Determining a company's financial health is a very important step in making a decision whether or not to invest. There are many different ways to compute a company's financial health, but in this test, I take into consideration Lowes' (LOW) profitability, debt and capital, and operating efficiency. Based on these three criteria we get to see sales, returns, margins, liabilities, assets, returns and turnovers.
Profitability is class of financial metrics that are used to assess a business's ability to generate earnings as compared to its 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.
1. Net Income 2012 = $1.839 billion
To pass, the company needs to have a positive net income. Lowes passes.
2. Operating Cash Flow 2012 = $4.349 billion
Operating Cash Flow is the cash generated from the operations of a company, generally defined as revenues 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. Lowes passes
3. 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 2011 = 5.96
ROA in 2012 = 5.47
Net income growth 2011 to 2012 = 2.7%
Assets growth in 2011 to 2012 = -.41%
Even though the ROA fell the net income grew 2.7% from 2011 to 2012 while the assets fell .41%. Lowes passes.
4. 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 = $4.349 billion
Net Income = $1.839 billion
To pass the operating cash flow must exceed the net income. Lowes 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 growing organically or raising cash by selling off stock.
5. 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 - 2011 = $33.699 billion
Total Assets - 2012 = $33.559 billion
Equals a drop in Assets of -.41%
Total Liabilities 2011 = $15.587 billion
Total liabilities 2012 = $17.026 billion
Increase of 8.6%
Lowes increase in Total Liabilities exceeded the percentage of Total Assets. Total Assets dropped by .41%, while the total liabilities increased by 8.6%. Lowes does not pass.
6. 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 firms 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 2011 = 1.40
Current Ratio 2012 = 1.28
Lowes current ratio dropped from 1.4 to 1.28, but 1.28 is still an acceptable number, as the industry standard is 1.5.
Lowes does not pass
7. Shares Outstanding
Current Shares Outstanding = 1.2 billion
2011 Shares Outstanding = 1.34 billion
To pass, the company's shares must increase less than by 2%. Lowes is buying back shares. Lowes passes.
Operating Efficicncy 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.
8. 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 2011 = $17.152 / $48.815 = 35.13%
Gross Margin 2012 = $17.350 / $50.208 = 34.55%
The gross profit margins decreased slightly in 2012 over 2011. The gross margin slipped from 35.13% to 34.55%. Even though it was a small amount, Lowes does not pass.
9. 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 which is 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 - 2011 sales = $48.815 billion
Sales growth - 2012 sales = $50.208 billion
2.8% sales growth
Asset growth - Assets in 2011 = $33.699 billion
Asset growth - Assets in 2012 = $33.559 billion
Decline in Asset growth of .41%
As the Sales growth is exceeding the Asset growth this implies that inventory is being moved. Lowes passes
Based on the nine tests that Lowes received on profitability, debt and capital, and operating efficiency, Lowes received 6 passes out of 9. Even with three failing tests, there is no need for concern as these fails were extremely minor and raised no red flags. These tests state that Lowes is very profitable, is growing organically, and is using its assets to produce revenue.
To find out more on Lowes, read my article: Lowe's Stragety For Success Paying Off
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.