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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 Seadrill Limited's (NYSE:SDRL) 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 = $1.353 billion
  • Net Income 2010 = $1.172 billion
  • Net Income 2011 = $1.482 billion

To pass, the company needs to have a positive net income. Seadrill Limited passes. Over the past 3 years the company net income has increased by 9.53%.

  • Operating Cash Flow 2009 = $1.372 billion
  • Operating Cash Flow 2010 = $1.625 billion
  • Operating Cash Flow 2011 = $1.774 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. Seadrill Limited passes. Over the past 3 years the company's operating cash has increased by 29.30%.

  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 = $1.353 billion
    • Net Income 2010 = $1.172 billion
    • Net Income 2011 = $1.482 billion
  • Total Asset growth

    • Total Assets 2009 = $13.831 billion
    • Total Assets 2010 = $17.497 billion
    • Total Assets 2011 = $18.304 billion
  • ROA -- Return On Assets

    • Return On Assets 2009 = 9.78%
    • Return On Assets 2010 = 6.70%
    • Return On Assets 2011 = 8.10%

Over the past 3 years, Seadrill's ROA has decreased from 9.78% to 8.10%. 8.10% is still a strong ROA but as the ratio has decreased Seadrill does not pass.

  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 = $1.372 billion
  • Net Income 2009 = $1.353 billion

2010

  • Operating Cash Flow 2010 = $1.625 billion
  • Net Income 2010 = $1.172 billion

2011

  • Operating Cash Flow 2011 = $1.774 billion
  • Net Income 2011 = $1.482 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, Seadrill Limited 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 = $13.831 billion
    • Total Assets 2010 = $17.497 billion
    • Total Assets 2011 = $18.304 billion
    • Equals an increase of 32.34%
  • Total Liabilities

    • Total Liabilities 2009 = $9.652 billion
    • Total Liabilities 2010 = $12.100 billion
    • Total Liabilities 2011 = $12.327 billion
    • Equals an increase of 27.71%

Over the past three years Seadrill Limited's increase in total assets was more than the percentage increase of total liabilities. This indicates that much of the company's assets have not been financed by debt. Over the past three years the company's total assets increased by 32.34%, while the total liabilities increased by 27.71%. As the total assets increased more than the total liabilities, Seadrill Limited 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 Ratio = Current Assets/Current liabilities

  • Current Assets

    • Current Assets 2009 = $2.261 billion
    • Current Assets 2010 = $2.883 billion
    • Current Assets 2011 = $1.967 billion
  • Current liabilities

    • Current liabilities 2009 = $2.034 billion
    • Current liabilities 2010 = $2.514 billion
    • Current liabilities 2011 = $2.771 billion
  • Current Ratio 2009 = 1.11
  • Current Ratio 2010 = 1.15
  • Current Ratio 2011 = 0.71

Over the past three years, Seadrill Limited's current ratio has dropped from 1.11 in 2009 to 0.71 in 2011. This indicates that the company has less of the 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 Seadrill's current ratio has decreased over the past 3 years, Seadrill Limited does not pass.

Shares Outstanding

  • 2009 Shares Outstanding = 399.0 million
  • 2010 Shares Outstanding = 443.1 million
  • 2011 Shares Outstanding = 467.8 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 11.05%, while between 2010 and 2011 the company's shares increased by 5.57%. As the shares increased by more than 2% in both years, Seadrill does not pass.

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 = $1.846 billion / $3.254 billion = 56.73%
  • Gross Margin 2010 = $2.257 billion / $4.041 billion = 55.85%
  • Gross Margin 2011 = $2.539 billion / $4.214 billion = 60.25%

Over the past three years, the gross margin has increased from 56.73% to 60.25%. 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, Seadrill Limited 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 = $3.254 billion
    • Revenue 2010 = $4.041 billion
    • Revenue 2011 = $4.214 billion
    • Equals an increase of 29.50%
  • Total Asset growth

    • Total Assets 2009 = $13.831 billion
    • Total Assets 2010 = $17.497 billion
    • Total Assets 2011 = $18.304 billion
    • Equals an increase of 32.34%

As the revenue growth has not exceeded the asset growth, this implies that the company needs to producing more revenue on its assets. Seadrill Limited does not pass.

Based on the nine tests that Seadrill Limited received on profitability, debt and capital, and operating efficiency, the company achieved five passes out of nine. This is a good grade for financial health. Seadrill Limited did not pass the return on assets, the working capital, the shares outstanding and the asset turnover aspect of the test. These are some aspects of the company to keep an eye on moving forward. Overall, the company is showing good results regarding its financial health with five passes out of nine.

Source: Seadrill Limited: Inside The Numbers