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 EOG Resources' (NYSE:EOG) profitability, debt and capital, and operating efficiency. Based on these criteria, we get to see sales, returns, margins, liabilities, assets, returns and turnovers.
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.
- Net Income 2011 = $1.091 billion
To pass, the company needs to have a positive net income. EOG Resources passes.
- Operating Cash Flow 2011 = $2.113 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. EOG Resources passes.
- 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 = 0.74%
ROA in 2011 = 4.39%
Net income growth 2010 = $161 million to 2011 = $1.091 billion, a increase of 677.64%
Total Asset growth 2010 = $21.624 billion to 2011 = $24.839 billion, an increase of 14.86%
In 2010-11, EOG's ROA increased from 0.74% to 4.39%. As the ROA increased, EOG Resources passes.
- 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 = $2.113 billion
Net Income 2011 = $1.091 billion
To pass, the operating cash flow must exceed the net income. As operating cash flow exceeds net income, EOG Resources 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.
- 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 = $21.624 billion
Total Assets 2011 = $24.839 billion
Equals an increase of 14.86%
Total Liabilities 2010 = $11.393 billion
Total liabilities 2011 = $12.198 billion
Equals an increase of 7.07%
EOG Resources' increase in total assets was more than the percentage increase of total liabilities. Total assets increased by 14.86%, while the total liabilities increased by 7.07%. As the total assets increased more than the total liabilities, EOG Resources passes.
- 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 = 1.14
- Current Ratio 2011 = 1.29
EOG's current ratio increased from 1.14 in 2010 to 1.29 in 2011. As its current ratio increased, EOG Resources passes.
- Shares Outstanding
2010 Shares Outstanding = 254.5 million
2011 Shares Outstanding = 266.3 million
To pass, the company's shares must increase less than by 2%. EOG's shares increased by 4.63%. EOG Resources does not pass.
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.
- 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 = $4.877 billion/ $6.100 billion = 80.00%
- Gross Margin 2011 = $8.620 billion/ $10.126 billion = 85.13%
The gross margin increased from 80.00% in 2010 to 85.13% in 2011. As the gross margin increased, EOG Resources passes.
- 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 = $6.100 billion
Sales growth -- 2011 sales = $10.126 billion
66.00% sales increase
Total Assets -- 2010 = $21.624 billion
Total Assets -- 2011 = $24.839 billion
Equals an increase of 14.86%
As the sales growth exceeded the asset growth, this implies that the company produced revenue on its assets. EOG Resources passes.
Based on the nine tests that EOG Resources received on profitability, debt and capital, and operating efficiency, the company achieved eight passes out of nine. This is an excellent grade for financial health. EOG Resources did not pass the shares outstanding aspect of the test, as the company issued 11.8 million shares in 2011. Overall, the company is showing excellent results regarding its financial health with eight passes out of nine.
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.