Analysis of Financial Annual Reports

Analysis of Financial Annual Reports 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. â€Å"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.†Ã‚   (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 s tability 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 c ontracts, 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