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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 Valero Energy (NYSE:VLO) 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 = $2.090 billion

To pass, the company needs to have a positive net income. Valero Energy passes.

  1. Operating Cash Flow 2011 = $3.680 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. Valero Energy 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 = 0.86%

  • ROA in 2011 = 4.89%

  • Net income growth 2010 = $324 million to 2011 = $2.090 billion, a increase of 645.06%

  • Total Asset growth 2010 = $37.621 billion to 2011 = $42.783 billion, an increase of 13.72%

In 2010-11, Valero's ROA increased from 0.86% to 4.89%. As the ROA increased, Valero Energy 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 = $3.680 billion

  • Net Income 2011 = $2.090 billion

To pass, the operating cash flow must exceed the net income. As operating cash flow exceeds net income, Valero Energy 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 = $37.621 billion

  • Total Assets -- 2011 = $42.783 billion

  • Equals an increase of 13.72%

  • Total Liabilities 2010 = $22.596 billion

  • Total liabilities 2011 = $26.360 billion

  • Equals an increase of 16.66%

Valero Energy's increase in total assets was less than the percentage increase of total liabilities. Total assets increased by 13.72%, while the total liabilities increased by 16.66%. As the total liabilities increased more than the total assets, Valero Energy 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 = 1.54

  • Current Ratio 2011 = 1.26

Valero Energy's current ratio decreased from 1.54 in 2010 to 1.26 in 2011. As its current ratio decreased, Valero Energy does not pass.

  1. Shares Outstanding
  • 2010 Shares Outstanding = 568 million

  • 2011 Shares Outstanding = 569 million

To pass, the company's shares must increase less than by 2%. Valero Energy shares increased by 0.18%. Valero 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 = $3.814 billion/ $82.233 billion = 4.64%
  • Gross Margin 2011 = $5.785 billion/ $125.987 billion = 4.59%

The gross margin decreased from 4.64% in 2010 to 4.59% in 2011. As the gross margin decreased, Valero 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 = $82.233 billion

  • Sales growth -- 2011 sales = $125.987 billion

  • 53.21% sales increase

  • Total Assets -- 2010 = $37.621 billion

  • Total Assets -- 2011 = $42.783 billion

  • Equals an increase of 13.72%

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

Based on the nine tests that Valero Energy received on profitability, debt and capital, and operating efficiency, the company achieved six passes out of nine. This is a good grade for financial health. Valero Energy did not pass the TL/A ratio, working capital and the gross margin aspects of the test. The TL/A ratio indicates that the company financed much of the assets through debt. The working capital aspect of the paper indicates that the company has less liquidity as it did a year ago and the gross margin aspect of the paper reveals that the company was not as efficient in its manufacturing and distribution as it was a year ago. These are a few aspect of the company to watch moving forward. Overall, the company is showing good results regarding its financial health with six passes out of nine.

Source: Valero Energy: Inside The Numbers