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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 Hewlett-Packard HPQ, 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 Hewlett-Packard's financial condition. The information that I am using for this article comes from HP's website here. Note that this article is not a comprehensive review as to whether Hewlett-Packard 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

Hewlett-Packard is a leading global provider of products, technologies, software, solutions, and services to consumers, as well as businesses of all sizes. They also serve the government, healthcare, and education sectors. HP's business is divided into seven segments. They are Personal Systems, Printing, Enterprise Group, Enterprise Services, Software, HP Financial Services, and Corporate Investments.

The company's Personal Systems segment accounts for 29% of HP's revenue. This segment offers commercial and personal PCs, workstations, calculators, software, and support for consumers and businesses. The Printing segment is responsible for approximately 20% of the company's revenue and offers printer hardware, inkjet printers, LaserJet printers, supplies, media, printer software, and scanning devices. The Enterprise Group segment accounts for 17% of Hewlett-Packard's revenue and includes servers, storage, networking, and technological services. The Enterprise Services segment contributes 28% of the company's revenue and offers technology consulting, outsourcing, and support across infrastructure, applications, and business process domains. The Software segment accounts for 3% of revenue and includes IT management, information management, and security solutions for businesses of all sizes. HP Financial Services offers leasing, financing, and financial asset management services for large enterprise customers. Corporate Investments include numerous business incubation projects of the company, and accounts for less than 1% of sales.

Hewlett-Packard has a market capitalization of $42.6B and has recorded almost $120B in sales over the last 12 months. 65% of its sales comes from outside of 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 Jan. 31, 2013, Hewlett-Packard had $12.6B 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 $42.6B. This means that the company is trading for less than four times its cash position, which can be very attractive for value-oriented investors. Over the last 12 months, HP repurchased $634M worth of stock, and paid out $1.03B in dividends. These activities are both well-supported by its trailing 12-month free cash flow of $8.48B. The company currently has $8.9B remaining under its current share repurchase program, and recently announced a 10% increase to its dividend.

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.

Hewlett-Packard had a total of $14.2B in net receivables on its balance sheet, which represents 11.9% of its trailing 12-month sales of $119B. For fiscal 2012, which ended on Oct. 31, 2012, 13.7% of its sales were booked as receivables, while that percentage was at 14.3% for fiscal 2011.

Given that this figure is not an outlandish amount, and is trending down, I'm not too concerned about it.

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 Hewlett-Packard is 1.12, which is decent.

Property, Plant, and Equipment

Every company, regardless of the industry in which it operates, 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, Hewlett-Packard has $11.7B worth of property, plant, and equipment on its balance sheet. This figure is slightly below the $12.0B that the company reported 3 months ago, and the $12.3B that they reported at the end of fiscal 2011. Of these assets, 64% is in machinery and equipment, while 34% is in buildings and leasehold improvements.

Given the consistency of HP's position here and the fact that these assets account for just over 10% of its asset total, I don't see anything to be alarmed about here.

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.

Hewlett-Packard has $31.0B worth of goodwill on its most recent balance sheet, which is inline with the $31.1B worth of goodwill that it reported 3 months prior. However, it is significantly lower than the $44.6B of goodwill that the company reported at the end of fiscal 2011, and the $38.5B that was reported at the end of fiscal 2010.

The $6.1B increase that was seen in fiscal 2011 stems from four acquisitions that were made for a total of $11.4B. Of this, $6.9B was allocated toward goodwill. The biggest acquisition here was that of multinational enterprise software company, Autonomy, for $11.0B.

The sharp decrease in goodwill that was seen in fiscal 2012 comes from $13.7B in writedowns. $8.0B was in connection with acquisitions in the company's Enterprise Services division, while $5.7B of goodwill in the Autonomy acquisition was written off. The writedowns in connection with Autonomy were due to what the company claimed as accounting irregularities and "outright misrepresentations" at Autonomy prior to the acquisition.

Overall, goodwill accounts for about 29% of Hewlett-Packard's total assets of $107B. 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 at the beginning of this section. Since Hewlett-Packard is above this threshold, and has already had major writedowns in this area, this is an area of significant concern. If the company has any more writedowns in goodwill, then it can negatively impact the share price going forward, due to the decline in the company's net worth.

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.

Hewlett-Packard currently has $4.18B worth of intangible assets on its balance sheet. This is slightly down from the $4.52B that it had 3 months prior, and well below the $10.9B that the company reported at the end of fiscal 2011, and the $7.85B that was reported at the end of fiscal 2010.

The $3.05B increase that was seen in 2011 is due to the $4.7B worth of intangible assets that the company acquired in its four acquisitions that year, including that of Autonomy. The sharp decline in intangible assets that was seen in fiscal 2012 is due to a $3.1B writedown from Autonomy for the reasons discussed earlier, $1.78B worth of amortization, and a $1.2B impairment with the company's "Compaq" trademark.

HP's intangible assets consist of acquired customer contracts, customer lists, distribution agreements, developed technology, and patents. Most of these assets will be lost to amortization over the next 5 years. While the amortization of $4.18B 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 going forward, as these assets now account for less than 4% 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 Hewlett-Packard, the return on assets would be $7.80B in core earnings over the last 12 months, divided by $107B in total assets. This gives a return on assets for the trailing twelve months of 7.29%, which isn't bad in absolute terms, especially when considering that a huge asset base of $107B serves as a good barrier-to-entry. I also calculated HP'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

HPQ

7.29%

7.34%

8.00%

8.72%

Table 1: Returns On Assets From Hewlett-Packard

On the surface, while these numbers are creeping in the wrong direction, they're not that bad. However, there are two different things going on here that you need to be aware of. First, core earnings for fiscal 2012 declined by $2.4B versus fiscal 2011 due largely to a decline in revenues of about $7B over that time frame. Also, due to the writedowns in goodwill and intangible assets that were discussed earlier, the company's asset totals shrunk from $130B at the end of fiscal 2011 to $109B at the end of fiscal 2012. The reason why you don't see drastic changes in HP's returns on assets is that both the asset base and core earnings are falling at nearly the same rate. Declining earnings and a declining asset base are not what we want to see as investors.

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.

Hewlett-Packard has $6.48B worth of short-term debt, with $5.66B of that total being original long-term debt that is coming due within the fiscal year. This is a sizeable amount of short-term debt, but between the company's free cash flow that is currently north of $8B and the company's ability to refinance at least some of the debt, it shouldn't be an immediate concern.

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, Hewlett-Packard carries $21.8B of long-term debt. This figure is the same as what the company reported 3 months prior, and slightly lower than the $22.6B that they reported at the end of fiscal 2011. Of their $21.8B in long-term debt, $14.7B of it is due within the next 5 years.

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 Hewlett-Packard over this period is $9.77B. 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 Hewlett-Packard, here is how it looks: $21.8B / $9.77B = 2.23 years

This is pretty good for HP, in that the company can pay off its long-term debt with less than three years worth of earnings. If it wanted to, it could also dip into its domestic cash position to pay some of it off.

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 Hewlett-Packard stacks up here.

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

For Hewlett-Packard, it looks like this: $83.7B / $22.9B = 3.66

Right now, HP's debt-to-equity ratio is very high. The table below shows how this figure has changed over the last three years.

Symbol

1/31/2013

2012

2011

2010

HPQ

3.66

3.85

2.35

2.08

Table 2: Debt-To-Equity Ratios Of Hewlett-Packard

From the looks of this table, it can be seen that the debt-to-equity ratio of Hewlett-Packard is much higher than what is normally desirable, and has been trending higher up until now. The large jump that can be seen in fiscal 2012 can be attributed largely to the huge writedowns in goodwill and intangible assets that reduced the company's equity position. However, before any of that happened, the debt-to-equity ratio was still north of 2, which for me, is just too high. It should be mentioned that this ratio includes $7.8B in pension liabilities, $7.6B in deferred revenue, $3.4B in long-term deferred revenue, and $2.9B in long-term deferred tax liabilities, in addition to the company's borrowings.

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, Hewlett-Packard is not one of these companies.

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

$7.80B / $22.9B = 34.1%

This appears to be 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

HPQ

34.1%

35.7%

26.9%

27.0%

Table 3: Returns On Equity At Hewlett-Packard

Do you notice that substantial increase in return on equity between 2011 and 2012? This is not because management made tremendous progress in increasing efficiencies. Rather, this is due to the fact that while core earnings declined by about 23% during that time period, the company's equity position declined by about 42%. When the equity position falls at a faster rate than earnings, the return on equity will rise. However, this is not the kind of return on equity increase that you want to see.

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.

Below, you can see how the retained earnings have fared at Hewlett-Packard.

Symbol

Q1 2013

2012

2011

2010

HPQ

$22.2B

$21.5B

$35.3B

$32.7B

Table 4: Retained Earnings At Hewlett-Packard

From the above table, you can see that while HP has an impressive retained earnings figure that is north of $22B, this figure is in decline when compared to what the company reported in 2010 and 2011. This is due to the $12.7B in reported net losses that Hewlett-Packard incurred in 2012, as a result of the impairments that were recorded in goodwill and intangible assets. If these writedowns do not continue, then we should expect reported earnings to normalize and the retained earnings figure to grow again.

Conclusion

After reviewing the most recent balance sheet, it can be concluded that there are some good things about Hewlett-Packard's financial position, along with some not-so-good things. For starters, the company has a relatively large cash position when compared to its market capitalization. In spite of what the company has been through recently, HP has still managed to generate more than $8B in free cash flow over the last 12 months. The company also has enough current assets on hand in order to meet its short-term obligations in the event that their operations encounter an unlikely disruption.

However, while the company lost a lot of goodwill from its balance sheet over 2012, the remaining goodwill still accounts for almost 30% of the company's total assets. If more of Hewlett-Packard's acquisitions fail to produce the value that management expects, then we may see more writedowns, which may punish the stock price significantly. The company also has a very high debt-to-equity ratio, which raises questions as to whether the company is able to handle both its short-term and long-term financial obligations. While some of this is due to the non-cash writedowns, the debt-to-equity ratio was still above 2 before the writedowns. Also, HP's increases in return on equity are due to an equity position that has declined faster than the company's earnings, which have also declined. These are two things that we as investors do not want to see. The company needs to build its equity position back up by paying down debt, and earnings need to improve.

While this is not a comprehensive review as to whether Hewlett-Packard should be bought or sold, I would be very concerned about HP's financial condition going forward.

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 Healthy Is Hewlett-Packard's Financial Condition?