Wednesday, June 10, 1998
Pfizer's Balance Sheet
by Phil Weiss
Towaco, NJ (June 10, 1998) -- In last night's report we went through the items on Pfizer's income statement. Tonight we're going to review the information reported on Pfizer's balance sheet. Too many investors and analysts focus their analysis on just a company's income statement. Wall Street goes nuts over quarterly earnings-per-share announcements. "Did the company beat the estimates?! Did it post more than six cents for the quarter?"
Granted there's a lot of important information reported on the income statement. Measuring customer demand and short-term performance is what the income statement is all about. But the Cash-King approach to investing also requires a thorough understanding of the balance sheet. In some ways we feel that the information reported on the balance sheet is doubly more important than what we find on the income statement. Yep, as long-term investors, we believe that the balance sheet is 2x more important than the income statement.
The balance sheet can be broken down into three sections. The first is labeled Assets and essentially represents what the company owns as well as what is owed to the company. The next is called Liabilities and, as a general rule, represents a company's payment obligations. The third is called Shareholders' Equity, which shows a combination of the money invested by shareholders in the company's stock and the total earnings retained by the company.
Tonight, I'd just like to cover the asset side of the balance sheet; tomorrow night, I'll tackle liabilities and shareholders' equity. Continuing from last night, I'm going to use Pfizer (NYSE: PFE) as my model. Its balance sheet is available from the company's website -- click here: Pfizer's 1997 Balance Sheet. If you have a copy of Pfizer's annual report on hand, the balance sheet appears on page 42. I recommend that you have the balance sheet open in front of you for this report (otherwise, it's going to get real boring!).
On to the assets...
On the balance sheet, assets are listed in order of how readily convertible they are into cash. That's why the first item you see in the asset section of every balance sheet is Cash and Cash Equivalents. Note 1B tells us that Pfizer's cash equivalents are items almost as liquid as cash (CDs, time deposits, etc.).
The next line is Short-term Investments. According to Note 1B, Pfizer's short-term investments are essentially cash equivalents that are part of a larger investment pool. These are just as liquid, just packaged in with other investments.
So right up top here, we see that Pfizer has about $1.6 billion in cash sitting in short-term investment vehicles. All told, the cash is earning fairly low rates of return for Pfizer, but is readily available for research, product development, or acquisitions.
One slot down we come across Accounts Receivable. Accounts receivable represents amounts owed to the company by its customers. The figure is listed net of the allowance for doubtful accounts. In other words, the company reduces the total amount of incoming payments by a percentage to represent the natural delinquencies. The allowance for unpaid bills is created based generally upon Pfizer's prior experience in collecting its receivables.
As Cash-Kingers we don't really like to see our companies with lots of outstanding receivables. Yeah, they're listed as assets, but they're really a liability of sorts. All they represent are as-of-yet-uncollected sales. And we think there's a good argument to be made that no company should be allowed to announce sales until they've collected them. In that light, receivables start looking like the liability we think they are.
Before moving on to the next line item, I wanted to share a few ways to measure the accounts receivable of a company. One of the first things that I like to look at is Days of Sales Outstanding. This is a pretty simple calculation -- just divide the company's total sales by its total accounts receivable. Then divide 365 (days) by the result. Here's how to calculate it with Pfizer:
DSO = 365 / (Sales / Receivables) DSO = 365 / ($12.5 billion / $2.5 billion) DSO = 365 / 5 Days of Sales Outstanding = 73What does this mean? Well, it means that, on average, it takes Pfizer 73 days to collect each dollar of sales. From the moment it delivers product to the distributor, it takes them 73 days to collect payment for their effort. How do we feel about that? We believe that 73 days is on the high side, both inside the industry and out. For more details on this, check the following article -- 4/7/98: Pfizer's Receivables Problem.
Another item worth checking out is the relationship between the growth in total sales and the growth in receivables. If receivables are outgrowing sales, this may foreshadow danger. The company may be recording sales too aggressively, and it may be failing to disclose that its customer base isn't of high enough quality (it's having trouble collecting the payments).
Finally, you might also want to check the trend of a company's allowance for doubtful accounts relative to its receivables. In Pfizer's case, the allowance is consistently between 2% and 3% of receivables. To calculate this, simply divide the doubtful account listing by the total accounts receivable.
Thus, when looking at receivables, we have three measurements: counting days of sales outstanding, relating the growth of sales to receivables, and watching the levels of allowances for doubtful accounts. Following receivables may seem like a petty way to spend your days -- but we believe that receivable levels play an extremely important role in company progress and thus in stock valuation. It's best to keep an eye on receivables even while Wall Street is shouting out earnings estimates.
The next asset of interest to us is Inventory. Pfizer breaks its inventory down into three components: Raw Materials, Work in Process, and Finished Goods. Note 1C tells us a little bit about how this inventory is valued. You'll generally find that companies in the same industry value their inventory in the same way.
Since inventory is in the numerator of the Flow Ratio, at a minimum, we want to see if the company is selling its products quickly after finishing them. Ideally, of course, the companies that you invest in will take raw materials to finished goods to sold products in an instant. Turning product into cash is what the financial side of a business is all about. The faster, the better.
In the weeks ahead, we'll walk you through measurements of what is called Inventory Turnover. You'll come to find that companies like Dell (Nasdaq: DELL) do an extraordinary job of turning their inventory, while others do a poor job of it. Again, as with accounts receivable, even though inventory is listed as an asset, we consider it a liability. We prefer to see our companies selling into such great demand with such efficiency that they are turning products into collected cash quickly.
The next line of the income statement contains even more "stuff" that we consider to actually be a liability. Prepaid Expenses represent expenditures for benefits that are expected to be received in the future. Put another way, the company is paying for a product or service it hasn't yet received. We don't like that. Now, since companies feel the same way, trying to conserve their cash, rarely is there cause for concern about levels of prepaid expenses.
Okay, Fool, take a breather. We've covered cash, short-term investments, receivables, inventory, and prepaid expenses. That's pretty much the run of current assets -- those assets that the company expects to convert into cash in the next year. And those are the assets that are of most importance to us. But there's another half of the asset listings, non-current assets, which we'll cover in the next few paragraphs. But how about a stretch, or check your email, or grab a cookie.
Okay... non-current assets are not of great importance to Cash-King investors, so I'm just very briefly going to run through definitions of them. Pfizer has broken its non-current assets down into four types: 1) Long-term Loans and Investments; 2) Property, Plant and Equipment (PP&E); 3) Goodwill; and 4) Other Assets.
First, our company has made $1.3 billion in long-term loans or investments in developers, distributors, and researchers. The second, PP&E, is broken out in Pfizer's Note 6 and Note 1D. They provide us with some additional information about what types of assets are included in PP&E. PP&E is written off over the life of the related assets and deducted from income in the form of depreciation expense.
Note 1D also gives us a little more information about goodwill and other intangible assets. Goodwill is created when a business is acquired for more than the fair market value of its underlying assets. Like PP&E, goodwill is written off against income over the life of the underlying assets. Other intangible assets that may be amortized over time include such items as acquired patents and copyrights. A quick glance at Note 16 tells us what acquisitions Pfizer has made over the last three years. It is likely that each of these transactions created goodwill.
That concludes our discussion of the asset section of the balance sheet. Tomorrow night I'll finish my discussion of Pfizer's balance sheet by covering liabilities and shareholders' equity. I hope you got a good grasp of current assets from this report. Those are of extreme import to us as C-K investors.
Before I send you off on your way through Fooldom, I wanted to let you know that we'll now be narrowing the list of nominees for our 8th C-K purchase right in the Cash-King Company folder listed below. To view the 23 companies that were nominated, click here to take a look at an excellent post offered up by DowDanny last night. Thanks, Fool! (The List of Cash-King Nominees).
Have a great evening.
Stock Change Bid ---------------- AXP + 5/16 107.69 CHV - 9/16 79.44 KO - 9/16 81.06 GPS +2 1/16 62.50 EK -1 3/8 70.25 XON -1 1/8 68.81 GM - 1/2 72.69 INTC -1 5/8 68.56 MSFT -1 1/16 86.00 PFE -3 1/2 109.00 TROW - 13/16 34.88
Day Month Year History C-K -0.84% 2.16% 8.05% 8.05% S&P: -0.55% 1.97% 11.08% 11.08% NASDAQ: -1.53% -0.32% 7.28% 7.28% Cash-King Stocks Rec'd # Security In At Now Change 2/3/98 22 Pfizer 82.30 109.00 32.44% 5/1/98 37 Gap Inc. 51.09 62.50 22.33% 2/27/98 27 Coca-Cola 69.11 81.06 17.30% 2/3/98 24 Microsoft 78.27 86.00 9.88% 2/6/98 56 T. Rowe Pr 33.67 34.88 3.57% 5/26/98 18 American E 104.07 107.69 3.48% 2/13/98 22 Intel 84.67 68.56 -19.03% Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Eastman Ko 63.15 70.25 11.25% 3/12/98 20 Exxon 64.34 68.81 6.96% 3/12/98 17 General Mo 72.41 72.69 0.39% 3/12/98 15 Chevron 83.34 79.44 -4.69% Cash-King Stocks Rec'd # Security In At Value Change 2/3/98 22 Pfizer 1810.58 2398.00 $587.42 5/1/98 37 Gap Inc. 1890.33 2312.50 $422.17 2/27/98 27 Coca-Cola 1865.89 2188.69 $322.80 2/3/98 24 Microsoft 1878.45 2064.00 $185.55 2/6/98 56 T. Rowe Pr 1885.70 1953.00 $67.30 5/26/98 18 American E 1873.20 1938.38 $65.18 2/13/98 22 Intel 1862.83 1508.38 -$354.46 Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Eastman Ko 1262.95 1405.00 $142.05 3/12/98 20 Exxon 1286.70 1376.25 $89.55 3/12/98 17 General Mo 1230.89 1235.69 $4.80 3/12/98 15 Chevron 1250.14 1191.56 -$58.58 CASH $2037.63 TOTAL $21609.07 *The year for the S&P and Nasdaq will be as of 02/03/98