Analysis of Financial Annual Reports

4900 words (20 pages) Essay

16th Jul 2018 Accounting Reference this

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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.

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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.

“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

Total Assets

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)

Description

2007

2006

2005

2004

2003

Long Term Assets

19447

16851

14235

12229

10541

Current Assets

         

Inventories

7144

6635

5850

4584

3968

Accounts Receivables (Included in Others)

         

Others

1170

1153

1016

1938

1600

Total Current Assets

8314

7788

6866

6522

5568

Total Assets

27761

24639

21101

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