Determining a company's financial health is a very important step in making a decision on 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 FirstEnergy Corporation's (FE) profitability, debt and capital, and operating efficiency. Based on these criteria, we get to see sales, returns, margins, liabilities, assets, returns, and turnovers.
Note: All numbers sourced from Morningstar.
Profitability is a class of financial metrics that are used to assess a business' ability to generate earnings, 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 = $885 million
To pass, the company needs to have a positive net income. FirstEnergy passes.
- Operating Cash Flow 2011 = $1.698 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. FirstEnergy 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 = 2.25%
ROA in 2011 = 1.87%
Net income growth, 2010 = $784 million to 2011 = $885 billion, a increase of 12.88%
Total Asset growth, 2010 = $34.805 billion to 2011 = $47.326 billion, an increase of 35.97%
In 2010-11, FirstEnergy's ROA decreased from 2.25% to 1.87%. As the ROA decreased FirstEnergy 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 = $1.698 billion
Net Income 2011 = $885 million
To pass, the operating cash flow must exceed the net income. FirstEnergy 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 = $34.805 billion
Total Assets -- 2011 = $47.326 billion
Equals an increase of 35.97%
Total Liabilities 2010 = $26.260 billion
Total liabilities 2011 = $34.046 billion
Equals an increase of 29.64%
FirstEnergy's increase in total assets was more than the percentage increase of total liabilities. Total assets increased by 35.97%, while the total liabilities increased by 29.64%. As the total assets exceeded the total liabilities, FirstEnergy 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 = 0.79
- Current Ratio 2011 = 0.69
FirstEnergy's current ratio dropped from 0.79 in 2010 to 0.69 in 2011. As FirstEnergy's current ratio dropped FirstEnergy does not pass.
- Shares Outstanding
2010 Shares Outstanding = 304.84 billion
2011 Shares Outstanding = 418.22 billion
To pass, the company's shares must increase less than by 2%. FirstEnergy's shares increased by 37.19%. FirstEnergy does not pass.
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 = $7.283 billion/ $13.339 billion = 54.60%
- Gross Margin 2011 = $8.955 billion/ $16.258 billion = 55.08%
The gross margin increased from 54.60% in 2010 to 55.08% in 2011. As the gross margin Increased, FirstEnergy 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 = $13.339 billion
Sales growth -- 2011 sales = $16.258 billion
21.88% sales increase
Asset growth -- Assets in 2010 = $34.805 billion
Asset growth -- Assets in 2011 = $47.326 billion
Asset increase of 35.97%
As the sales growth did not exceed the asset growth, this implies that the sales did not keep up with the asset growth. FirstEnergy does not pass.
Based on the nine tests that FirstEnergy 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. First Energy did not pass the ROA, the working capital, the shares outstanding and the asset turnover aspects of the test. As the company did not pass the ROA aspect of the test this implies that the company was not a profitable in relation to its total assets as 2010. As the company did not pass the working capital aspect of the test this implies that the company does not have as much liquidity as the previous year. The shares outstanding aspect of the test implies that the company issued 114 million shares in 2011 which was an increase of 37.19% over 2010. Finally the asset turnover aspect of the test implies that sales growth did not keep up with asset growth in 2011. These are some aspects of the company to watch moving forward. 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.