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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 Apple (AAPL), 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 Apple's financial condition. The information that I am using for this article comes from Apple's website here.

Note that this article is not a comprehensive review as to whether Apple should be bought or sold, but rather, just an important piece of the puzzle when doing the proper due diligence.

Before I go any further, I should mention that not everyone is going to derive a benefit from this article. Many of you who are already familiar with the workings of Apple might say that this article has about the same effect as saying that Michael Jordan was a good basketball player. That's fine. However, for those who aren't that familiar with Apple and are starting to consider it as an investment given the stock's recent downturn, and new investors who are trying to formulate an approach toward researching stocks in general, this article may help them understand some of the things that they need to look for before making a final decision.

Background

Apple designs, manufactures, and sells mobile communication devices, personal computing products, portable digital music players, and software around the world. Their communication devices include the iPhone, which combines the functionality of a cell phone, an iPod, and an internet connection. They produce and sell desktop computers, like the iMac, and portable computers, like the MacBook Pro. The iPod is a very popular portable music and media player. Their software offerings include the iOS and OS X operating system software.

Apple has a market capitalization of $416B and has recorded over $165B in sales over the last 12 months. 56% of its sales in the last quarter came from the iPhone, while the iPad accounted for 20% of revenues.

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. 29, 2012, Apple had $39.9B in cash and short-term investments, which can be easily converted into cash. This is a substantial amount of cash for a company that has a market cap of $416B. This means that the company is trading for a little over ten times its cash position, which can be very attractive for value-oriented investors.

In fiscal year 2012, Apple paid out $2.5B in dividends, which are well-supported by its 2012 free cash flow of $42.6B. This is the company's first year of paying out dividends since 1995. Going forward, Apple plans on paying a regular quarterly dividend of $2.65 per share. The company has also authorized a share repurchase program, under which the company can buy back up to $10B worth of common stock, starting in 2013.

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.

In its most recent 10-Q filing, Apple reported a total of $11.6B in net trade receivables on its balance sheet, which represents approximately 7% of its trailing 12-month sales of $165B. For fiscal 2012, which ended on Sept. 29, 2012, 7% of its sales were booked as receivables, while that percentage was at 5% for fiscal 2011.

Given that trade receivables are accounting for only 7% of the company's total revenue, and the fact that that figure is fairly consistent with what the company has reported in the past, I see nothing to worry about 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 Apple is 1.54, 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, Apple has $15.4B worth of property, plant, and equipment on its balance sheet. Apple reported in its 10-Q filing that most of this is in machinery, equipment, and internal-use software.

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.

For the reason discussed above, I generally don't like to see goodwill account for more than 20% of a company's total assets. Apple has $1.38B worth of goodwill on its most recent balance sheet. Given that this represents less than 1% of the company's total assets of $196B, I don't see anything to worry about on this end.

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.

Apple currently has $4.46B worth of intangible assets on its balance sheet. Virtually all of these assets have finite lives that range between 3 and 7 years, and consist mostly of patents and licenses. As of the end of fiscal 2012, the remaining weighted-average amortization period for these assets was 5.2 years.

While the amortization of $4.46B worth of intangible assets over the next 5 years isn't a good thing for the balance sheet, I am not too concerned about it, as these assets account for less than 3% of the company's 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 Apple, the return on assets would be $41.7B in core earnings over the last 12 months, divided by $196B in total assets. This gives a return on assets for the trailing twelve months of about 21.3%, which is really strong, especially when considering that a huge asset base of $196B serves as a good barrier-to-entry. I also calculated Apple's returns on assets over fiscal years 2012, 2011, and 2010 for comparative purposes. This can be seen in the table below.

Symbol

ttm

2012

2011

2010

AAPL

21.3%

23.7%

22.3%

18.6%

Table 1: Nice Returns On Assets From Apple

These are really good returns on assets that are fairly consistent, although the trailing 12-month figure is lower than what was reported just 3 months before, at the end of fiscal 2012. This is due to the fact that earnings for the first quarter of fiscal 2013 were flat when compared to the same quarter a year ago due to declining gross margins, and also due to the fact that the asset base expanded by $20B, due largely to increases in cash and long-term investments.

The gross margin for the quarter was about 39% versus 45% in the same quarter a year ago, and according to Apple, this decline is due to the introduction of new versions of existing products with higher costs and flat or reduced pricing. For instance, the iPad mini has a lower gross margin than what has been average for the company. There have also been price reductions on some of their other products. Management expects 2013 gross margins to be lower than in 2012, ranging between 37.5% and 38.5%.

This will have a negative effect on returns on assets and returns on equity going forward, but for the time being, the company is still in pretty good shape. Investors, however, will need to keep an eye on this figure in the years and quarters to come.

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 problem at all for Apple, as the company doesn't have any short-term borrowings.

Long-Term Debt

Long-term debt is debt on borrowed money 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, Apple doesn't carry any long-term borrowings. So, when it comes to long-term debt, Apple has nothing to worry about at the moment.

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 Microsoft stacks up here.

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

For Apple, it looks like this: $68.7B / $127B = 0.54

Apple's debt-to-equity ratio looks pretty decent. Remember that while the company doesn't have any short or long-term borrowings, it still does have liabilities such as accounts payable and deferred taxes that need to be taken into account. When calculated this way, the debt-to-equity ratio does that. 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.

Symbol

12/29/2012

2012

2011

2010

AAPL

0.54

0.49

0.52

0.57

Table 2: Debt-To-Equity Ratios Of Apple

From the looks of this table, the debt-to-equity ratio of Apple 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 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. However, Apple is not one of these companies.

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

$41.7B / $127B = 32.8%

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.

Symbol

ttm

2012

2011

2010

AAPL

32.8%

35.3%

33.8%

29.3%

Table 3: Returns On Equity At Apple

The return on equity has been really strong over the last three years. We see a drop in the trailing 12-month period versus fiscal 2012 due to the gross margin decline in the first quarter of fiscal 2013 mentioned above. The $9B increase in Apple's equity position also contributed to this small decline.

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. In the table below, you can see how retained earnings have fared at Apple. It shows the retained earnings at the end of the first quarter of fiscal 2013, compared with the ends of the three previous fiscal years.

Symbol

Q1 2013

2012

2011

2010

AAPL

$110B

$101B

$62.8B

$37.2B

Table 4: Retained Earnings At Apple

From the end of 2010, retained earnings have grown by 195%, nearly tripling. Needless to say, this is outstanding growth.

Conclusion

After reviewing the most recent balance sheet, it can be concluded that there is much to like about the financial condition of Apple. It has a large amount of cash and short-term investments that can be used for acquisitions, 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. Apple doesn't have any short or long-term borrowings that it needs to service. The company has shown very good returns on assets and returns on equity, along with exceptionally good growth in retained earnings over the last three years that the company can invest for future growth.

The only possible weakness that I see with regard to Apple's financial condition is the risk to the company's returns on assets and equity if gross margins continue to drop. However, I don't think that the company is financially-distressed in any way.

While this is not a comprehensive review as to whether Apple should be bought or sold, it can certainly be said that Apple 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: A Check-Up On Apple's Financial Condition