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 considering Kraft Food Inc's (KFT) 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's 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 = $3.527 billion
To pass, the company needs to have a positive net income. Kraft Foods passes.
- Operating Cash Flow 2011 = $6.657 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. Kraft 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 = 4.32%
ROA in 2011 = 3.76%
Net income growth, 2010 = $4.114 billion to 2011 = $3.527 billion, a increase of 16.40%
Total Asset growth, 2010 = $95.289 billion to 2011 = $93.837 billion, a difference of .46%
In 2010 to 2011, Kraft's ROA fell from 4.32% to 3.76%. Kraft does not pass.
- 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 = $6.657 billion
Net Income 2011 = $3.527 billion
To pass, the operating cash flow must exceed the net income. Kraft 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 = $95.289 billion
Total Assets - 2011 = $93.837 billion
Equals an decrease of 1.55%
Total Liabilities 2010 = $59.455 billion
Total liabilities 2011 = $58.620 billion
Equals an decrease of 1.42%
Kraft's decrease in total assets was more than the percentage decrease of total liabilities. Total assets decreased by 1.55%, while total liabilities decreased by 1.42%. As the total assets decreased more than the total liabilities decreased, Kraft 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 = 1.04
Current Ratio 2011 = .88
Kraft's current ratio went from 1.04 in 2010 to .88 in 2011. As Kraft's current ratio decreased, Kraft does not pass.
- Shares Outstanding
2010 Shares Outstanding = 1.748 billion
2011 Shares Outstanding = 1.767 billion
To pass, the company's shares must increase less than by 2%. Kraft's shares increased by 1.08% Kraft 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 = $17.902 billion / $49.207 billion = 36.38%
Gross Margin 2011 = $19.015 billion/ $54.365 billion = 34.98%
The gross margin decreased from 36.38% in 2010 to 34.98% in 2011. As the gross margin decreased, Kraft 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 = $49.207 billion
Sales growth - 2011 sales = $54.365 billion
1.02% sales increase
Asset growth - Assets in 2010 = $95.289 billion
Asset growth - Assets in 2011 = $93.837 billion
Asset decrease of 5.46%
As the Sales growth is exceeding the Asset growth, this implies that the company is making money on its assets. Kraft Foods passes.
Based on the nine tests that Kraft Foods received on profitability, debt and capital, and operating efficiency, the company achieved five passes out of nine. This is a good grade for financial health.
Kraft Foods declined in the ROA metric of the test, the TL/A ratio, the working capital aspect of the test and the gross margin aspect of the test. The ROA metric implies the company was not as profitable relative to its total assets as the year before. The TL/A ratio implies that the much of the company's assets have been financed by debt. The working capital aspect implies that the company does not have as much liquidity as the year before. The gross margin implies that the company was not as efficient in its manufacturing and distribution during the production process.
As there were four aspects of the test that did not pass, it implies that the company did pass the test but does have some weaknesses that should be analyzed. Based on the nine tests, overall, the company is showing good results with five passes out of nine.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.