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Determining a company's financial health is a very important step in making a decision 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 taking into consideration Home Depot Incorporation's (NYSE:HD) profitability, debt and capital, and operating efficiency. Based on this criteria, we get to see sales, returns, margins, liabilities, assets, returns and turnovers.

Profitability

Profitability is a class of financial metrics that are used to assess a business' ability to generate earnings as 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.

  1. Net income 2012 = $3.883 billion

To pass, the company needs to have a positive net income. Home Depot Inc. passes.

  1. Operating cash flow 2012 = $6.661 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. Home Depot passes.

  1. 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 = 8.2%

  • ROA in 2012 = 8.9%

  • Net income growth, 2011 = $3.338 billion to 2012 = $3.883 billion, a gain of 16.3%

  • Total Asset growth, 2011 = $40.518 billion to 2012 = $43.30 billion, a gain of 6.8%

In 2010 to 2011, the company's ROA and net income increased. Home Depot 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.

  • Operating cash flow 2012 = $6.661 billion

  • Net income 2012 = $3.883 billion

To pass, the operating cash flow must exceed the net income. Home Depot Inc. passes. Operating cash flow exceeds net income.

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 - 2011 = $40.518 billion

  • Total Assets - 2012 = $43.300 billion

  • Equals an increase of 6.8%

  • Total Liabilities 2011 = $22.620 billion

  • Total liabilities 2012 = $25.325 billion

  • Equals an Increase of 11.95%

Home Depot's increase in total assets does not exceed the percentage of total liabilities. Total assets increased by 6.8%, while the total liabilities increased by 11.95%. As the total assets did not exceed the total liabilities, Home Depot Inc. 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 Assets / Current liabilities

  • Current Ratio 2011 = 1.54

  • Current Ratio 2012 = 1.43

Home Depots' current ratio went from 1.54 in 2011 to 1.43 in 2012. Home Depots' current ratio fell in 7% in 2012. Home Depots' current ratio is inline with the industry standard of 1.4.

As the current ratio decreased, Home Depot does not pass.

  1. Shares Outstanding
  • 2011 Shares Outstanding = 1.62 billion

  • 2012 Shares Outstanding = 1.54 billion

To pass, the company's shares must increase less than by 2%. Home Depots' shares decreased by 5%. Home Depot Inc. 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 2011 = $23.304 / $67.997 = 34.27%

  • Gross Margin 2012 = $24.262 / $70.395 = 34.46%

The gross margins increased in 2012 from 2011. The gross margin went from 34.27% to 34.46%, even though they are virtually the same. Home Depot Inc 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.

  • Sales growth - 2011 sales = $67.997 billion

  • Sales growth - 2012 sales = $70.395 billion

  • 3.5% sales growth

  • Asset growth - Assets in 2011 = $40.125 billion

  • Asset growth - Assets in 2012 = $40.518 billion

  • Asset growth of 0.9%

As the sales growth is exceeding the asset growth, this implies that the company is making money on its assets. Home Depot passes.

Based on the nine tests that Home Depot received on profitability, debt and capital, and operating efficiency, the company received seven passes out of nine - this is a strong grade for financial health. Even with the two failing tests in TL/A ratio and Current Ratio, there is no need for concern as these fails were minor and raised no red flags. These tests state that Home Depot is very profitable, is growing organically, and is using its assets to produce revenue. Based on the nine tests, overall the company is showing strong results.

Source: Home Depot: Inside The Numbers