Measurements of Financial StrengthThere are five balance sheet metrics I consider to be key here:
Total Debt/Equity: Total debt divided by total shareholder equity. The lower, the better.
Current Ratio: Current assets divided by current liabilities. It’s a measure of liquidity; and the higher, the better.
Interest Coverage Ratio: How many times over operating income covers interest expense on debt. The higher, the better.
Total Debt/Income: Total debt divided by annual income. A look at how quickly the company could pay down debt if management wanted to. The lower, the better.
Total Goodwill/Equity: Percentage of shareholder equity that consists of goodwill. Goodwill isn’t bad, but it’s an accounting asset rather than a tangible asset.
Many of these metrics vary by industry. A good balance sheet for the fast-paced, non-capital-intensive software industry is different than a good balance sheet for a slow-moving, capital-intensive infrastructure business that generates steady cash flow. So, these metrics are best compared both to their peers, as well as examined in the absolute sense, to determine a good balance sheet.
A balance sheet isn’t everything, since less quantitative aspects like diversification and reliability of revenue are key aspects of stability as well. That’s the sixth metric to look at here.
So, here are the four companies with a perfect AAA credit rating:
Johnson and Johnson (NYSE:JNJ)Johnson and Johnson (NYSE:JNJ), is one of the largest blue-chip companies, has several decades of consistent dividend increases without a miss, and currently yields 3.49%.
As a diversified health care company, Johnson and Johnson’s revenues and profits are spread out rather well. They have a pharmaceutical business, a medical device business, and a consumer beauty and health business. The pharmaceutical business had sales of $24.4 billion in 2011, which makes them the eighth largest pharmaceutical business in the world, and no drug consisted of more than 25% of the total. The medical device business had sales of $25.8 billion, which makes them the number one largest medical device maker in the world. This segment is itself divided up into numerous groups, and none of them produce more than 25% of the total sales of this segment. The consumer health segment had $14.9 billion in sales, which makes it the sixth largest consumer health business. The biggest group in the segment, which is OTC pharmaceuticals, accounted for less than 30% of the sales of this segment, and is itself comprised of numerous products.
So as can be seen, Johnson and Johnson’s sales are highly diversified, with their biggest drugs, biggest medical devices, and biggest consumer products, each only providing a fairly small percentage of the total sales. This diversification is what it allowed it to absorb a major string of recalls over the last few years with no disruption to the dividend and with no major balance sheet or free cash flow shortfall.
Their total debt/equity is a very conservative 35%, and the interest coverage ratio is over 25, which is quite high. Goodwill only makes up a third of the shareholder equity, the debt/income ratio is around 2, and the current ratio is over 2. Overall, by all metrics, Johnson and Johnson has a solid balance sheet. Combined with a diversified revenue stream, the credit rating appears well earned.
Microsoft Corporation (NASDAQ:MSFT)Microsoft is currently rated as having an AAA credit rating as well. The numbers certainly support it, but do the revenue diversification and safety support it as well?
First, it’s worth going over the numbers. Microsoft’s debt/equity ratio is under 20%, and their interest coverage ratio is over 70. Their current ratio is a bit below 3, and goodwill makes up less than 30% of shareholder equity. Total debt/income is considerably below 1. The company has over $50 billion in cash sitting on its balance sheet. By all metrics, the numbers are excellent.
In terms of revenue diversification, Microsoft is reasonably diversified, but not to the extent of Johnson and Johnson. The company brought in $22.1 billion in revenue and $14.1 billion in operating income from the business division, which produces most of their software applications like Office. Their other primary segment is Windows, which brought in $19 billion in revenue and $12.2 billion in operating income. Their third largest segment, Server and Tools, has more promising growth opportunities, but only accounted for $6.6 billion in operating income. The Entertainment division has had very strong performance, but brings in rather small income, and their online businesses of MSN and Bing have negative profits. So it’s mainly about Windows, business software applications like Office and Sharepoint, and Server software. Their revenue is a bit more concentrated than Johnson and Johnson’s, and tech can range more rapidly.
I recently published a rather lengthy analysis of Microsoft. Overall, I’d say Microsoft deserves their perfect credit rating, since they have considerably more cash than debt, and so the risk to bondholders is minimal. But from a common stock standpoint, Microsoft is considerably riskier than Johnson and Johnson, in my view. They do offer one of the more consistent dividends in the tech industry, with annual growth over much of the last decade, and a yield of 2.46%.
Exxon Mobile (NYSE:XOM)Exxon Mobil is one of the largest public companies in the world. The enormous revenue and earnings are fairly diversified as well. The largest chunk by far, comes from upstream operations, with downstream operations and chemicals bringing in secondary major sources of income. In 2011, their upstream business brought in $34.4 in net income, while the downstream and chemical businesses each brought in approximately $4.4 billion in net income.
The company is highly diversified geographically, with operations, projects, and proved reserves on all continents. In addition, the company has diversification among conventional and unconventional resource types, and both oil and gas, with gas expected to play a more important role over time.
The company’s balance sheet is quantitatively strong as well. Total debt/equity is only around 10%, and the interest coverage ratio is extremely high (well over 100) due to the low debt and low interest rates. The current ratio is actually a bit below 1, but they do have some longer-term equity positions, and total debt/income is below 1 (actually below 0.5).
Exxon Mobil currently offers a fairly small dividend yield of 2.17% with decades of consistent dividend growth, and my most recent published analysis of the company can be found here.
Automatic Data Processing (NASDAQ:ADP)Automatic Data Processing, like the other companies here, has decades of consistent annual dividend increases without a miss. The company provides human resource outsourcing, benefits, payroll, taxes, time and attendance, and administrative services, and is several times larger than their largest direct competitor. In my previous discussions on economic moats, I pointed out that Automatic Data Processing has high switching costs to its many clients, since they hand over an essential and complex part of their business to ADP to handle. The dividend yield is currently 2.83%.
The company has virtually zero debt, the current ratio is over 1, and goodwill makes up only about half of shareholder equity.
With such a clean balance sheet, combined with a large and “sticky” client base, ADP certainly deserves its perfect credit rating in my view. I recently published an analysis of ADP, where I discussed why they stand to benefit from increased interest rates.
ConclusionLooking over the four companies, JNJ and ADP are probably the safer bets, while XOM is more cyclical and MSFT has the largest uncertainty at any given time. They can all serve potential places in a dividend growth portfolio. I view JNJ, XOM, and MSFT being at reasonable valuations at the current time, while I view ADP as a tad bit expensive, and would write long term puts on the stock if I were interested in acquiring shares at a lower cost basis.
Full Disclosure: I am long MSFT, JNJ, and XOM at the time of this writing.