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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 Whole Foods Market (NASDAQ:WFM) 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 Whole Foods. The information that I am using for this article comes from the company's most recent annual report, which can be found here. Note that this article is not a comprehensive review as to whether Whole Foods 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

Whole Foods Market is the largest retailer of natural and organic foods in the United States, and the 12th largest food retailer overall in the U.S. The company operates 362 stores, with 347 in the U.S. Whole Foods owns 13 of these stores and leases the rest. In the company's most recent 10-K filing, they state that their mission is devoted to promoting organically-grown foods, healthy eating, and the sustainability of our ecosystem.

Whole Foods has been a high-growth company, with compounded annual sales growth of 25% over the last 22 years. The company's strategy is to expand through the opening of new stores. During the 12 months ending on Sept. 29, 2013, they opened 26 new stores and acquired 6 more. Since the end of fiscal 2009, the number of operating stores has increased by 27%.

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 Sept. 29, 2013, Whole Foods Market had $1.02B in cash and short-term investments that can easily be converted into cash.

During fiscal year 2013, Whole Foods paid out $508M in quarterly and special dividends. Of this dividend payout, approximately $370M was the result of a special dividend that the company paid in December 2012, in an attempt to keep investors from having to pay a higher tax rate on their dividends due to the fiscal cliff debacle. The company just recently announced a 20% increase to its regular dividend.

When it comes to share repurchases, the company repurchased a net $44M worth of stock during fiscal 2013. They recently announced an authorization for $500M worth of more stock buybacks through fiscal 2015, in addition to their current $300M authorization that is good through fiscal 2014. During the last 12 months, the company generated $472M in free cash flow.

Inventory

With retail companies like Whole Foods Market, 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.

At the end of fiscal 2013, Whole Foods had $414M worth of inventory, which amounts to 3.21% of the company's sales for that year. At the end of fiscal 2012, this level was at 3.20% of sales, while at the end of fiscal 2011, it was at 3.34% 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 Whole Foods Market is 1.82, which is very good.

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 significant amount 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.

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 Whole Foods Market is 1.44, which is outstanding.

Property, Plant, and Equipment

For retail companies like Whole Foods Market 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, Whole Foods has $2.43B worth of property, plant, and equipment on its balance sheet. This figure is slightly above the $2.19B that it reported at the end of fiscal 2012, and the $2.00B 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. In its 10-K filing, the company said that 54% of these assets are in buildings and leasehold improvement, while 38% are in fixtures and equipment.

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.

Whole Foods Market has $679M worth of goodwill on its most recent balance sheet, which is inline with the $663M worth of goodwill that it reported in each of the last two years before.

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 goodwill accounts for only 12.3% of the assets of Whole Foods, I don't see much 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.

For Whole Foods Market, the return on assets would be $551M in core earnings over the last 12 months, divided by $5.54B in total assets. This gives a return on assets for fiscal 2013 of 9.95%, which is decent. I also calculated the company's returns on assets over fiscal 2012, fiscal 2011, and fiscal 2010 for comparative purposes. This can be seen in the table below.

Symbol2013201220112010
WFM9.95%8.81%8.00%6.02%

Table 1: Growing Returns On Assets At Whole Foods Market

These are very good returns on assets that have been growing. Over the last three years, the asset base of Whole Foods grew from $3.99B to $5.54B, while its core earnings grew from $240M to $551M, showing that the company's earnings are outpacing its asset base, which is what we want to see.

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.

The balance sheet of Whole Foods Market shows that the company is currently carrying just $1M of short-term debt in the form of installments of capital lease obligations. This is all but negligible, when compared to the company's earnings and free cash flow generation.

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, Whole Foods carries just $26M of long-term debt that can be seen on the balance sheet. This debt is related to long-term capital lease obligations. This figure is dwarfed by the company's average earnings of $453M over the last three fiscal years.

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 Whole Foods Market stacks up here.

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

For Whole Foods, it looks like this: $1.66B / $3.88B = 0.43

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

Symbol2013201220112010
WFM0.430.390.430.68

Table 2: Debt-To-Equity Ratio At Whole Foods

In Table 2, we see that the debt-to-equity ratio at Whole Foods is very good, and has come down from where it was in 2010. This was because in 2011, the company repaid a $490M outstanding balance on a loan to acquire Wild Oats Markets in 2007.

In the company's recent 10-K filing, management said that they expect to fund its continued expansion and capital expenditures with operating cash flows, existing cash, and its short-term investments, rather than by debt.

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 Whole Foods is equal to $551M in net income, divided by shareholder equity of $3.88B, which is equal to 14.2%.

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

Symbol2013201220112010
WFM14.2%12.3%11.5%10.1%

Table 3: Returns On Equity At Whole Foods

Here, we see that returns on equity have been on the rise at Whole Foods, as the company's earnings growth has outpaced the growth in the company's equity position. Overall, 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.

On its most recent balance sheet, Whole Foods Market shows a retained earnings figure of $1.27B. 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 more than doubled, leaving Whole Foods with money left over to reinvest into their business.

Symbol

2013

2012

2011

2010

WFM

$1.27B

$1.23B

$870M

$599M

Table 4: Retained Earnings At Whole Foods Market

Off Balance Sheet Arrangements

Not included in this analysis are obligations that are associated with operating leases that the company holds. The liabilities that are associated with these leases do not show up on the balance sheet, as the lessee (Whole Foods) does not assume the risk of ownership of the properties in question, like it would in a capital lease. Because of this, operating lease obligations (rents) are regarded as operating expenses that deduct from earnings, but do not represent actual debt. For this reason, I did not include it in the above analysis, but added it here, so that readers can be aware and use the information how they wish.

Whole Foods currently has $7.44B of these operating lease obligations, with $359M due within the next 12 months, $2.07B due in the next 5 years, and the remaining $5.37B due beyond 5 years. So far, the company has been able to post consistent gross margins of 35% with these expenses included. If the company can maintain this level of profitability, then they should be able to manage fine in the face of these expenses.

Conclusion

After reviewing the most recent balance sheet, there are several things to like about the financial condition of Whole Foods Market. The company has excellent current and quick ratios, which shows that the company should still be able to meet its short-term financial obligations in the event of an unexpected disruption to its operations. The company has shown very good 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. The company currently has very little debt on its balance sheet, and has exhibited very good retained earnings growth over the last several years. This gives the company more money to reinvest for future growth.

While this is not a comprehensive review as to whether Whole Foods Market should be bought or sold here, I think that its overall financial condition is very good at this point in time.

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!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: How Fresh Is The Balance Sheet At Whole Foods?