The Home Depot and Lowe’s Companies are major American home improvement retailers, keen rivals with Home Improvement leading both in sales and in profits. This assignment aims to analyse their operational and financial results in detail for a period of five years, namely 2002 to 2006 on the basis of the following Annual Reports filed by the companies with the Securities Exchange Commission (SEC)
Company
Year Ending
Year Ending
Year Ending
Year Ending
Year Ending
Home Depot
January 28, 2007
January 29, 2006
January 30, 2005
February 1, 2004
February 2, 2003
Lowe’s
February 2, 2007
February 3, 2006
January 28, 2005
January 30, 2004
January 31, 2003
The working details and financial calculations used for the analysis are available in the appendices at the end of the assignment.
Whilst the two companies operate in the same market and are keen rivals, with Lowe’s’ being the nearest competitor to The Home Depot, the actual distance between these two is prima facie substantial with The Home Depot being practically two times the size of Lowe’s, both in sales and in profits.
The analysis of the financial statements of the two companies for the five years 2002 to 2006 covers issues like the percentage increase in sales and profits during this period, as well as the analysis of a number of ratios that indicate (a) year on year increase of turnover and profits, (b) profitability, (c) use of long term assets, capital employed and working capital, and (d) capital gearing. An analysis and comparison of various financial and operational ratios over a period of a number of years helps in validating the authenticity of presented figures by enabling analysts to compare related figures, for example year on year increases in sales and profits, and the relationships between sales and profits, sales and capital employed, and current assets and current liabilities, and locate and investigate anomalies that arise from year to year.
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“While it is useful to understand the absolute quantum of each asset, liability and revenue item in isolation, far greater understanding of its implication with respect to the trend and performance of the company can be achieved by a `relationship’ study. For instance, if one studies profits in relation to sales for the current year and compares it with the same relationship for a series of years, a greater understanding of the trend and performance can be had. The `relationship’ study referred has two facets: i) the relationship of one item to another for the current or previous years, but in respect of the same company, and ii) the relationship of these parameters with industry figures or representative figures of competitors or of firms of similar size and operations. The first set enables one to understand the performance of the company in isolation, while the second gives an insight as to where the company stands vis-à-vis the industry or competition.”
(Osteryoung & Others, 1992, p72)
The following inferences can be drawn on the basis of information culled from the audited financial accounts and filed with the SEC.
Whilst The Home Depot has been growing at a steady pace of around 10 to 11 % during the specified five year period, Lowe’s, which recorded a much higher pace of growth (of around 18 %) during the first four years found its year on year increase slowing to 8 % in the fifth (last) year. Both companies have comfortable Gross and Operating profit margins. Whilst GP margins have consistently been in the region of 30 %, Operating profit margins have remained at around 10 to 11 percent. Although both companies maintained their profitability margins during the five years, the profit before tax for The Home Depot was eroded significantly in 2006 because of substantial increase in finance charges, consequent to significant increase in debt. This increase in debt has increased the capital gearing ratio of the company from a low 0.08 to a more comfortable 0.30. An analysis of various operational ratios for both the companies over the five year period, by and large, indicates substantial stability in their operations. Practically all ratios, ( and that too for both the companies), be they return on capital employed, asset utilisation, profitability, liquidity, working capital, or capital gearing, are remarkably stable from year to year for all five years, a fact that counters, (even if it does not negate) the possibility of manipulation of figures. The single large scale departure from the norm occurs in the case of capital gearing ratios for The Home Depot but that is explained by the increase in debt from 2672 million USD for the company in 2006 to 11643 million USD in 2007, a fact that also explains the change in interest cover and profit before tax for 2007.
A detailed ratio analysis of the figures made available in the financial statements filed by the two companies with the SEC would thus tend to indicate (a) that both companies are progressing well, both in sales and in operational results, and (b) that the figures presented can be taken to be fair and representative of the working of the companies.
Gauging the fairness and reliability of information available in the financial statements is however a far more complex exercise, the validity of the presented figures also depending upon other factors like (a) the value of plant, property and equipment, which may be depreciated on historical cost and thus be recorded at values much below current market rates, (b) securities reported at lower of cost or market, which usually means a recorded value below the current market rate, (c) recording of inventories at LIFO, whereas replacement costs are usually higher, (d) recording of debts or leases at favourable rates, (which amount to unrecorded assets because the company’s effective liability becomes lower than normal), (e) uncollected receivables bearing little or no interest, (e) obsolete or slow moving inventories, (f) under or overstatement of contingent liabilities such as threatened or imminent lawsuits, employee settlements like dismissal recompense, service and incentive contracts, obligations for goods returns and discounts, merchandise warranties, and guarantees of third-party borrowing. (Radebaugh & Others, 2006)
An analysis of the accounting policies and procedures of Lowe’s reveals that the company (a) operates a reserve for losses on obsolete inventory, inventory shrinkage, and sales returns, which is adjusted and charged to earnings every year, (b) records receivables that may change depending upon the performance of the company’s products, (c) does not have off balance sheet financing, apart from executing operating leases (d) monitors risks that could arise out of change in interest in long term debt, (e) has entered into an arrangement with GE in 2004 for sale of existing accounts receivables and those that would arise subsequently (f) has entered into an agreement with GG whereby GE funds the company’s proprietary credit card purchases (g) values assets at cost and depreciates them over their useful lives (h) undertakes self insurance for certain liabilities relating to workmen’s compensation, automobile, property and general and product liability claims. (Annual Reports of Lowe’s Companies, 2003 to 2007)
Whilst The Home Depot also by and large follows similar principles, the company (a) offers credit purchase programmes through third party credit providers, (b) depends substantially for sales achievement on offering extensive credit to customers (c) continually patents its intellectual property, (d) is involved in a large number of legal proceedings that could lead to payment of substantial amounts of money, (e) values inventories at lower of cost or market, a practice that could lead to off balance sheet assets (f) uses a number of estimates for reporting assets, liabilities, contingent liabilities, revenues and expenses, (g) has reasonably high receivables, which it needs to collect and whose accuracy is largely a matter of surmise (h) records assets at cost and depreciates them over their estimated useful lives (i) checks goodwill every year for impairment purposes (j) committed errors in stock option practices that led to an erosion of retained earnings to the tune of 227 million in 2006 (Annual Reports of The Home Depot, 2003 to 2007)
Off balance sheet assets for both of these companies could arise from undervalued plant, property, and equipment, as well as inventories that may be worth more than their recorded value. On the other hand both companies do not have systems strong enough for effective recording of obsolescence, a fact that could lead to certain slow moving inventory items being shown at values higher than what could be realised in the market. With the companies having receivables that could change on the basis of the post sales performance of products, adverse changes in this area could lead to negative effect upon earnings. However it also needs to be considered at this stage that The Home Depot and Lowe’s have large operations and changes arising from behaviour of off balance sheet items could well be negligible in comparison to actual recorded figures.
In value terms much of the difference in the evaluation of balance sheet items could arise from value of plant, property and equipment. With both retailers having extensive prime quality real estate by way of shop space in well frequented locations, the actual value of property may be far in excess of that stated in the financial statements. Whilst an actual quantification of value would have to be preceded by an elaborate exercise, it would be fair to surmise that such a valuation would lead to a substantial enhancement in the market values of both firms.
Both companies recognise revenues when customers take possession of goods, whilst goods that have been paid for but not delivered to customers are shown as deferred revenue. This method is open to criticism because it does not sufficiently provide either for return of goods taken by customers or the possibility of customers not picking up goods for which they have made advance payments. Whilst large sales volume turnovers effectively mask the impact of such basic anomalies in accounting procedures, the adoption of conservative accounting practices for revenue recognition, where sales are confirmed only after customers accept goods as purchased could impact sales volumes significantly. Such a practice would obviously have a strong impact on ratios that concern sales, operations, and profitability.
Whilst an analysis of ratios over a five year period for both companies does indicate long term stability of accounting practices, the accounting practices followed by The Home Depot indicate an excessive preponderance to use estimates and approximations for arriving at revenue figures. Although such practices could be based on past practice as well as eminently reasonable assumptions, the fact that serious errors have occurred in the past, especially in the practice and disclosure of stock options, indicate that the company should implement much stronger systems and adopt more conservative accounting policies. Another issue of concern with The Home Depot is the substantial amount of litigation in which it is currently involved. With the company admitting the possibility of the results of these lawsuits going against the company, the chances of substantial future outflows with adverse effects upon the company’s earnings does exist.
As such, whilst The Home Depot is a far larger company, both by way of sales and by way of profits, than Lowe’s, an impartial evaluation of accounting policies and procedures indicates Lowe’s to be more carefully run. Whilst the current depression in the housing market is keeping investors away from home improvement companies, Lowe’s could well prove to be better equipped to riding out the current crisis and therefore a safer investment.
Appendices
All figures in Million US Dollars (unless otherwise stated)
1. Appendix A
Balance Sheet of the Home Depot
Description
2007
2006
2005
2004
2003
Long Term Assets
34263
29136
24747
21111
18094
Current Assets
Inventories
12822
11401
10076
9076
8388
Accounts Receivables
3223
2396
1494
1097
1072
Others
1955
1472
2703
3155
2507
Total Current Assets
18000
15269
14273
13328
11917
52263
44405
39020
34437
30011
Current Liabilities
Accounts Payables
7356
6032
5766
5159
4560
Others
5575
6674
4689
4395
3475
Total
12931
12706
10455
9554
8035
Debt
11643
2672
2148
856
1321
Others
2659
2118
2259
1620
853
Equity
25030
26909
24158
22407
19802
Total Liabilities
52263
44405
39020
34437
30011
2. Appendix B
Profit and Loss Account of the Home Depot
Description
2007
2006
2005
2004
2003
Net Sales
90387
81511
73094
64816
58247
Percentage Change
10.89
11.51
12.77
11.28
Cost of Sales
61054
54191
48664
44236
40139
Gross Profit
29783
27320
24430
20580
18108
Operating Expenses
20110
17957
16504
13734
12278
Operating Profits (before Interest and Tax)
9673
9363
7926
6846
5830
Finance Charges
365
81
14
3
(42)
Profit before Tax
9308
9282
7912
6843
5872
Percentage Change
–
17
16
17
Tax
3547
3444
2911
2539
2208
Profits after Tax
5761
5838
5001
4304
3664
Basis Earnings per share
2.80
2.73
2.27
1.88
1.56
3. Appendix C
Ratio Analysis of Home Depot Financial and Operational Results
A. Profitability Ratios
1. Return on Capital Employed = Operating Profits (before Interest and Tax)/ Capital Employed
Details
2007
2006
2005
2004
2003
Capital Employed is equal to Total Assets less Current Liabilities
39332
31699
28575
24483
22076
Operating Profits (before Interest and Tax)
9673
9363
7926
6846
5830
Return on Capital Employed (%)
24.59
29.53
27.73
27.96
26.41
2. Asset Turnover Ratio = Sales/ Capital Employed
Details
2007
2006
2005
2004
2003
Capital Employed is equal to Total assets less Current Liabilities
39332
31699
28575
24483
22076
Sales
90387
81511
73094
64816
58247
Asset Turnover Ratio
2.29
2.57
2.56
2.65
2.64
3. Gross Profit Margin = Gross Profit/ Sales * 100
Details
2007
2006
2005
2004
2003
Gross Profit
29783
27320
24430
20580
18108
Sales
90387
81511
73094
64816
58247
Gross Profit Margin (%)
32.95
33.57
33.42
31.75
31.09
4. Operating Profit Margin = Operating Profit (Profit before Interest and Tax) / Sales * 100
Details
2007
2006
2005
2004
2003
Operating Profits (before Interest and Tax)
9673
9363
7926
6846
5830
Sales
90387
81511
73094
64816
58247
Operating Profit Margin (%)
10.70
11.44
10.84
10.56
10.01
B. Asset Turnover Ratios
5. Long Term Assets Turnover = Sales/ Long Term Assets
Details
2007
2006
2005
2004
2003
Long Term Assets
34263
29136
24747
21111
18094
Sales
90387
81511
73094
64816
58247
Long Term Assets Turnover
2.63
2.80
2.95
3.07
3.22
C. Liquidity Ratios
6. Current Ratio = Current Assets / Current Liabilities
Details
2007
2006
2005
2004
2003
Current Assets
18000
15269
14273
13328
11917
Current Liabilities
12931
12706
10455
9554
8035
Current Ratio
1.39
1.20
1.37
1.40
1.48
7. Accounts Payable Cover = Current Assets / Accounts Payables
Details
2007
2006
2005
2004
2003
Current Assets
18000
15269
14273
13328
11917
Accounts Payables
7356
6032
5766
5159
4560
Accounts Payable Cover
2.45
2.53
2.48
2.58
2.61
D. Capital Structure, Gearing and Risk Ratios
8. Gearing Ratio = Long Term Debt/ Capital Employed
Details
2007
2006
2005
2004
2003
Long Term Debt
11643
2672
2148
856
1321
Capital Employed = Total Assets less Current Liabilities
39332
31699
28575
24483
22076
Gearing Ratio
0.30
0.08
0.08
0.04
0.06
9. Shareholder’s Ratio = Shareholder’s Funds/ Capital Employed
Details
2007
2006
2005
2004
2003
Shareholders Funds
25030
26909
24158
22407
19802
Capital Employed
39332
31699
28575
24483
22076
Shareholder’s Ratio
0.64
0.85
0.85
0.92
0.90
10. Interest Cover = Profit before Interest and Tax/ Interest
Details
2007
2006
2005
2004
2003
Operating Profits (before Interest and Tax)
9673
9363
7926
6846
5830
Finance Charges
365
81
14
3
(42)
Interest Cover
26.5
115
566
2282
NA
4. Appendix D
Balance Sheet of Lowe’s Companies
All figures in Million US Dollars (unless otherwise stated)
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