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 ConocoPhillips (NYSE:COP) 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's 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 = $12.436 billion
To pass, the company needs to have a positive net income. ConocoPhillips passes.
- Operating Cash Flow 2011 = $23.001 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. ConocoPhillips 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 = 7.27%
ROA in 2011 = 8.12%
Net income growth, 2010 = $11.358 billion to 2011 = $12.436 billion, a increase of 9.49%
Total Asset growth, 2010 = $156.314 billion to 2011 = $153.230 billion, an decrease of 1.97%
In 2010-11, ConocoPhillips ROA went from 7.27% to 8.12%. As the ROA increased ConocoPhillips 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 = $23.001 billion
Net Income 2011 = $12.436 billion
To pass, the operating cash flow must exceed the net income. ConocoPhillips 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 = $156.314 billion
Total Assets - 2011 = $153.230 billion
Equals an decrease of 1.97%
Total Liabilities 2010 = $87.752 billion
Total liabilities 2011 = $88.006 billion
Equals an increase of 0.29%
ConocoPhillips increase in total assets was less the percentage increase of total liabilities. Total assets decreased by 1.97%, while the total liabilities increased by 0.29%. As the total assets did not exceed the total liabilities, ConocoPhillips 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 = 1.26
- Current Ratio 2011 = 1.07
ConocoPhillips current ratio went from 1.26 in 2010 to 1.07 in 2011. As ConocoPhillips current ratio decreased ConocoPhillips does not pass.
- Shares Outstanding
2010 Shares Outstanding = 1.491 billion
2011 Shares Outstanding = 1.387 billion
To pass, the company's shares must increase less than by 2%. ConocoPhillips shares decreased by 6.98%. ConocoPhillips 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 = $52.269 billion/ $198.655 billion = 26.31%
- Gross Margin 2011 = $54.589 billion/ $251.226 billion = 21.73%
The gross margin decreased from 26.31% in 2010 to 21.73% in 2011. As the gross margin decreased, ConocoPhillips 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 = $198.655 billion
Sales growth - 2011 sales = $251.226 billion
26.46% sales increase
Asset growth - Assets in 2010 = $156.314 billion
Asset growth - Assets in 2011 = $153.230 billion
Asset decrease of 1.97%
As the sales growth exceeded the asset growth, this implies that the company is producing revenue on its assets. ConocoPhillips passes.
Based on the nine tests that ConocoPhillips received on profitability, debt and capital, and operating efficiency, the company achieved six passes, out of nine - this is a very good grade for financial health. ConocoPhillips did not pass the TL/A ratio, the working capital and the gross margin aspects of the test. As the company did not pass the TL/A ratio this implies that the company is financing its assets through debt. 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 it did a year ago, while as the company did not pass the gross margin aspect of the test this reveals that the company was not as efficient in its manufacturing and distribution during the production process as the previous year. These are a few of aspects of the company to watch moving forward, but overall the company looks to be very good regarding financial health. Based on the nine tests, overall, the company is showing very good results.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.