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Red Book Financial Analysis Project

Home Depot and Lowe’s

By: Joshua Klein

Partner: Andrew Freeman

ACC 211 C

December 5, 2008

  1. Quantitative Analysis

Do you believe the operations your corporations are engaged in will still be in good business activities in the next five to ten years? Why?

Yes, I believe that The Home Depot, Inc. and Lowe’s Company, Inc. will still be engaged in good business activities in the coming future. Since the economic situation that the United States is currently in forces me to believe that the general public is going to continue their home improvements by themselves as opposed to hiring people at more costly prices.

Do the corporations you have selected have basically one product or service or many? Do they have few customers or many? What situation do you believe is preferable? Explain briefly.

Both corporations sell “do it yourself” products that range from flooring, to painting, to kitchen work. Also, these companies offer services to instruct their customers on how to go about completing certain tasks. Home Depot and Lowe’s both have a very large customer base. Also, since they can sell their products for much less than contractors would, people are attracted to these companies. I believe that having the large range of products all within a certain category and a large customer base is very preferable and seems to be profitable. Moreover, since the products sold at both companies do not perish, there is no pressure for turnover.

Do the corporations you have selected sell their products or services mainly in the United States or worldwide? If they have worldwide operations, what is their political and economic exposure in the countries they operate? What geographical business approach do you prefer?

Home Depot and Lowe’s mainly sell their products domestically in the United States. However, both companies have store locations in Canada. While Home Depot already has stores in Mexico and China, Lowe’s does not but is planning on building in Mexico soon. In order to sell in other countries, Home Depot and Lowe’s need to figure out which countries will have similar guidelines when it comes to home improvement. Obviously, certain countries that do not have a similar economic standing to the United States, Canada, and Mexico may not have any need for home improvement stores and thus the companies will not be profitable. I do prefer having a worldwide business operation. Having an international business approach is important to get the name of your company out there and see where there may be needs for home improvement products in the world. However, this worldwide approach needs to be well thought out and needs to be carried out in a delicate fashion.

Was there something in your reading of the contingencies that would negatively affect your judgment about the future growth of the corporations you selected?

Home Depot has displayed that they are currently involved in a number of legal issues that could potentially pose a detriment to future operations and increased costs for the company. On the other hand, Lowe’s is only involved in legal cases that they consider “normal”. Lowe’s does not believe that their cases will be considered material. After learning this information, I do not believe that either company will change day to day operations.

Perhaps as a compendium of all the above, do you believe that from a growth of business point of view, the corporations you selected will grow significantly in future years. (Remember, there are no guarantees in life, and the only person that does not make mistakes is the one that never makes a decision to takes any action. On the other hand, will you be willing to support your decision with your money or your job if this were a real life situation?)

I do believe that Home Depot and Lowe’s can grow but there will eventually be a point where there will not be any more home improvement to be done. Unless there is a huge technological breakthrough, people will only have so much improvement to do and will not be willing to do anymore. There is only so much that a nonprofessional will do on his/her own.

  1. Quantitative Analysis (All Numbers in Millions)
  1. Tests of Profitability and Efficiency (Using Mainly Income Statement Data)
  1. Gross Profit Ratio = Gross Profit

Net Sales

  1. Home Depot = (25,997) / (77,349) = .3361 = 33.61%
  2. Lowe’s = (16,727) / (48,283) =.3464 = 34.64%
  1. Expense Ratio = Each Category of Expense

Net Sales

  1. Home Depot
  2. Cost of Sales = (51,352) / (77,349) = 66.39%
  3. Selling General and Administrative = (17,053) / (77,349) = 22.05%
  4. Depreciation and Amortization = (1,702) / (77,349) = 2.20%
  5. Lowe’s
  6. Cost of Sales = (31,556) / (48,283) = 65.36%
  7. Selling General and Administrative = (10,515) / (48,283) = 21.78%
  8. Others = (1,507) / (48,283) = 3.12%
  1. Net Profit Margin = Net Income

Net Sales

  1. Home Depot = (4,395) / (77,349) = .0568 = 5.68%
  2. Lowe’s = (2,809) / (48,283) = .0582 = 5.82%

Home Depot (In Millions): Vertical Analysis

Year 3 2008 / % / Year 2 2007 / % / Year 1 2006 / %
Net Revenue / 77,349 / 100 / 79,022 / 100 / 77,091 / 100
Cost of Sales / 51,352 / 66.4 / 52,476 / 66.4 / 51,081 / 66.3
Gross Profit / 25,997 / 33.6 / 26,546 / 33.6 / 25,938 / 33.6
Total Operating Expenses / 18,755 / 24.2 / 17,680 / 24.3 / 16,891 / 22.4
Income from Operations / 7,242 / 9.4 / 8,866 / 9.4 / 9,047 / 11.2
Net Interest / 622 / 0.8 / 364 / 0.8 / 80 / 0.5
Income before Taxes / 6,620 / 8.6 / 8,502 / 8.6 / 8,967 / 10.8
Income Taxes / 2,410 / 3.1 / 3,236 / 3.1 / 3,326 / 4.1
Net Income / 4,395 / 5.7 / 5,761 / 7.3 / 5,838 / 7.6

Lowe’s (In Millions): Vertical Analysis

Year 3 2008 / % / Year 2 2007 / % / Year 1 2006 / %
Net Revenue / 48,283 / 100 / 46,927 / 100 / 43,243 / 100
Cost of Sales / 31,556 / 65.36 / 30,729 / 65.48 / 28,453 / 65.8
Gross Profit / 16,727 / 34.64 / 16,198 / 34.52 / 14,790 / 34.2
Total Operating Expenses / 12,216 / 25.3 / 11,200 / 23.87 / 10,294 / 23.81
Income from Operations
Net Interest / 194 / 0.4 / 154 / 0.33 / 158 / 0.37
Income before Taxes / 4,511 / 9.34 / 4,998 / 10.65 / 4,496 / 10.39
Income Taxes / 1,702 / 3.52 / 1,893 / 4.03 / 1,731 / 4.0
Net Income / 2,809 / 5.82 / 3,105 / 6.62 / 2,765 / 6.39
  1. What are the trends of Revenues, Gross Profit, Expenses, Operating Income and Net Income
  2. What do they tell you?
  3. If there are major differences from year to year what could be the reasons for these?
  4. Which corporation presents the better operational picture?

Home Depot:

  1. For Home Depot, all forms of income (Revenue, Gross Profit, Operating Income, and Net Income) have decreased over the past three years while operating expenses have increased.
  2. These trends tell me that Home Depot is having a struggle to continue selling their products at lower prices. Because of this, they are forced to increase prices and thus sales decrease. When sales decrease, profits also will drop.
  3. There are no major differences. From year to year I am only noticing a slow downfall. The problem that can be attributed to this could be the slumping housing market.
  4. Of the two corporations, Home Depot seems to be in worse shape that Lowe’s according to vertical analysis. While their sales are falling and expenses are growing, Lowe’s seems to be operating with fewer decreases and is thus more promising.

Lowe’s:

  1. Lowe’s revenues, gross profit and expenses have risen, but their net income fell a little.
  2. These trends tell me that Lowe’s experienced an increase in sales even though they also had a greater increase in expenses. Since the expenses went up even more than their sales did, they experienced a decrease in net income.
  3. There are no major differences from year to year. Their sales are going up as well as their expenses, which unfortunately has gone up more than their sales have.
  4. Of the two corporations, Home Depot seems to be in worse shape that Lowe’s according to vertical analysis. While their sales are falling and expenses are growing, Lowe’s seems to be operating with fewer decreases and is thus more promising.

What do you consider a more important measurement of profitability, growth in operating income or net income? Why?

Home Depot:

I believe net income is a more important measurement of profitability because it would mean that a company is increasing revenue while keeping its expenses down. In the case of Home Depot, they seem to be in a little bit of financial trouble by not being able to keep their expenses down. Meanwhile, their sales have not been increasing either which both hurt their net income.

Lowes:

I believe net income is a more important measurement of profitability because it would mean that a company is increasing revenue while keeping its expenses down. Lowe’s has both revenue and expenses increasing. Even though they are increasing their expenses, eventually they will find a way to decrease their expenses and hopefully keep their sales up. This would result in a higher net income.

If any of the two corporations being reviewed suffered losses what was the cause were the losses due to extraordinary circumstances? In your opinion, how important is this?

Neither of the corporations suffered from a net loss over the period.

  1. Return on Total Assets = (Net Income + Interest Expense (Net of Tax))

Average Total Assets

  1. Home Depot
  2. 2008 = (4,395+622) / [(44,324+52,263)/2] = .1039 = 10.39%
  3. 2007 = (5,761+364) / [(52,263+44,405)/2] = .1266 = 12.67%
  4. Lowe’s
  5. 2008 = (2,809+194) / [(30,869+27,767)/2] = .1024 = 10.24%
  6. 2007 = (3,105+154) / [( 27,767+24,639)/2] = .1244 = 12.44%
  1. Fixed Assets Turnover Ratio = Net Sales Revenue

Average Total Assets

  1. Home Depot
  2. 2008 = (77,349) / [(44,324+52,263)/2] = 1.6016
  3. 2007 = (79,022) / [( 52,263+44,405)/2] = 1.6349
  4. Lowe’s
  5. 2008 = (48,283) / [(30,869+27,767)/2] = 1.6469
  6. 2007 = (46,927) / [( 27,767+24,639)/2] = 1.7909
  1. Return on Equity = Net Income _ Preferred

(From Continuing Operations) Dividends

Average Stockholder Equity

  1. Home Depot
  2. 2008 = (4395-0) / [(17,714+25,030)/2] = .2056 = 20.56%
  3. 2007 = (5,761-0) / [( 25,030+26,909)/2] = .2218 = 22.18%
  4. Lowe’s
  5. 2008 = (2,809-0) / [(16,098,+ 15,725)/2] = .1765 = 17.65%
  6. 2007 = (3,105-0) / [( 15,725+14,296)/2] = .2068 = 20.68%
  1. Receivables Turnover Ratio = Net Sales

Average Accounts Receivable

  1. Home Depot
  2. 2008 = (77,349) / [( 1,259+3,223)/2] = 34.52
  3. 2007 = (79,022) / [( 3,223+2,396)/2] = 28.13
  4. Lowe’s
  5. 2008 = (48,283) / [( 247+161)/2] = 236.68
  6. 2007= (46,927) / [( 161+173)/2] = 281.00
  1. Inventory Turnover Ratio = Cost Of Goods Sold

Average Inventory

  1. Home Depot
  2. 2008 = (51,352) / [(11,731+12,822)/2] = 4.18
  3. 2007 = (52,476) / [( 12,822+11,401)/2] = 4.33
  4. Lowe’s
  5. 2008 = (31,556) / [( 7,611+7,144)/2] = 4.28
  6. 2007 = (30,729) / [(7,144+6,635)/2] = 4.46

Efficiency:

365 Days = (Days accounts receivable are outstanding)

Receivables Turnover Ratio

Home Depot:

(365) / (34.52) = 10.57

Lowe’s:

(365) / (236.68) =1.54

Efficiency:

365 Days = (Days it takes to turnover the inventories)

Inventory Turnover Ratio

Home Depot:

(365) / (4.18) = 87.32

Lowe’s:

(365) / (4.28) = 85.28

Action Required From Students

Home Depot:

Return on total assets = 2008 = 10.39%

2007 = 12.67%

Lowe’s:

Return on total assets = 2008 = 10.24%

2007 = 12.44%

What Do You Think

Which of the two corporations uses its assets more efficiently? Why do you think this may be the case?

Even though I believe that both Home Depot and Lowe’s use their assets very efficiently, I would have to say that Home Depot does a slightly better job at this. While both companies experienced a decrease in assets from 2007 to 2008, Home Depot’s was slightly larger than that of Lowe’s. This could be the result of many different things such as Lowe’s reacting better to the economic crisis which has allowed them to minimize their decreases in assets. Aside from looking at the exact decreases and comparing them to one another, the companies are basically the same in terms of asset usage.

Home Depot

Return on Equity= 2008= 20.56%

2007= 22.18%

Lowe’s

Return on Equity = 2008 = 17.65%

2007 = 20.68%

What Do You Think

What do the above numbers tell you? Some analysts strongly believe that it is unwise for a corporation to retain earnings if the ratio of return on equity is not satisfactory. Some investors believe that the payment of dividends is always a good measurement as to the soundness of their investment in the corporation. Other investors prefer a stock buy back. What are your ideas on all of these areas?

Lowe’s has a better ratio of return on equity than Home Depot which basically means that Lowe’s is better at turning their returns on equity into income. Between buying back stock or paying dividends, I would have to say that paying dividends shows more strength and soundness of a company. If a company buys back stock as an investment, I do not believe that it would show any extra signs of stability other than the hope that the stock values will increase over time. With the payment of dividends, it shows that the company has the money to pay back to its investors. Either way, however, there is no single good measurement of a company’s strength and stability; many different factors need to be taken into account.

Home Depot

Receivables Turnover Ratio = 2008 = 34.52

2007 = 28.13

Lowe’s

Receivables Turnover Ratio = 2008 = 236.68

2007 = 281.00

What Do You Think

Management of ABC Corp. is proposing that commissions to sales personnel be paid based on collection and not on credit sales as presently being done. Would you approve of this change if you were in charge of marketing ABC Corp?

If I was in charge of marketing for ABC Corp, I would definitely approve of this decision. The decision to pay the sales personnel commission based on cash collection sales rather than on credit sales would really improve the money ABC receives up front. With more emphasis being placed on cash sales, the receivables account would be much less and the actual money on hand would be much higher. There would not be as high of a risk in waiting for the sales to arrive than actually having the money right away.

Present one idea as to how your company can reduce the number of days the receivables are uncollected.

The easiest way to reduce the number of days the receivables are uncollected is probably to increase the discount over a shorter period of time so that it is smarter for the owing company to pay sooner. This would obviously take away from my company’s ability to collect more money but I would still receive most of what I am owed instead of nothing at all in some cases.

Home Depot:

Inventory Turnover Ratio = 2008 = 4.18

2007 = 4.33

Lowe’s

Inventory Turnover Ratio = 2008 = 4.28

2007 = 4.46

What Do You Think

Which of the two corporations manage their inventories more efficiently? Why is not “moving” your inventory a negative factor?

Lowe’s manages its inventory slightly better than Home Depot. The change from 2007 to 2008 for both companies is close to the industry average of 4.2. To me, not moving the inventory is very bad for a company, especially a company in the retail market. When inventory sits around on the shelves for a while, it will appear to the customers that it is stale and “not wanted” by the general public. In the food industry, companies have to even deal with food going bad over time. In general, it is very important for a company to give off an image that their products are always new and always a hot commodity for the customers.

Give one policy you will implement in order to keep your inventories low.

For my company to keep my inventory always moving, I would have to implement a very strict policy that would keep tabs of which products are seasonal, which are more needed by the general public and which do not seem to move off the shelves. By taking all of these factors, as well as many others, the products that are purchased or not purchased depending on the situation will always make the store look as if items are being sold and replenished. The products that go stale will not be replenished and thus money will not be wasted on them.

B. Tests of Profitability and Efficiency (Using Mostly Data from the Statement of Cash Flows)

1)Quality of Income Ratio=Cash Flows From Operating Activities

Net Income

  1. Home Depot
  2. 2008 = (5,727) / (4,395) = 1.3031
  3. 2007 = (7,661) / (5,761) = 1.3298
  4. Lowe’s
  5. 2008 = (4,347) / (2,809) = 1.5475
  6. 2007 = (4,502) / (3,105) = 1.4499

2)PPE Acquisition Ratio = Cash Flow From Operating Activities

Cash Paid For PPE

  1. Home Depot
  2. 2008 = (5,727) / (3,558) = 1.6096
  3. 2007 = (7,661) / (3,542) = 2.1629
  4. Lowe’s
  5. 2008 = (4,347) / (4,010) = 1.0840
  6. 2007 = (4,502) / (3,916) = 1.1496

Action Required From Students

HomeDepot

Quality of Income Ratio = 2008 = 1.3031

2007 = 1.3298

Lowe’s

Quality of Income Ratio = 2008 = 1.5475

2007 = 1.4499

What Do You Think

How do the two corporations you are reviewing compare? If you were management of either corporation what would you recommend to improve the above ratios?

In comparison, Lowe’s does a much better job of turning their inventories and receivables into cash. While Home Depot’s ratios are not bad, Lowe’s simply does a better job at this which leads me to believe that Lowe’s does not usually have a problem with collecting from those who pay on credit. For Home Depot to improve their ratios, it would be important to stress collection from those who owe them as well as not hanging onto inventory that does not sell.

Examples of Red Flag Warnings - Home Depot

Year 3 / Year 2 / Year 1
Revenues / 77,349 / 79,022 / 77,019
% Change / -2.12% / +2.60% / -
Accounts Receivable / 1,259 / 3,223 / 2,396
% Change / -60.94% / +34.52% / -
Inventories / 11,731 / 12,822 / 11,401
% Change / -8.5% / +12.46% / -

What Do You Think

Does a percentage of growth in Accounts Receivable and Inventories greatly exceed that in Revenues?

The accounts receivables and inventories are down which means that Home Depot is not in danger of any red flags. In fact, Home Depot was able to minimize their accounts receivables from the previous year, even though their inventories were down in relation to its revenues.

Examples of Red Flag Warnings- Lowe’s

Year 3 / Year 2 / Year 1
Revenues / 48,283 / 46,927 / 43,243
% Change / +2.89% / +8.52% / -
Accounts Receivable / 247 / 161 / 173
% Change / +53.42% / -6.94% / -
Inventories / 7,611 / 7,144 / 6,635
% Change / +6.54% / +7.67% / -

What Do You Think

Does a percentage of growth in Accounts Receivable and Inventories greatly exceed that in Revenues?

The fact that Lowe’s has significantly increased the size of their accounts receivable causes me to worry about their future in terms of collecting money. It would be wise to keep track of this even though Lowe’s has a rather small accounts receivable given the size of their company.

Home Depot

Property Plant and Equipment = 1.6096

Acquisition Ratio

Lowe’s

Property Plant and Equipment = 1.0840

Acquisition Ratio

What Do You Think

How do the two corporations compare? What would you recommend to improve the above ratios? Are there any potential problems that could originate from your recommendation?

Home Depot has a much better PPE acquisition ratio than Lowe’s. Lowe’s has a low ratio which may be due to spending too much on capital expenditures. To solve this problem, it may be wise for Lowe’s to decrease the amount that they spend on property, plants, and equipment. If Lowe’s spends too little on PPE, however, then their company will not grow and look stagnant to the general public in a very competitive market.

Interpret the financial activities section of each corporation. What can you tell from your analysis?

Home Depot:

To me, it seems as if Home Depot is making an added effort in buying back stock and issuing dividends to their stockholders. By doing this, it seems as if they are trying to bolster their image to the public. This may not be a wise decision, though, given that we are not in the best of times in terms of the economy.

Lowe’s

Everything about Lowes’ numbers shows that the company is expanding. Even though Lowe’s did buy back some stock, they also took out loans to expand the company. On the other hand, Lowe’s did take a substantial hit in the debt department by taking out these loans which could become an issue when it becomes time to pay them back.