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Determining a company's financial health is a very important step in making a decision on whether or not to invest or to stay invested. There are many different ways to compute a company's financial health. In this test, I will be considering Southwestern Energy Company (SWN) profitability, debt and capital, and operating efficiency. Based on these criteria, we get to see sales, returns, margins, liabilities, assets, returns and turnovers.

All numbers sourced from Morningstar.

Profitability

Profitability is a class of financial metrics used to assess a business's ability to generate earnings, compared with expenses and other relevant costs incurred during a specific period of time. In this section, we will look at four tests of profitability. They are: Net Income, Operating Cash Flow, Return on Assets, and Quality of Earnings. From these four metrics, we will establish if the company is making money, and gauge the quality of the reported profits.

  1. Net Income 2011 = $638 million

To pass, the company needs to have a positive net income. Southwestern Energy passes.

  1. Operating Cash Flow 2011 = $1.075 billion

Operating Cash Flow is the cash generated from the operations of a company, generally defined as revenue less all operating expenses, but calculated through a series of adjustments to net income.

To pass, the company needs to have a positive operating cash flow. Southwestern Energy passes.

  1. ROA -- Return On Assets

ROA is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as "return on investment."

  • ROA in 2010 = 10.03%

  • ROA in 2011 = 8.07%

  • Net income growth 2010 = $604 million to 2011 = $638 million, a increase of 5.63%

  • Total Asset growth 2010 = $6.017 billion to 2011 = $7.903 billion, an increase of 31.34%

In 2010-11, Southwestern's ROA decreased from 10.03% to 8.07%. As the ROA decreased, Southwestern Energy does not passes.

  1. Quality of Earnings

Quality of Earnings is the amount of earnings attributable to higher sales or lower costs rather than artificial profits created by accounting anomalies such as inflation of inventory.

  • Operating Cash Flow 2011 = $1.075 billion

  • Net Income 2011 = $638 million

To pass, the operating cash flow must exceed the net income. As operating cash flow exceeds net income, Southwestern Energy passes.

Debt and Capital

The Debt and Capital section establishes if the company is sinking into debt or digging its way out. It will also determine if the company is growing organically or raising cash by selling off stock.

  1. Total Liabilities to Total Assets, or TL/A ratio

TL/A ratio is a metric used to measure a company's financial risk by determining how much of the company's assets have been financed by debt.

  • Total Assets -- 2010 = $6.017 billion

  • Total Assets -- 2011 = $7.903 billion

  • Equals an increase of 31.34%

  • Total Liabilities 2010 = $3.053 billion

  • Total liabilities 2011 = $3.934 billion

  • Equals an increase of 28.86%

Southwestern Energy's increase in total assets was more than the percentage increase of total liabilities. Total assets increased by 31.34%, while the total liabilities increased by 28.86%. As the total assets increased more than the total liabilities, Southwestern Energy passes.

  1. Working Capital

Working Capital is a general and quick measure of liquidity of a firm. It represents the margin of safety or cushion available to the creditors. It is an index of the firm's financial stability. It is also an index of technical solvency and an index of the strength of working capital.

  • Current Assets/Current liabilities

  • Current Ratio 2010 = 0.84

  • Current Ratio 2011 = 1.11

Southwestern Energy's current ratio increased from 0.84 in 2010 to 1.11 in 2011. As its current ratio increased, Southwestern Energy passes.

  1. Shares Outstanding
  • 2010 Shares Outstanding = 349 million

  • 2011 Shares Outstanding = 350 million

To pass, the company's shares must increase less than by 2%. Southwestern Energy shares increased by 0.29%. Southwestern Energy passes.

Operating Efficiency

Operating Efficiency is a market condition that exists when participants can execute transactions and receive services at a price that equates fairly to the actual costs required to provide them. An operationally efficient market allows investors to make transactions that move the market further toward the overall goal of prudent capital allocation without being chiseled down by excessive frictional costs, which would reduce the risk/reward profile of the transaction.

  1. Gross Margin: Gross Income/Sales

The gross profit margin is a measurement of a company's manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue/sales left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors and industry is more efficient. Investors tend to pay more for businesses that have higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.).

  • Gross Margin 2010 = $1.808 billion/ $2.611 billion = 69.25%
  • Gross Margin 2011 = $2.003 billion/ $2.953 billion = 67.83%

The gross margin decreased from 69.25% in 2010 to 67.83% in 2011. As the gross margin decreased, Southwestern Energy does not pass.

  1. Asset Turnover

The formula for the asset turnover ratio evaluates how well a company is utilizing its assets to produce revenue. The numerator of the asset turnover ratio formula shows revenues found on a company's income statement and the denominator shows total assets, which is found on a company's balance sheet. Total assets should be averaged over the period of time that is being evaluated.

  • Sales growth -- 2010 sales = $2.611 billion

  • Sales growth -- 2011 sales = $2.953 billion

  • 13.10% sales increase

  • Total Assets -- 2010 = $6.017 billion

  • Total Assets -- 2011 = $7.903 billion

  • Equals an increase of 31.34%

As the sales growth did not exceed the asset growth, this implies that the company did not produce enough revenue on its assets. Southwestern Energy does not pass.

Based on the nine tests that Southwestern Energy received on profitability, debt and capital, and operating efficiency, the company achieved six passes out of nine. This is a good grade for financial health. Southwestern Energy did not pass the return on assets, the gross margin and the asset turnover aspects of the test. The return on assets indicates that the company was not as efficient at using its assets to generate income as the year before. The gross margin aspect of the paper reveals that the company was not as efficient in its manufacturing and distribution as it was a year ago, while the asset turnover aspect of the paper indicates how well the company utilized its assets to generate income. These are a few aspect of the company to watch moving forward. Overall, the company is showing good results regarding its financial health with six passes out of nine.

Source: Southwestern Energy: Inside The Numbers