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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 Amazon.com AMZN, 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 Amazon.com's financial condition. The information that I am using for this article comes from the company's website here. Note that this article is not a comprehensive review as to whether Amazon.com 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. More information on how I analyze financial statements can be found at my website here.

Background

Amazon.com sells millions of unique items on their retail websites. These items include everything from books to electronic items to fishing tackle. Most of these items have been purchased by the company for resale. In doing this, one of their aims is to provide the lowest possible prices to consumers. Customer orders are fulfilled either in U.S. or international fulfillment centers that are operated either by the company or third parties. The company also produces and sells electronic Kindle devices that allow the user to read books without physically owning the books.

Amazon.com enables sellers to sell items on the company's websites, as well as on the sellers' own branded websites. By doing this, the company earns either fixed fees, revenue-sharing fees, or per-unit activity fees.

They own Kindle Direct Publishing, which allows independent authors and publishers to make their books available in the Kindle Store, where content creators can get royalties of up to 70%. Amazon.com also offers other programs that help musicians, filmmakers, and app developers to publish and sell content.

The company also operates Amazon Web Services, which provides access to technology infrastructure for enterprises.

In 2012, Amazon.com generated 57% of its sales in North America, with the remaining 43% from elsewhere.

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 June 30, 2013, Amazon.com had $7.46B in cash and cash equivalents, which can be easily converted into cash. Over the last 12 months, Amazon did not pay out any dividends or buy back any shares, although they do have $763M remaining under a $2B buyback program that was established in 2010. Over the past 12 months, the company generated $260M in free cash flow.

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.

Amazon.com had a total of $2.86B in net receivables on its most recent balance sheet, which represents 4.28% of its trailing 12-month sales of $66.9B. For fiscal 2012, 5.50% of its sales were booked as receivables, while that percentage was at 5.34% for fiscal 2011.

This shows that only a small percentage of the company's sales are booked as receivables. Given that this percentage is small and fairly consistent, I don't see any reason why investors should be worried about this.

Inventory

With retail companies like Amazon.com, 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.

As of June 30, 2013, Amazon.com had $5.42B worth of inventory, which amounts to 8.1% of the company's sales over the last 12 months. At the end of fiscal 2012, this level was at 9.9% of sales, while at the end of fiscal 2011, it was at 10.4% of sales. It should be noted that inventory levels at Amazon have grown over the last few years. However, sales have grown at an even faster rate, which explains the falling percentages mentioned above. This is good for Amazon.com.

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 Amazon.com is 1.11, which is decent.

Quick Ratio

Most of the time when it comes to short-term liquidity, I usually end the discussion at the current ratio. However, with companies that have a large chunk of their current assets in inventories, one has to wonder whether all of that inventory can quickly be converted into cash in the event that the company suddenly needs it. Some of the inventory might be obsolete, or have to be disposed of for less than it was originally valued at. Given that inventories currently constitute about one-third of Amazon's current assets, this is a very real concern here.

To address this issue, I calculate what I call the quick ratio. The quick ratio is calculated simply by subtracting the inventory from the total current assets and then dividing the remainder by the current liabilities. I usually like to see a quick ratio of at least 1.0. That way, even if the company's inventory is worthless, they will still have enough other current assets on hand to meet their short-term financial obligations in the event of an unlikely disruption to their operations.

The quick ratio of Amazon.com is 0.74. This is less than ideal. As it stands right now, the company could stand up to a 28% markdown in the value of its inventory from current levels before their current assets would fall below their current liabilities. Over the last couple of years, Amazon's quick ratio has steadily declined from 1.0 back in 2010 to where it is now. As a result, investors may want to pay attention to this issue going forward.

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 their 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, Amazon.com has $8.79B worth of property, plant, and equipment on its balance sheet. This figure is above the $7.06B that the company reported at the end of fiscal 2012, and significantly more than the $4.42B that it reported at the end of fiscal 2011. The increase that was seen during 2012 was due in part to the company acquiring its corporate headquarters, which consisted of land and 11 buildings.

Of the company's current property, plant, and equipment assets, 65% is in equipment and internal-use software, while 31% is in land and buildings.

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.

Amazon.com has $2.61B worth of goodwill on its most recent balance sheet, which is inline with the $2.55B worth of goodwill that it reported 6 months prior. It is higher than the $1.96B that was reported at the end of fiscal 2011. The increase that was seen during fiscal 2012 was due to the company's acquisition of Kiva Systems in an effort to improve fulfillment center productivity.

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. For Amazon.com, goodwill accounts for less than 9% of its total assets. Since Amazon is well below the 20% threshold, I don't see anything to be concerned about here.

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).

Unfortunately for Amazon, no meaningful figure for return on assets can be calculated for the trailing twelve-month period and fiscal 2012, due to the fact that the company lost money over both of these periods. However, the company did report positive earnings over 2011 and 2010. The trend in return on assets can be seen in the table below.

Symbol

ttm

2012

2011

2010

AMZN

-0.3%

-0.1%

2.49%

6.12%

Table 1: Returns On Assets At Amazon.com

From Table 1, it can be seen that returns on assets for Amazon have been in steady decline, due to shrinking profits. During this time, the company's asset base increased from $18.8B to $29.6B. Reasons offered by the company for the decline in earnings over the last couple of years in its 10-K for 2012 include increased cost of sales due to increased sales volumes, increased fulfillment costs, increases in marketing spending (sponsored search ads and more television advertising), and increased payroll costs in connection with more aggressive marketing and building out Amazon's technology infrastructure.

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.

Amazon.com has $691M worth of short-term debt, which constitutes the current portion of its long-term debt. Given the company's cash position of almost $7.5B, and the ability to refinance some of this debt at very low interest rates, this short-term debt appears to be very manageable for Amazon.

Long-Term Debt

Long-term debt is debt that is due more than a year from now. 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, Amazon carries $3.04B of long-term debt. This figure is inline with the $3.08B that was reported just 6 months prior, and significantly higher than the $255M that was reported at the end of fiscal 2011. The increase is due to the company issuing $3B in unsecured senior notes with maturities ranging from 2015 to 2022 during 2012. Effective interest rates on these notes range from 0.84% to 2.66%, which isn't bad at all. According to the company, this debt was issued in order to support general corporate purposes.

Once again, given the company's cash position of nearly $7.5B, they should be able to pay this debt off if they need to. Otherwise, they can use their earnings power in order to pay it off, but as we have already seen, the company needs to get back on track in order to be able to do that.

Debt-To-Equity Ratio

The debt-to-equity ratio, as normally calculated, 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 Amazon stacks up here.

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

For Amazon.com, the debt-to-equity ratio is calculated by dividing its total liabilities of $20.9B by its shareholder equity of $8.73B. This yields a debt-to-equity ratio of 2.39.

This is not good. However, we should consider the fact that of their nearly $21B worth of total liabilities, $9B is in accounts payable, and $5.75B is in accrued expenses and other. The accrued expenses are associated with both unredeemed gift cards where the liability goes away when the cards are redeemed or expire, and unearned revenue, where payments are received in advance for the company's services.

Many people will not include accounts payable and the accrued expenses in their calculations of the debt-to-equity ratio, choosing instead to factor in just what the company has borrowed through formal arrangements. Calculating the debt-to-equity ratio this way would yield a much different result. However, I like to factor all of the liabilities in, because they all represent money for which the company is on the hook.

The table below shows how the debt-to-equity ratio has changed over the last few years.

SYMBOL

Q2 2013

2012

2011

2010

AMZN

2.39

2.98

2.26

1.74

Table 2: Debt-To-Equity Ratio Of Amazon.com

Here, we see that the debt-to-equity position of Amazon deteriorated between 2010 and 2012, but has since started to move in the other direction. Hopefully, we will continue to see the debt-to-equity ratio come down, but for now, it is still a lot higher than where we want it to be.

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.

As was the case with the return on assets, a meaningful return on equity figure cannot be calculated for Amazon.com for the trailing twelve-month period and fiscal 2012 due to the company not reporting a profit for these periods. However, the company did report profits for 2010 and 2011, so we will show the return on equity figures in the table below.

Symbol

ttm

2012

2011

2010

AMZN

-1.17%

-0.47%

8.13%

16.8%

Table 3: Returns On Equity At Amazon.com

Table 3 shows the same trend as the returns on assets shown in Table 1. The return on equity has steadily declined over the last few years.

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 Amazon.com at the ends of each of the last four fiscal years.

Symbol

2012

2011

2010

2009

AMZN

$1.92B

$1.96B

$1.32B

$172M

Table 4: Retained Earnings At Amazon.com

From Table 4, we can see that Amazon.com had a huge leap in retained earnings during the year 2010. This is due to earning $1.15B during 2010, while buying back no stock. Marginal profits in 2011 brought it up slightly for that year, while losses in 2012 brought the figure back down.

Conclusion

After reviewing the financial condition of Amazon.com, there are some positives that can be taken away. For starters, net receivables account for less than 5% of the company's sales. If the company ends up getting stiffed on some of these accounts, then it won't cripple them, as those accounts represent such a small part of their business. Goodwill only accounts for about 9% of the company's total assets. Due to this, any writedowns in this area resulting from failed acquisitions won't hurt them as badly. It is also good that the company has kept its borrowings under control. Right now, their cash position is big enough to cover their notes.

However, there are a number of negatives. First off, a declining quick ratio raises concerns over whether the company can meet all of its short-term financial obligations in the event that their operations encounter an unexpected disruption. However, even bigger than that is the fact that the company has reported losses over the last eighteen months, leading to negative returns on assets and equity. As mentioned earlier, the company blames these losses on increased costs of everything from items purchased for resale to advertising to labor. These increased costs are most likely to blame for the company's high debt-to-equity ratio, where accounts payable serve as the biggest component of liabilities. The losses also explain the slowdown in retained earnings growth, which translates into less money that the company can plow back into its business without having to borrow. If what management is saying is correct, then in order for Amazon.com to improve their financial condition, they must get their costs under control, and find more ways to keep more of their revenues, which have been steadily growing year after year.

While this is not a comprehensive review as to whether Amazon.com should be bought or sold, I am very concerned about the company's current financial condition.

Source: A Check-Up On Amazon's Financial Condition