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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 Royal Dutch Shell PLC (NYSE:RDS.A) 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 2010 = $20.127 million
  • Net Income 2011 = $30.918 million
  • Net Income 2012 TTM = $26.421 million

To pass, the company needs to have a positive net income. Shell passes. So far in 2012, the company reported a net income of $26.421 billion.

  • Operating Cash Flow 2010 = $35.344 billion
  • Operating Cash Flow 2011 = $55.660 billion
  • Operating Cash Flow 2012 TTM = $49.731 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. Shell passes.

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 2010 = $20.127 billion
    • Net Income 2011 = $30.918 billion
    • Net Income 2012 TTM = $26.421 billion
  • Total Asset growth

    • Total Assets 2010 = $322.560 billion
    • Total Assets 2011 = $345.257 billion
    • Total Assets 2012 TTM = $360.350 billion
  • ROA -- Return On Assets

    • Return On Assets 2010 = 6.24%
    • Return On Assets 2011 = 8.96%
    • Return On Assets 2012 TTM = 7.33%

Over the past three years, Royal Dutch Shell's ROA has increased from 6.24% in 2010 to 7.33% in 2012 TTM. This indicates the company is making money on its assets. As the ROA has increased, Shell 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. To ensure there are no artificial profits being processed, the operating cash flow must exceed the net income.

2010

  • Operating Cash Flow 2010 = $35.344 billion
  • Net Income 2010 = $20.127 million

2011

  • Operating Cash Flow 2011 = $55.660 billion
  • Net Income 2011 = $30.918 billion

2012 TTM

  • Operating Cash Flow 2012 TTM = $49.731 billion
  • Net Income 2012 TTM = $26.421 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, Royal Dutch Shell 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

    • Total Assets 2010 = $322.560 billion
    • Total Assets 2011 = $345.257 billion
    • Total Assets 2012 TTM = $360.350 billion
    • Equals an increase of 11.72%
  • Total Liabilities

    • Total Liabilities 2010 = $174.547 billion
    • Total Liabilities 2011 = $175.740 billion
    • Total Liabilities 2012 TTM = $175.167 billion
    • Equals an decrease of 0.35%

Over the past three years, Shell's increase in total Assets was more than the percentage increase of total Liabilities. This indicates that the company has not been financing its assets through debt. Over the past three years, the company's total assets increased by 11.72%, while the total liabilities increased by 0.35%. As the total Assets increased more than the total Liabilities, Shell 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 Ratio = Current Assets/Current liabilities

  • Current Assets

    • Current Assets 2010 = $112.894 billion
    • Current Assets 2011 = $119.777 billion
    • Current Assets 2012 TTM = $122.169 billion
  • Current liabilities

    • Current liabilities 2010 = $100.552 billion
    • Current liabilities 2011 = $102.659 billion
    • Current liabilities 2012 TTM = $104.229 billion
  • Current Ratio 2010 = 1.12
  • Current Ratio 2011 = 1.17
  • Current Ratio 2012 TTM = 1.17

Over the past three years, Shell's current ratio has increased from 1.12 in 2010 to 1.17 in 2012. This indicates that the company has more 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 Royal Dutch Shell's current ratio has increased over the past three years, Royal Dutch Shell passes.

Shares Outstanding

  • 2010 Shares Outstanding = 3.07 billion
  • 2011 Shares Outstanding = 3.11 billion
  • 2012 Shares Outstanding = 3.13 billion

To pass, the company's shares must increase less than by 2% in any one-year segment. Between 2010 and 2011, the company's shares increased by 1.3%, while between 2011 and 2012, the company's shares increased by 0.64%. As the company's shares have increased by less than 2%, Royal Dutch Shell 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.

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 = $70.518 billion / $378.152 billion = 18.65%
  • Gross Margin 2011 = $87.987 billion / $484.489 billion = 18.16%
  • Gross Margin 2012 TTM = $84.043 billion / $478.217 billion = 17.57%

Over the past three years, the gross margin has decreased from 18.65% to 17.57%. As the margin has increased, this indicates the company has been less efficient in its manufacturing and distribution. As the gross margin decreased, Royal Dutch Shell does not pass.

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 are found on a company's balance sheet. Total assets should be averaged over the period of time that is being evaluated.

  • Revenue growth

    • Revenue 2010 = $378.152 billion
    • Revenue 2011 = $484.489 billion
    • Revenue 2012 TTM = $478.217 billion
    • Equals an increase of 28.84%
  • Total Asset growth

    • Total Assets 2010 = $322.560 billion
    • Total Assets 2011 = $345.257 billion
    • Total Assets 2012 TTM = $360.350 billion
    • Equals an increase of 11.72%

As the revenue growth has exceeded the asset growth, this implies that the company has been producing revenue on its assets. Royal Dutch Shell passes.

Based on the nine tests that Royal Dutch Shell received on profitability, debt and capital, and operating efficiency, the company achieved eight passes out of nine. This is a excellent grade for financial health. Shell did not pass the gross margin aspect of the test. This is one aspect of the company to keep an eye on moving forward.

More support for the strength that this article indicates is that analysts at Credit Suisse have upgraded Royal Dutch Shell plc to Outperform from Neutral. Analysts have given the stock a price target of $79 per share. Overall, the company is showing excellent results regarding its financial health with eight passes out of nine and is looking to maintain its strength moving forward.

Source: Royal Dutch Shell: Inside The Numbers