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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 Target (NYSE:TGT) 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 Target. The information that I am using for this article comes from Target's most recent financial reports, which can be found here. Note that this article is not a comprehensive review as to whether Target 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

Target is a retailer that sells a wide variety of items that include health and beauty items, personal care items, furniture, electronics, and groceries. As of Aug. 3, 2013, the company had 1,788 stores throughout the U.S. and Canada.

The company does business in two segments: U.S. Retail and Canadian. Their U.S. Retail segment includes all U.S. merchandising operations, in which they provide everyday essentials and differentiated merchandise at discount prices. People can buy their products at their stores, online, and on mobile devices. They used to offer credit to qualified customers through branded proprietary credit cards, but they sold their credit card receivables portfolio to TD Bank in the first quarter of fiscal 2013. However, Target continues to service these accounts and carry out the primary marketing functions in order to earn a portion of the profits that are generated by the portfolio.

The company's Canadian segment as of now includes costs that are incurred due to their 2013 market entry into Canada.

Of their 2012 sales, 25% came from household essentials, such as pharmacy items, beauty, personal care, baby care, and cleaning products. 20% of Target's revenues in 2012 came from groceries and pet supplies. 19% came from apparel and accessories, such as apparel for men, women, children, and infants, along with jewelry and shoes. 18% came from the sale of electronics, music, books, software, sporting goods, and toys. The remaining 18% of company sales in 2012 came from the sale of furniture, lighting, kitchenware, small appliances, bed and bath items, and home improvement items.

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.

Target is one such company. As of Aug. 3, 2013, Target had just $1.02B in cash and short-term investments that can easily be converted into cash. However, the company generated $3.37B in free cash flow over the last 12 months, allowing them to pay $933M in dividends and buy back $1.67B worth of stock.

Target has paid dividends every quarter since the company went public in 1967. The company has increased its dividend in 46 consecutive years. The company also takes its buybacks seriously, as they repurchased $1.9B worth of stock in both fiscal years 2012 and 2011. They also bought back $2.51B worth of stock in fiscal 2010.

Inventory

With retail companies like Target, 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 Aug. 3, 2013, Target had $8.44B worth of inventory, which amounts to 11.5% of the company's sales over the last 12 months. At the end of fiscal 2012, this level was at 10.8% of sales, while at the end of fiscal 2011, it was at 11.3% of sales. This shows that the company's inventory levels are steady relative to the revenues. I don't see anything here that would indicate boom and bust cycles or the possibility of a large number of their products going obsolete. So, I see nothing to worry about here at this time.

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 Target is 0.90, which is less than ideal, but still not terrible.

Quick Ratio

Most of the time when it comes to short-term liquidity, I 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 almost three-quarters of Target'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 Target is 0.23. This is much less than ideal. As it stands right now, the company's current assets are already less than its current liabilities. Any markdowns in the company's inventory would make the situation even worse.

However, the amount of emphasis that you put behind this figure when doing your independent research on Target depends on how you feel about the likelihood of the company's operations coming to a grinding halt. With operations in nearly 1,800 stores across the U.S. and Canada, I find it hard to imagine the company's operations coming to a complete stop, requiring Target to suddenly expend all of its current assets in order to meet its short-term obligations. Now, if the company in question had its operations concentrated in just one or two places, or focused on selling just one or two products, then I might be more concerned. So, while the quick ratio of Target is much less than ideal, I don't see a need to push the panic button at this time.

Property, Plant, and Equipment

For retail companies like Target to operate, a certain amount of capital expenditure is required. Land has to be bought, stores 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, Target has $31.4B worth of property, plant, and equipment on its balance sheet. This figure is slightly above the $30.7B that it reported at the end of fiscal 2012, and the $29.1B that the company reported at the end of fiscal 2011. This increase is due largely to the company opening up new stores, as it attempts to grow. Since the end of fiscal 2011, 25 new stores have opened, and 320 have been remodeled. In its 10-K filing, the company said that 65% of their PP&E assets are in buildings, 14% is in land, and 12% are in fixtures and equipment.

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 Target, the return on assets would be $3.13B in core earnings over the last 12 months, divided by $44.2B in total assets. This gives a return on assets for the last 12 months of 7.08%, which is decent. I also calculated Target's returns on assets over fiscal 2012, fiscal 2011, and fiscal 2010 for comparative purposes. This can be seen in the table below.

Symbolttm201220112010
TGT7.08%6.56%6.48%6.45%

Table 1: Consistent Returns On Assets At Target

These are good returns on assets that are very consistent. We don't see a lot of growth here, as the company's core earnings and asset base have grown at about the same rate.

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.

Target, right now, carries $1.83B in short-term debt, much of which represents the current portion of its long-term debt. I don't see this as a problem when I compare the short-term debt to its $3.37B in trailing twelve-month free cash flow. However, they might want to scale back their share repurchases some, or refinance some of the debt at lower rates if they can.

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, Target carries $12.7B of long-term debt. This is lower than the $14.7B that it carried six months prior, as well as the $13.7B that they carried at the end of fiscal 2011. This shows that the company is paying down its long-term debt, which is good. The average interest rate on its long-term debt is 4.7%, with rates ranging from as low as 3.6% to as high as 6.8%. Of this debt, approximately 40% is due within the next five 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 Target over this period is $3B. 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 Target, here is how it looks: $12.7B / $3.00B = 4.23 years

This shows that Target's long-term debt is currently equal to just over four years of the company's core earnings. Due to the earnings power of Target, I believe that the company's long-term debt should be manageable. It's just the fact that so much of it matures in the next five years that worries me.

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 Target stacks up here.

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

For Target, it looks like this: $28.1B / $16.0B = 1.76

In the table below, you can see how this ratio has changed over the last few years.

SymbolQ2 2013201220112010
TGT1.791.901.951.82

Table 2: Debt-To-Equity Ratio At Target

In Table 2, we see that Target's debt-to-equity ratio has been pretty steady since at least the end of fiscal 2010. However, this ratio is higher than what we, as investors would like to see. Much of the reason for this is the company's nearly $13B of long-term debt, which they seem to be addressing.

Another reason why the company's debt-to-equity ratio is higher than ideal is their almost $11B in accounts payable and accrued current liabilities, such as wages, taxes, dividends payable, and gift card liabilities. While many people will not include these figures in their debt-to-equity calculations due to the fact that they don't represent actual borrowings, I include them due to the fact that they still represent money for which the company is on the hook.

We'll need to monitor the debt-to-equity ratio of Target as the years and quarters progress. Hopefully, they can reduce it as time goes on.

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 Target over the last 12 months is equal to $3.13B in net income, divided by shareholder equity of $16.0B, which is equal to 19.6%.

To illustrate how the returns on equity of Target have changed over the last few years, I have created the table below for the return on equity.

Symbolttm201220112010
TGT19.6%19.0%19.1%18.2%

Table 3: Returns On Equity At Target

The returns on equity at Target have been very consistent, between fiscal 2010 and Q2 2013, as the company's earnings growth slightly outpaced the growth in the company's equity position. These returns are good, and they show that management is making efficient use of its equity.

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.

At the end of fiscal 2012, Target showed a retained earnings figure of $13.2B. In the table below, you can see how this figure has grown over the last three years. Over this time period, we see that retained earnings grew by a cumulative amount of just over 2%. This anemic growth in retained earnings is due in large part to the company spending anywhere from 75% to 100% of its core earnings on buybacks and dividends in each of the last three full fiscal years. This is great for shareholders who like to receive steadily growing dividends, and see their shares represent an increasingly larger stake in the company. However, this practice doesn't leave much for Target to plow back into its operations for more growth.

Symbol

2012

2011

2010

2009

TGT

$13.2B

$13.0B

$12.7B

$12.9B

Table 4: Retained Earnings At Target

Conclusion

After reviewing the most recent balance sheet, there are a couple of things to like about Target's financial condition. One is the fact that inventory levels have been at a very consistent percentage of sales over the last couple of years, reducing the likelihood of any boom and bust cycles that might otherwise trip them up going forward. Also, the company has shown decent returns on assets and equity over the last few years, that have been highlighted by earnings growth and increases in the company's asset base as it continues to grow.

Things that concern me include the higher than ideal debt-to-equity ratio, which is due to the company's nearly $13B worth of long-term debt, much of which is financed at relatively high interest rates, and the company's large amount of operating expenses. We'll see how the company addresses this matter going forward. While the company's long-term debt appears to be manageable, I am concerned about the fact that almost half of the debt comes due within the next five years. They should be able to pay it off, but it will take some discipline. Depending on where interest rates will be later on, refinancing some of the debt may or may not be an option.

Also of concern is the company's nearly non-existent growth in retained earnings, which translates into less money that the company can reinvest into its operations for future growth. Given the company's prolific history of buybacks and dividends, management may be creating this condition by design, as they might prefer to reward shareholders, as opposed to striving for more growth.

While this is not a comprehensive review as to whether Target should be bought or sold, I think that its overall financial condition is fair. Investors should not let the company's debt-to-equity ratio alone deter them from buying the company's shares or doing further due diligence.

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: Retail Rundown: Does Target's Balance Sheet Hit The Bulls Eye?