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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 3M (MMM) 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 3M'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 3M 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

3M is a manufacturing and services company whose operations are divided into five segments. They are Industrial, Safety and Graphics, Electronics and Energy, Health Care, and Consumer.

The company's Consumer segment features products that are used to keep homes and offices clean and organized. The products that are manufactured by this segment include Post-It notes, Scotch tape, Scotch-Brite scouring pads, Filtrete air cleaning filters, O-Cel-O sponges, Nexcare first aid products, and Command adhesives.

The Industrial segment of 3M provides products that serve a broad range of industries from automotive to aerospace to paper and packaging to food and beverage. Such products include tapes, abrasives, adhesives, specialty materials, and filtration systems.

The Safety and Graphics segment makes products that help keep people safe. These products include fire protection items, insulation for apparel, window films, and reflective materials that can be worn at night. This segment of 3M also produces computer privacy filters, touch screen systems, and architectural and display enhancement solutions.

The Electronics and Energy segment involves products and services that are used in high-performance electronic devices and telecommunications networks. Some of the products that this segment makes are used in renewable energy applications.

The Healthcare segment provides items that help healthcare professionals do their job. This segment of 3M is a leader in medical and oral care products, as well as in drug delivery and health information systems.

The operations of 3M are geographically-diversified, as 36% of the company's sales over the last 9 months came from the U.S., while 29% came from the Asia-Pacific region. 23% of the company's sales came from Europe, the Middle East, and Africa. Latin America and Canada combined to account for 12% of the company's sales year to date.

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.

3M is one such company. As of Sept. 30, 2013, 3M had $3.31B in cash and cash equivalents, which can be easily converted into cash. It should be mentioned that of the company's $5B total of cash and investments, all but $300M is being held internationally, with no current plan by management to repatriate it. For this reason, 3M is not able to pay dividends or buy back stock with this money.

However, the company did pay $1.71B in dividends over the last 12 months and bought back $2.64B worth of stock over the same period, due in large part to the $3.94B in free cash flow that the company generated over that time. Management intends to continue using its free cash flow and access to capital markets to pay out dividends and buy back stock, as opposed to repatriating its existing cash position and dealing with U.S. taxes.

3M has increased its dividend in 55 consecutive years, and $4.1B remains available under the company's February 2013 authorization to buy back up to $7.5B in stock.

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.

3M had a total of $4.59B in net receivables on its balance sheet, which represents 15.0% of its trailing 12-month sales of $30.7B. For fiscal 2012, 13.6% of its sales were booked as receivables, while that percentage was at 13.1% for fiscal 2011.

While this figure is high in absolute terms, it has been fairly consistent, and is more than likely reflective of the nature of the company's businesses. I don't see anything to be alarmed about here.

Inventory

With manufacturing and service companies like 3M, 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 Sept. 30, 2013, 3M had $3.95B worth of inventory, which amounts to 12.9% of the company's sales over the last 12 months. At the end of fiscal 2012, this level was at 12.8% of sales, while at the end of fiscal 2011, it was at 11.6% of sales. At the end of fiscal 2010, the company's inventory levels were equal to 11.8% of the company's sales for that year. These figures show 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 3M is 1.79, which is very good. If you strip out the inventory from the company's current assets when doing this calculation, that ratio (also known as the quick ratio) comes in at 1.26. This means that even if the company's inventory was worthless, 3M would still have enough current assets on hand to meet its short-term obligations in the very unlikely event that operations encountered a disruption.

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, 3M has $8.45B worth of property, plant and equipment on its balance sheet. This figure is inline with the $8.38B that the company reported at the end of fiscal 2012, and slightly more than the $7.67B that it reported at the end of fiscal 2011. Of these assets, 63% is tied up in machinery and equipment and 31% is in buildings and leasehold improvements.

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.

3M has $7.34B worth of goodwill on its most recent balance sheet, which is inline with the $7.39B worth of goodwill that it reported 9 months prior. It is also inline with the $7.05B that was reported at the end of fiscal 2011.

Overall, goodwill accounts for about 22% of 3M's total assets. 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. 3M is slightly above this threshold, so while I don't see a need to press the panic button, this is something to keep an eye on.

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.

3M currently has $1.75B worth of intangible assets on its balance sheet. This is inline with the $1.93B that it had 9 months prior, as well as the $1.92B that the company reported at the end of fiscal 2011, and the $1.82B that was reported at the end of fiscal 2010. Of these assets, about 80% are trademarks and customer relationships, while the remaining 20% are in patents. 93% of these intangible assets have finite lives, meaning that they will eventually come off of the balance sheet due to amortization.

While the eventual loss of about $1.6B from the balance sheet is not a good thing, considering that amount accounts for only about 5% of the company's total assets, and the fact that a lot of this amortization will go on for years to come, I don't see anything to be alarmed about here, going forward.

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 3M, the return on assets would be $4.55B in core earnings over the last 12 months, divided by $33.6B in total assets. This gives a return on assets for the trailing twelve months of 13.5%, which is very good. I also calculated 3M'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

MMM

13.5%

13.1%

13.5%

13.8%

Table 1: Strong, Consistent Returns On Assets At 3M

The numbers shown in the above table are very good and consistent returns on assets, and they show that management is doing a good job at making efficient use of what it has as its disposal.

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.

3M has $2.24B worth of short-term debt, most of which is the current portion of its long-term debt. Given the company's free cash flow generation of about $4B in each of the last three fiscal years, and the ability to refinance some of this debt at very low interest rates, this short-term debt is very manageable for 3M.

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, 3M carries $3.53B of long-term debt. This figure is below the $4.92B that was reported just 9 months prior, as well as the $4.48B that was reported at the end of fiscal 2011. Of this debt, 88% is due within the next five years. Maturities on the company's long-term debt range from 2013 to 2044. The weighted average effective interest rate on 3M's long-term debt is 3.16%.

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 3M over this period is $4.30B. 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 3M, here is how it looks: $3.53B / $4.30B = 0.82 years

This is very good for 3M in that the company can pay off its long-term debt with an amount that is less than just one year of profits. If rates stay low, they can even refinance some of the debt. To me, this shows that the company's debt position is very manageable when considering the company's earnings power.

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 often 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. In this case, I will try to calculate the debt-to-equity ratio and the return on equity both ways to help give the reader an idea as to how much effect the treasury stock really has.

3M, which most can agree is a historically-strong company, has a whopping $14.1B in treasury stock.

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 3M stacks up here.

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

For 3M, the debt-to-equity ratio is calculated by dividing its total liabilities of $15.4B by its shareholder equity of $17.8B. This yields a debt-to-equity ratio of 0.87.

This tells us that 3M is in fairly decent shape with regard to its debt and equity positions.

However, when you cancel out the negative effects that the treasury stock has on the equity, it gets even better.

In these instances, I calculate what I like to call the adjusted debt-to-equity ratio. It is calculated as follows.

Adjusted Debt-To-Equity Ratio = Total Liabilities / (Shareholder Equity + Treasury Stock)

Using the data from the most recent balance sheet of 3M, this figure is calculated as: $15.4B / $31.9B = 0.48. The tables below show how both the normal and adjusted debt-to-equity ratios have changed over the last few years.

SYMBOL

Q3 2013

2012

2011

2010

MMM

0.87

0.90

1.03

0.90

Table 2: Debt-To-Equity Ratios Of 3M

SYMBOL

Q3 2013

2012

2011

2010

MMM

0.48

0.53

0.58

0.54

Table 3: Adjusted Debt-To-Equity Ratios Of 3M

From these two tables, we can see that 3M's debt is very manageable when compared to its equity position. Both ratios are well below 1.0 and have been very consistent. This is good to see when assessing a company's financial condition.

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, 3M is not one of these companies.

So, the return on equity for 3M is as follows:

$4.55B / $17.8B = 25.6%

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

MMM

25.6%

25.2%

27.8%

26.6%

Table 4: Returns On Equity At 3M

Table 4 shows that 3M has generated consistently strong returns on equity over the last 3-4 years.

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

When I strip out the negative effects of the treasury stock, here is what I come up with when using the data from the most recent balance sheet.

Adjusted Return On Equity = $4.55B / $31.9B = 14.3%.

This appears to be a pretty solid return on equity as well. In the table below, you can see how the adjusted return on equity has fared over the past three years.

Symbol

ttm

2012

2011

2010

MMM

14.3%

14.8%

15.8%

16.0%

Table 5: Adjusted Returns On Equity At 3M

Table 5 shows that the adjusted returns on equity have been creeping down just a bit as the company's adjusted equity has grown at a faster rate than earnings due in part to the company buying back more and more stock.

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.

3M currently has an impressive retained earnings figure of $32.4B. Below, you can see how the retained earnings have fared at 3M at the end of each of the last four fiscal years.

Symbol

2012

2011

2010

2009

MMM

$30.7B

$28.3B

$26.0B

$23.8B

Table 6: Retained Earnings At 3M

From the above table, you can see that the retained earnings at 3M have been steadily growing since the end of fiscal 2009, at a cumulative rate of 34.5%. This has been happening as the company has been buying back stock and paying dividends. These impressive figures are a testament to the strong earnings power of 3M.

Conclusion

After reviewing the most recent balance sheet, it can be concluded that there are a lot of things to like about the financial condition of 3M. For starters, 3M has very good current and quick ratios, which show that the company has enough current assets on hand in order to meet its short-term financial obligations in the event that its operations encounter an unlikely disruption. 3M has solid and consistent returns on assets and equity. The company's debt is also quite manageable as can be seen by its debt-to-equity ratio and the fact that less than one year's worth of earnings could cover its long-term debt. Retained earnings growth has also been very good, leaving 3M with plenty of money to reinvest back into the company for more growth.

While this is not a comprehensive review as to whether 3M should be bought or sold, I think that the company is in very good financial shape overall, with its manageable debt, economic moats, brand strength and tremendous earnings power. As long as it can keep generating consistent returns on assets and equity and maintaining its relatively low debt levels, I remain optimistic on its prospects.

For more information on how I analyze financial statements, check out my website at this link.

Thanks for reading and I look forward to your comments!

Source: What Does The Balance Sheet Say About The Financial Condition Of 3M?