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 General Electric Company's (NYSE:GE) profitability, debt and capital, and operating efficiency. Based on this criteria, we get to see sales, returns, margins, liabilities, assets, returns and turnovers.
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.
- Net Income 2011 = $14.151 billion
To pass, the company needs to have a positive net income. General Electric passes.
- Operating Cash Flow 2011 = $20.098 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. General Electric passes.
- 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 2010 = 1.55%
ROA in 2011 = 1.97%
Net income growth, 2010 = $11.644 billion to 2011 = $14.151 billion, a gain of 21.53%
Total Asset growth, 2010 = $747.793 billion to 2011 = $717.242 billion, a difference of -4.25%
In 2010 to 2011, the company's ROA grew. General Electric 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.
Operating Cash Flow 2011 = $20.098 billion
Net Income 2011 = $14.151 billion
To pass, the operating cash flow must exceed the net income. General Electric 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.
- 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 - 2010 = $747.793 billion
Total Assets - 2011 = $717.242 billion
Equals an decrease of 4.25%
Total Liabilities 2010 = $628.857 billion
Total liabilities 2011 = $600.804 billion
decrease of 4.66%
General Electric's decrease in Total Assets was less than the percentage decrease of Total Liabilities. Total Assets decreased by 4.25%, while the total liabilities decreased by 4.66%. The Total Assets exceeded the Total liabilities, General Electric 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 Assets / Current liabilities
Current Ratio 2010 = 1.70
Current Ratio 2011 = 1.59
General Electric's current ratio went from 1.70 in 2010 to 1.59 in 2011. Even though General Electric's current ratio dropped, it is still above the industry standard of 0.9. As the current ratio decreased, General Electric does not pass.
- Shares Outstanding
2010 Shares Outstanding = 10.62 billion
2011 Shares Outstanding = 10.57 billion
To pass, the company's shares must increase less than by 2%. General Electric's decrease in shares was .4%. GE passes.
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 = $61.176 / $149.593 = 40.89%
Gross Margin 2011 = $59.414 / $147.300 = 40.33%
The gross profit margins decreased slightly in 2011 from 2010. The gross margin went from 40.89% to 40.33%. General Electric 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 is found on a company's balance sheet. Total assets should be averaged over the period of time that is being evaluated.
Sales growth - 2010 sales = $149.593 billion
Sales growth - 2011 sales = $147.300 billion
1.55% sales decrease
Asset growth - Assets in 2010 = $747.793 billion
Asset growth - Assets in 2011 = $717.242 billion
Asset decrease of 4.25%
As the sales decrease was less than the asset decrease, this implies that the company is making money on its current assets, but as General Electric's revenues were down 1.55% from a year ago with will neutralize the point. This point is neutral.
Based on the nine tests that GE received on profitability, debt and capital, and operating efficiency, the company received six passes and a neutral out of nine - this is a good grade for financial health. The company did not pass the Working Capital metric of the test. This implies that the company has less assets compared to its liabilities than the previous year. The other metric that GE did not pass was the Gross Margin. As the gross margin fell this states that GE was not as efficient in its distribution as the previous year.
These are two major aspects of the company to keep an eye on going forward. If these metrics continue to erode, this will raise some concerns about the company. Another concern that is apparent, is the decrease in revenue. As the company's revenues were down last year, and inconsistent over the past few years, it will take more information to get a good idea on the overall success of the company. Based on the nine tests, GE scored six passes and one neutral out of nine. Overall the company is showing good results.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.