Invest in Costco? First Understand Its Balance Sheet

For anyone who has ever pushed a giant shopping cart through throngs of Costco customers on a Saturday, it looks like business at the membership shopping warehouse is booming. But how healthy is Costco Wholesale Corp. (COST), really? One way to assess a company’s health is by examining its balance sheet. (See also Fundamental Analysis: The Balance Sheet.)

In a company’s financial statements, the balance sheet has one main purpose—to show the company’s assets and liabilities. Although the purpose is simple, how a company lists each line item is not altogether straightforward. A strong balance sheet can set a company apart and boost investor confidence by showing steady and sustainable growth. Costco is a $100 billion company and its primary competitors are big box stores like Wal-Mart Stores Inc (WMT) and Target Corp (TGT). Let’s first look back at Costco’s 2013 and 2014 balance sheets and see how to analyze its value. Then we can see how that compares with its figures for FY 2017. (See also Costco, Target or Walmart: Which Is the Best Bet?) 

A balance sheet provides a snapshot of how a company looks at a single point in time—that is, at the end of the reporting period. For Costco, that is August 31 each year. The balance sheet consists of three sections: assets, liabilities and equity. Each section has different line items that, when added together, provide the total value for that section. Breaking it down further, each line item consists of various inputs that are not listed on the balance sheet. These inputs can be found in the footnotes and management discussion section of the report. 

Let’s start by looking at current assets on Costco’s balance sheet. Current assets reflect the company’s short-term liquidity or how much cash Costco can access within the year. Current liabilities can be likened to bills that will be paid within the year. Together, current assets and liabilities can paint a picture of how financially sound the company is within the current year. But to get a true understanding of these values and see if the trend is positive or negative, calculating financial ratios and comparing these with prior year ratios is necessary.

The above table shows three liquidity ratios: the current ratio, the quick ratio, and the cash ratio. They show that Costco has a strong coverage of its current liabilities with its current assets. In addition, that coverage improved from 2013 to 2014. It is a positive trend. Particularly strong is the current ratio. A current ratio above 1.0 shows that a company is able to pay its liabilities in the near term. Costco shows a current ratio of 1.22 in 2014 (up from 1.19 in 2013). For fiscal year (FY) 2017, Costco had a current ratio of 0.99, a quick ratio of 0.41, and a cash ratio of 0.33; indicating that on average, Costco's liquidity picture has deteriorated somewhat since the early 2010s.

The balance sheet can also show how well Costco converts its inventory or collects its receivables. 

The activity ratios show that Costco improved its collection times in 2014. In 2013, the average number of days of receivables outstanding was 3.9. In 2014, the average collection period improved by 0.1 days to 3.8. However, in 2014, Costco began keeping it inventory in stock slightly longer—the average number of days in stock increased from 29.8 days to 30.3 days. Another negative trend (although the difference is so small it’s almost negligible) is that Costco’s average number of days for payables outstanding increased slightly (by 0.2 days). This shows the company was slower to pay its own bills in 2014. 

For FY 2017, receivables turnover was 88.1x, average collection period was 4 days, inventory turnover was 11.4x, average days in stock was 32, payables turnover was 11.6x, and average days payables outstanding was 31. Overall, these figures also indicate that Costco's financial situation has gotten slightly worse than a few years ago.

The operating efficiency ratios describe how well Costco is running its business. In other words, these ratios show how efficiently Costco is using its assets or equity to generate revenue. On a year-over-year basis, Costco has been consistent in deploying its assets to make sales. Its equity turnover shows a nice pick-up from 2013 to 2014 from 8.9 to 9.6. This indicates that Costco is generating more sales per dollar of equity, a good sign.

For FY 2017, total asset turnover was 3.5x, fix asset turnover 6.9x, and equity turnover 11.7x - showing mixed signals in terms of its position relative to 2014.

The financial risk ratios show Costco has low debt-to-capital and debt-to-equity and a positive trend. It also shows that the cash flow from operations-to-total debt is high and improving, another positive trend.  The financial leverage ratio shows that for every $2.81 of assets, there is a $1.00 of equity financing them (and $1.81 of debt financing the remainder.) While this is high, it is not onerous. However, if this ratio goes higher, it may become unsustainable for Costco to pay the increased interest costs. In general, equity financing is not cheaper than debt. In the current low-interest rate environment, it may be prudent to use more debt. 

For FY 2017, Costco's debt-to-capital was 0.38, debt-to equity 0.62.

The return on investment ratios are strong for Costco and show a consistent trend. In isolation, these ratios have very little meaning. However, over time, the trend should be analyzed for changes. Additionally, the ratios are very industry specific and need to be compared with competitors. Based on data from Yahoo! Finance, Costco's return ratios are in line with or better than those of its peers, Wal-Mart and Target. It is necessary to analyze both return on assets and return on equity since return on assets ignores capital structure (debt vs. equity). This is important because Costco can receive a high return on their assets but if the assets are 100% financed by equity or debt, for example then the shareholder's return may differ greatly. 

For FY 2017, Costco's ROE was approximately 25%.

Costco has adequate liquidity, particularly in the short term, but its inventory turnover and payables trends from 2013 to 2014 are slightly negative. Investors and analysts should keep on eye on these. The company’s operating efficiency trend is consistent and strong, particularly its equity turnover. Costco’s financial risk ratios show it was not in a risky position at the end of fiscal year 2014, and the trend is positive. Lastly, its return ratios are better than peers and consistent. Overall, it appears Costco’s balance sheet is strong and trending in the right direction. Between then and 2017, the company's financials seem to indicate a slight deterioration in quality, but this could be due to several factors, including growth of the business and an increase in the stock price.