from acquired trademarks, and 20% comes from acquired patents. 70% of these assets have finite lives that range from 17 to 24 years.

Over time, most of these assets will come off of the balance sheet, as they are amortized. This may result in a significant decline in the company's asset base and net worth if the assets are not replaced. With intangible assets currently accounting for 24% of Johnson & Johnson's total assets, this is a very real concern. We need to monitor this percentage in the years and quarters to come.

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 Johnson & Johnson, the return on assets would be $14.3B in core earnings over the last 12 months, divided by $121B in total assets. This gives a return on assets for 2012 of 11.8%, which is really good, especially when considering that a huge asset base of $121B serves as a good barrier-to-entry. I also calculated J&J's returns on assets over 2011 and 2010 for comparative purposes. This can be seen in the table below.

Symbol201220112010
JNJ11.8%12.2%12.9%

Table 1: Decent Returns On Assets From Johnson & Johnson

These are good returns on assets that are fairly consistent, although they are creeping in the wrong direction. This is due to the fact that while their earnings are growing, their asset base is growing slightly faster, which isn't necessarily a terrible thing. I see nothing to worry about here.

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, Johnson & Johnson doesn't have much to worry about here, as it reported $4.68B of short-term debt on its most recent balance sheet. And, as I discussed earlier, J&J 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 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, Johnson & Johnson carries $11.5B of long-term debt. This is lower than the $13.0B that it carried one year before. Of the company's long-term debt, a little over half of it is due within the next five years, while some of it isn't due until after 2030. The average interest rate on this debt is 4.1%.

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 Johnson & Johnson over this period is $13.8B. 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 J&J, here is how it looks: $11.5B / $13.8B = 0.83 years

This is fantastic for Johnson & Johnson, in that it can pay off its long-term debt with less than one year's worth of earnings. Due to the earnings power of Johnson & Johnson, I believe that the company's long-term debt is very manageable.

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.

Johnson & Johnson, which we can all agree is a historically-strong company, has a treasury stock figure of $18.5B.

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 Johnson & Johnson stacks up here.

Debt To Equity Ratio = Total Liabilities / Shareholder Equity

For JNJ, it looks like this: $56.5B / $64.8B = 0.87

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 J&J). While the regular debt-to-equity ratio of Johnson & Johnson isn't bad, the negative impact of treasury stock on the equity positions of some companies may make them appear to be mediocre or financially-distressed when they're really not.

Here, I add the treasury stock back into 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 J&J, it looks like this: $56.5B / $83.3B = 0.68

From looking at both regular and adjusted debt-to-equity ratios, it looks like Johnson & Johnson is in pretty decent shape in regard to its debt. In the two tables that follow, you can see how these ratios have changed over the last couple of years.

Symbol201220112010
JNJ0.870.990.82

Table 2: Debt To Equity Ratio At Johnson & Johnson

Symbol201220112010
JNJ0.680.720.60

Table 3: Adjusted Debt To Equity Ratio At Johnson & Johnson

From these two tables, you can see that the debt-to-equity ratios are fairly consistent and indicate that J&J is not in any state of major financial distress.

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 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.

The return on equity for Johnson & Johnson is equal to $14.3B in net income, divided by shareholder equity of $64.8B, which is equal to 22.1%.

To strip out the equity-reducing effect of treasury stock that I discussed earlier, here is how you can calculate what I call the adjusted return on equity.

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

So, the adjusted return on equity for J&J is as follows:

$14.3B / $83.3B = 17.2%

To illustrate how the returns on equity of Johnson & Johnson have changed over the last couple of years, I have created one table for the return on equity, and another for the adjusted return on equity.

Symbol201220112010
JNJ22.1%24.3%23.5%

Table 4: Returns On Equity At Johnson & Johnson

Symbol201220112010
JNJ17.2%17.6%17.2%

Table 5: Adjusted Returns On Equity At Johnson & Johnson

Whether you calculate the return on equity like most people, or strip out the treasury stock, you can see that J&J has very strong and consistent returns on equity. I see nothing to worry about in this department.

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.

Johnson & Johnson has a very impressive figure of $86.0B. In the table below, you can see how this figure has grown over the last three years. Over this time frame, retained earnings grew by more than 22%, which is very impressive for a mature dividend-paying company like Johnson & Johnson.

Symbol2012201120102009
JNJ$86.0B$81.3B$77.8B$70.3B

Table 6: Retained Earnings At Johnson & Johnson

Conclusion

After reviewing the most recent balance sheet, it can be concluded that there is much to like about the financial condition of Johnson & Johnson. It has a sizeable 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. An excellent current ratio shows that the company can meet its short-term financial obligations, even in the event of an unlikely disruption of its operations. J&J's short and long-term debt positions are easily managed by its cash position and earnings power. The company has shown very good returns on assets and returns on equity, along with good growth in retained earnings over the last three years.

The two concerns that I have here are the amounts of goodwill and intangible assets that are currently on the balance sheet. Goodwill, as a percentage of the company's total assets, has jumped over the past year, due mostly to its acquisition of Synthes. If Synthes or other acquisitions that Johnson & Johnson has made in previous years don't work out the way that they should, then we may see write-downs that could hurt the company's balance sheet and stock price. The same can be said for the intangible assets that the company acquired, which account for almost a quarter of the company's total assets.

While this is not a comprehensive review as to whether Johnson & Johnson should be bought or sold, I think that its overall financial condition is pretty good.

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 Good Is Johnson & Johnson's Financial Condition?