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 Eaton Corporation's (ETN) 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 = $1.350 billion
To pass, the company needs to have a positive net income. Eaton Corp passes.
- Operating Cash Flow 2011 = $1.553 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. Eaton Corp 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 = 5.38%
ROA in 2011 = 7.55%
Net income growth, 2010 = $929 million to 2011 = $1.350 billion, a increase of 45.31%
Total Asset growth, 2010 = $17.252 billion to 2011 = $17.873 billion, a difference of 3.60%
In 2010 to 2011, Eaton Corp's ROA rose from 5.38% to 7.55%. Eaton Corp. 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 = $1.553 billion
Net Income 2011 = $1.350 billion
To pass, the operating cash flow must exceed the net income. Eaton Corp. 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 = $17.252 billion
Total Assets - 2011 = $17.873 billion
Equals an increase of 3.60%
Total Liabilities 2010 = $9.890 billion
Total liabilities 2011 = $10.404 billion
Equals an increase of 5.19%
Eaton Corp's increase in total assets was less than the percentage increase of total liabilities. Total assets increased by 3.60%, while the total liabilities increased by 5.19%. As the total assets did not exceed the total liabilities, Eaton Corp does not pass.
- 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 = 1.60
Eaton Corp's current ratio went from 1.70 in 2010 to 1.60 in 2011. As Eaton Corp's current ratio decreased, Eaton Corp does not pass.
- Shares Outstanding
2010 Shares Outstanding = 339.90 million
2011 Shares Outstanding = 334.40 million
To pass, the company's shares must increase less than by 2%. Eaton Corp's shares decreased by 1.64%. Eaton Corp 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 = $4.082 billion / $13.715 billion = 29.76%
Gross Margin 2011 = $4.788 billion/ $16.049 billion = 29.83%
The gross profit margin increased slightly in 2011 from 2010. The gross margin went from 29.76% to 29.83%. As the gross margin increased Eaton Corp passes.
- 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 = $13.715 billion
Sales growth - 2011 sales = $16.049 billion
17.02% sales increase
Asset growth - Assets in 2010 = $17.252 billion
Asset growth - Assets in 2011 = $17.873 billion
Asset increase of 3.60%
As the sales growth is exceeding the asset growth, this implies that the company is producing revenue on its assets. Eaton Corp passes.
Based on the nine tests that Eaton Corp 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. The two metrics the company did not pass was the TL/A ratio and the Working Capital. A decrease in the TL/A ratio implies that some company of the company's assets have been financed by debt, while a decrease in the working capital implies the company's margin of safety or cushion available to the creditors was less than it was a year ago. As both of these metrics are in the debt and capital section, more analysis on the company's debt should be done.
As Eaton Corp passed seven out of nine tests, this shows that Eaton Corp is very profitable, efficient and is using its assets to produce revenue. Based on the nine tests, overall, the company is showing strong results.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.