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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 Spectra Energy Corporation's (NYSE:SE) 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 and Company Website.

Profitability

Profitability is a class of financial metrics used to assess a business' 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 2009 = $848 million
  • Net Income 2010 = $1.049 billion
  • Net Income 2011 = $1.184 billion

To pass, the company needs to have a positive net income. Spectra Energy passes. Over the past 3 years the company net income has increased by 39.62%.

  • Operating Cash Flow 2009 = $1.475 billion
  • Operating Cash Flow 2010 = $1.674 billion
  • Operating Cash Flow 2011 = $1.763 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. Spectra Energy passes. Over the past 3 years the company's operating cash has increased by 19.52%.

  1. ROA -- Return On Assets = Net Income / Total 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."

  • Net income growth

    • Net Income 2009 = $848 million
    • Net Income 2010 = $1.049 billion
    • Net Income 2011 = $1.184 billion
  • Total Asset growth

    • Total Assets 2009 = $24.079 billion
    • Total Assets 2010 = $26.686 billion
    • Total Assets 2011 = $28.138 billion
  • ROA -- Return On Assets

    • Return On Assets 2009 = 3.52%
    • Return On Assets 2010 = 3.93%
    • Return On Assets 2011 = 4.21%

Over the past 3 years, Spectra Energy's ROA increased from 3.52%% to 4.21%. This is an increase of 19.6%. As the ROA increased, Spectra Energy 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. To ensure there are no artificial profits being processed, the operating cash flow must exceed the net income.

2009

  • Operating Cash Flow 2009 = $1.475 billion
  • Net Income 2009 = $848 million

2010

  • Operating Cash Flow 2010 = $1.674 billion
  • Net Income 2010 = $1.049 billion

2011

  • Operating Cash Flow 2011 = $1.763 billion
  • Net Income 2011 = $1.184 billion

Over the past 3 years the operating cash flow has been higher than the net income. This indicates that the company is not artificially creating profits by accounting anomalies such as inflation of inventory. As operating cash flow exceeds net income all three years, Spectra 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

    • Total Assets 2009 = $24.079 billion
    • Total Assets 2010 = $26.686 billion
    • Total Assets 2011 = $28.138 billion
    • Equals an increase of 16.86%
  • Total Liabilities

    • Total Liabilities 2009 = $16.954 billion
    • Total Liabilities 2010 = $18.877 billion
    • Total Liabilities 2011 = $20.073 billion
    • Equals an increase of 18.40%

Over the past three years Spectra Energy's increase in total assets was less than the percentage increase of total liabilities. This indicates that much of the company's assets have been financed by debt. Over the past three years the company's total assets increased by 16.86%, while the total liabilities increased by 18.40%. As the total liabilities increased more than the total assets, Spectra Energy does not pass.

  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 Ratio = Current Assets/Current liabilities

  • Current Assets

    • Current Assets 2009 = $1.429 billion
    • Current Assets 2010 = $1.638 billion
    • Current Assets 2011 = $1.764 billion
  • Current liabilities

    • Current liabilities 2009 = $2.495 billion
    • Current liabilities 2010 = $2.523 billion
    • Current liabilities 2011 = $3.101 billion
  • Current Ratio 2009 = 0.57
  • Current Ratio 2010 = 0.65
  • Current Ratio 2011 = 0.57

Over the past three years, Spectra Energy's current ratio has remained the same. This indicates that the company has the same ability to pay off its short term obligations as it did three years ago. As the number is below 1 this indicates that the company would be unable to pay off its obligations if they came due at this point.

As its current ratio has not increased or decreased over the past 3 years, the is a moot point.

  1. Shares Outstanding
  • 2009 Shares Outstanding = 643 million
  • 2010 Shares Outstanding = 650 million
  • 2011 Shares Outstanding = 653 million

To pass, the company's shares must increase less than by 2% in any one year segment. Between 2009 and 2010 the company's shares increased by 1.08%, while between 2010 and 2011 the company's shares increased by 0.46%. As the shares did not increase by more than 2% in any one year time period, Spectra 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 2009 = $3.454 billion / $4.552 billion = 75.88%
  • Gross Margin 2010 = $3.889 billion / $4.945 billion = 78.66%
  • Gross Margin 2011 = $4.209 billion / $5.351 billion = 78.66%

Over the past three years, the gross margin has increased from 75.88% to 78.66%. As the margin has increased, this indicates the company has been more efficient in its manufacturing and distribution during the production process. As the gross margin increased, Spectra Energy passes.

  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.

  • Revenue growth

    • Revenue 2009 = $4.552 billion
    • Revenue 2010 = $4.945 billion
    • Revenue 2011 = $5.351 billion
    • Equals an increase of 17.60%
  • Total Asset growth

    • Total Assets 2009 = $24.079 billion
    • Total Assets 2010 = $26.686 billion
    • Total Assets 2011 = $28.138 billion
    • Equals an increase of 16.86%

As the revenue growth has exceeded the asset growth, this implies that the company is producing revenue on its assets. Spectra Energy passes.

Based on the nine tests that Spectra Energy received on profitability, debt and capital, and operating efficiency, the company achieved seven passes and a moot point out of nine. This is a very good grade for financial health. Spectra Energy did not pass the TL/A ratio indicating that over the past three years the company's liabilities have increased faster than the company's assets. Overall, the company is showing very good results regarding its financial health with seven passes and a moot point out of nine.

Source: Spectra Energy: Inside The Numbers