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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 General Dynamics (NYSE:GD) 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

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.

  1. Net Income 2011 = $2.526 billion

To pass, the company needs to have a positive net income. General Dynamics passes.

  1. Operating Cash Flow 2011 = $3.826 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 Dynamics 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 2010 = 8.06%

  • ROA in 2011 = 7.24%

  • Net income growth, 2010 = $2.624 billion to 2011 = $2.526 billion, a decrease of 3.96%

  • Total Asset growth, 2010 = $32.545 billion to 2011 = $34.883 billion, an increase of 7.81%

In 2010-11, General Dynamics ROA decreased from 8.06% to 7.24%. As the ROA decreased General Dynamics does not pass.

  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 2011 = $3.826 billion

  • Net Income 2011 = $2.526 billion

To pass, the operating cash flow must exceed the net income. General Dynamics 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 -- 2010 = $32.545 billion

  • Total Assets -- 2011 = $34.883 billion

  • Equals an increase of 7.81%

  • Total Liabilities 2010 = $19.229 billion

  • Total liabilities 2011 = $21.651 billion

  • Equals an increase of 12.59%

General Dynamics increase in total assets was less than the percentage increase of total liabilities. Total assets increased by 7.81%, while the total liabilities increased by 12.59%. As the total assets did not exceed the total liabilities, General Dynamics 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 2010 = 1.26

  • Current Ratio 2011 = 1.38

General Dynamics current ratio increased from 1.26 in 2010 to 1.38 in 2011. As General Dynamics current ratio increased General Dynamics passes.

  1. Shares Outstanding
  • 2010 Shares Outstanding = 372.05 billion

  • 2011 Shares Outstanding = 356.44 billion

To pass, the company's shares must increase less than by 2%. General Dynamics shares decreased by 4.38%. General Dynamics 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 2010 = $5.909 billion/ $32.466 billion = 18.20%
  • Gross Margin 2011 = $5.856 billion/ $32.677 billion = 17.92%

The gross margin decreased from 18.20% in 2010 to 17.92% in 2011. As the gross margin decreased, General Dynamics does not pass.

  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 -- 2010 sales = $32.466 billion

  • Sales growth -- 2011 sales = $32.677 billion

  • 0.64% sales increase

  • Asset growth -- Assets in 2010 = $32.545 billion

  • Asset growth -- Assets in 2011 = $34.883 billion

  • Asset increase of 7.81%.

As the sales growth did not exceed the asset growth, this implies that the sales did not keep up with the asset growth. General Dynamics does not pass.

Based on the nine tests that General Dynamics 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. General Dynamics did not pass the ROA, the TL/A ratio, the gross margin 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 as profitable in relation to its total assets as 2010. As the company did not pass the TL/A ratio of the test, this implies that much of the company's assets have been financed by debt. The gross margin aspect of the test implies that the company's was not as efficient in its manufacturing and distribution during the production process as the previous year and finally the asset turnover aspect of the test implies that sales growth did not keep up with asset growth in 2011. As these tests reveal a decline in some areas of profitability efficiency compared to 2010, this is one aspect 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.

Source: General Dynamics: Inside The Numbers