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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 Baker Hughes Inc.'s (BHI) profitability, debt and capital, and operating efficiency. Based on these criteria, we get to see sales, returns, margins, liabilities, assets, returns, and turnovers.

All numbers sourced from Morningstar and company website

Profitability

Profitability is a class of financial metrics 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.

  1. Net Income 2011 = $1.739 billion

To pass, the company needs to have a positive net income. Baker Hughes passes.

  1. Operating Cash Flow 2011 = $2.600 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. Baker Hughes 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 = 3.53%

  • ROA in 2011 = 7.00%

  • Net income growth 2010 = $812 million to 2011 = $1.739 billion, a increase of 114.16%

  • Total Asset growth 2010 = $22.986 billion to 2011 = $24.847 billion, an increase of 8.09%

In 2010-11, Potash's ROA increased from 3.53% to 7.00%. As the ROA increased, Baker Hughes 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 = $2.600 billion

  • Net Income 2011 = $1.739 billion

To pass, the operating cash flow must exceed the net income. As operating cash flow exceeds net income, Baker Hughes passes.

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 = $22.986 billion

  • Total Assets -- 2011 = $24.847 billion

  • Equals an increase of 8.09%

  • Total Liabilities 2010 = $8.886 billion

  • Total liabilities 2011 = $9.101 billion

  • Equals an increase of 2.42%

Baker Hughes increase in total assets was more the percentage increase of total liabilities. Total assets increased by 8.09%, while the total liabilities increased by 2.42%. As the total assets increased more than the total liabilities, Baker Hughes 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 = 2.77

  • Current Ratio 2011 = 2.80

Baker Hughes current ratio increased from 2.77 in 2010 to 2.80 in 2011. As its current ratio increased, Baker Hughes passes.

  1. Shares Outstanding
  • 2010 Shares Outstanding = 432 million

  • 2011 Shares Outstanding = 437 million

To pass, the company's shares must increase less than by 2%. Baker Hughes shares increased by 1.16%. Baker Hughes 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 = $3.230 billion/ $14.414 billion = 22.41%
  • Gross Margin 2011 = $4.567 billion/ $19.831 billion = 23.03%

The gross margin increased from 22.41% in 2010 to 23.03% in 2011. As the gross margin increased, Baker Hughes passes.

  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 = $14,414 billion

  • Sales growth -- 2011 sales = $19,831 billion

  • 37.58% sales increase

  • Total Assets -- 2010 = $22.986 billion

  • Total Assets -- 2011 = $24.847 billion

  • Equals an increase of 8.09%

As the sales growth exceeded the asset growth, this implies that the company is producing revenue on its assets. Baker Hughes passes.

Based on the nine tests that Baker Hughes received on profitability, debt and capital, and operating efficiency, the company achieved nine passes out of nine. This is an excellent grade for financial health. Overall, the company is showing excellent results regarding its financial health.

Source: Baker Hughes: Inside The Numbers