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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 American Electric Power Company Inc's (NYSE:AEP) 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 = $1.946 billion

To pass, the company needs to have a positive net income. American Electric Power passes.

  1. Operating Cash Flow 2011 = $2.782 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. American Electric Power 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 = 2.40%

  • ROA in 2011 = 3.72%

  • Net income growth, 2010 = $1.214 billion to 2011 = $1.946 billion, a increase of 60.29%

  • Total Asset growth, 2010 = $50.455 billion to 2011 = $52.223 billion, an increase of 3.50%

In 2010-11, American Electric Power's ROA increased from 2.40% to 3.72%. As the ROA increased American Electric Power passes.

  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 = $2.782 billion

  • Net Income 2011 = $1.946 billion

To pass, the operating cash flow must exceed the net income. American 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.

  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 = $50.455 billion

  • Total Assets - 2011 = $52.223 billion

  • Equals an increase of 3.50%

  • Total Liabilities 2010 = $36.833 billion

  • Total liabilities 2011 = $37.559 billion

  • Equals an increase of 1.97%

American Electric Power's increase in total assets was more than the percentage increase of total liabilities. Total assets increased by 3.50%, while the total liabilities increased by 1.97%. As the total assets exceeded the total liabilities, American Electric Power passes.

  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 = 0.77

  • Current Ratio 2011 = 0.63

American Electric Power's current ratio dropped from 0.77 in 2010 to 0.63 in 2011. As American Electric Power's current ratio dropped American Electric Power does not pass.

  1. Shares Outstanding
  • 2010 Shares Outstanding = 480.81 billion

  • 2011 Shares Outstanding = 483.42 billion

To pass, the company's shares must increase less than by 2%. American Electric Power's shares increased by 0.54%. American Electric Power 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 = $9.398 billion/ $14.427 billion = 65.14%
  • Gross Margin 2011 = $9.504 billion/ $15.116 billion = 62.87%

The gross margin decreased from 65.14% in 2010 to 62.87% in 2011. As the gross margin decreased, American Electric Power 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 = $14.427 billion

  • Sales growth - 2011 sales = $15.116 billion

  • 4.77% sales increase

  • Asset growth - Assets in 2010 = $50.455 billion

  • Asset growth - Assets in 2011 = $52.223 billion

  • Asset increase of 3.50%

As the sales growth is exceeding the asset growth, this implies that the company is producing revenue on its assets. American Electric Power passes.

Based on the nine tests that American Electric Power received on profitability, debt and capital, and operating efficiency, the company achieved seven passes out of nine - this is a strong grade for financial health. American Electric Power did not pass the working capital and the Gross margin aspects of the test. As the company did not pass the working capital aspect of the test, this implies that the company did not have as much liquidity as the previous year. The gross margin aspect of the test reveals that the company was not as efficient in its manufacturing and distribution during the production process. These are a couple of aspects of the company to watch moving forward. Based on the nine tests, overall, the company is strong good results with seven passes out of nine.

Source: American Electric Power Company: Inside The Numbers