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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 Linn Energy's (NASDAQ:LINE) 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 the company's Form 10-K.

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 = $(298) million
  • Net Income 2010 = $(114) million
  • Net Income 2011 = $438 million

To pass, the company needs to have a positive net income. Linn Energy passes. In 2011 the company reported a net income of $438 million.

  • Operating Cash Flow 2009 = $(187) million
  • Operating Cash Flow 2010 = $159 million
  • Operating Cash Flow 2011 = $806 million

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. Linn Energy passes. In 2010 and 2011 the company's reported positive operating cash.

  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 = $(298) million
    • Net Income 2010 = $(114) million
    • Net Income 2011 = $438 million
  • Total Asset growth

    • Total Assets 2009 = $4.340 billion
    • Total Assets 2010 = $5.933 billion
    • Total Assets 2011 = $8.000 billion
  • ROA -- Return On Assets

    • Return On Assets 2009 = -6.87%
    • Return On Assets 2010 = -1.92%
    • Return On Assets 2011 = 5.78%

Over the past three years, Linn Energy's ROA has increased from -6.87% to 5.78%. This indicates the company is making money on its assets. As the ROA has increased Linn 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 = $(187) million
  • Net Income 2009 = $(298) million

2010

  • Operating Cash Flow 2010 = $159 million
  • Net Income 2010 = $(114) million

2011

  • Operating Cash Flow 2011 = $806 million
  • Net Income 2011 = $438 million

Over the past three 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, Linn 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 = $4.340 billion
    • Total Assets 2010 = $5.933 billion
    • Total Assets 2011 = $8.000 billion
    • Equals an increase of 84.33%
  • Total Liabilities

    • Total Liabilities 2009 = $1.888 billion
    • Total Liabilities 2010 = $3.145 billion
    • Total Liabilities 2011 = $4.571 billion
    • Equals an increase of 142.11%

Over the past three years Linn Energy's increase in total liabilities was more than the percentage increase of total assets. 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 84.33%, while the total liabilities increased by 142.11%. As the total liabilities increased more than the total assets, Linn 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 = $409 million
    • Current Assets 2010 = $711 million
    • Current Assets 2011 = $621 million
  • Current liabilities

    • Current liabilities 2009 = $209 million
    • Current liabilities 2010 = $315 million
    • Current liabilities 2011 = $493 million
  • Current Ratio 2009 = 1.96
  • Current Ratio 2010 = 2.26
  • Current Ratio 2011 = 1.26

Over the past three years, Linn Energy's current ratio has dropped from 1.96 in 2009 to 1.26 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 above 1 this indicates that the company would be able to pay off its obligations if they came due at this point.

As Linn Energy's current ratio has decreased over the past three years, Linn Energy does not pass.

Shares Outstanding

  • 2009 Shares Outstanding = 119 million
  • 2010 Shares Outstanding = 143 million
  • 2011 Shares Outstanding = 173 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 20.17%, while between 2010 and 2011 the company's shares increased by 20.98%. As the shares increased by more than 2% in both years, Linn Energy 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 = $122 million / $273 million = 44.69%
  • Gross Margin 2010 = $594 million / $772 million = 76.94%
  • Gross Margin 2011 = $1.361 billion / $1.622 billion = 83.91%

Over the past three years, the gross margin has increased from 44.69% to 83.91%. 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, Linn 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 = $273 million
    • Revenue 2010 = $772 million
    • Revenue 2011 = $1.622 million
    • Equals an increase of 594.13%
  • Total Asset growth

    • Total Assets 2009 = $4.340 billion
    • Total Assets 2010 = $5.933 billion
    • Total Assets 2011 = $8.000 billion
    • Equals an increase of 84.33%

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

Based on the nine tests that Linn 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. Linn Energy did not pass the debt aspects of the test. The company did not pass the TL/A ratio, the working capital and the shares outstanding aspects of the test. These are some aspects of the company to keep an eye on moving forward. As the report indicates Linn Energy is growing at a strong pace but is also increasing it's debt load at a strong pace as well. Overall, the company is showing good results regarding its financial health with six passes out of nine.

Source: Linn Energy: Inside The Numbers