Analysis of Financial Annual Reports

Analysis of Financial Annual ReportsThe family unit Depot and Lowes Companies are major(ip) American home improvement retailers, keen rivals with plate Improvement leading both in gross revenue and in lettuces. This assignment aims to analyse their operable and monetary results in detail for a spot of vanadium 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 EndingYear EndingYear EndingYear EndingYear EndingHome DepotJanuary 28, 2007January 29, 2006January 30, 2005February 1, 2004February 2, 2003LowesFebruary 2, 2007February 3, 2006January 28, 2005January 30, 2004January 31, 2003The working(a) details and pecuniary calculations habituated for the analysis are available in the appendices at the end of the assignment.Whilst the ii companies operate in the same market and are keen rivals, with Lowes 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 Lowes, both in sales and in additions.The analysis of the financial statements of the two companies for the five years 2002 to 2006 covers issues identical 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 name 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 received assets and current liabilities, and locate and investigate anomalies that arise from year to year.While it is useful to go through the absolute quantum of from each one asset, indebtedness 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 a nonher for the current or preceding(prenominal) years, hardly 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--vis the industry or competi tion.(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, Lowes, 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 demand comfortable gross(a) and Operating profit margins. Whilst GP margins suffer 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 fr om 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 non negate) the chess opening 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 tilt 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 early(a) factors like (a) the appraise 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 companys effective liability becomes lower than normal), (e) uncollected receivables bearing little or no interest, (e) obsolete or slow wretched 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 Lowes reveals that the company (a) operates a have got 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 companys 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 subseq uently (f) has entered into an agreement with GG whereby GE funds the companys proprietary credit control panel purchases (g) values assets at cost and depreciates them over their useful lives (h) undertakes self insurance for certain liabilities relating to workmens compensation, automobile, property and general and product liability claims. (Annual Reports of Lowes 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 motion 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 retribution 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 liabi lities, 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 thanksgiving 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 materialised in the market. With the companies having receivables that could change on the basis of the post sales performance of p roducts, uncomely 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 Lowes 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 e 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 free 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 pra ctices 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. other 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 unfavourable effects upon the companys 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 Lowes, an impartial evaluation of accounting policies and procedures indicates Lowes to be more carefully run. Whilst the current depression in the housing market is keeping investors international from home improvement companies, Lowes could well prove to be better equipped to riding out the current crisis and therefore a safer investment.AppendicesAll figures in Million US Dollars (unless otherwise stated)1. vermiform process ABalance Sheet of the Home DepotDescription20072006200520042003Long margin Assets3426329136247472111118094 flow AssetsInventories12822114011007690768388Accounts Receivables32232396149410971072Others19551472270331552507 bring Current Assets1800015269142731332811917Total Assets5226344405390203443730011Current LiabilitiesAccounts dues73566032576651594560Others55756674468943953475Total12931127061045595548035Debt11643267221488561321Others2659211822591620853Equity2503026909241582240719802Total Liabilities52263444053902034437300112. appurtenance B get and Loss Account of the Home DepotDescription20072006200520042003Net sales9038781511730946481658247Percentage Change10.8911.5112.7711.28Cost of sales6105454191486644423640139Gross Profit2978327320244302058018108Operating Expenses2011017957165041373412278O perating Profits (before amour and Tax)96739363792668465830Finance Charges36581143(42)Profit before Tax93089282791268435872Percentage Change171617Tax35473444291125392208Profits after Tax57615838500143043664Basis Earnings per share2.802.732.271.881.563. Appendix CRatio Analysis of Home Depot Financial and Operational ResultsA. Profitability Ratios1. Return on great(p) employ = Operating Profits (before fill and Tax)/ Capital EmployedDetails20072006200520042003Capital Employed is equal to Total Assets less Current Liabilities3933231699285752448322076Operating Profits (before pursuit and Tax)96739363792668465830Return on Capital Employed (%)24.5929.5327.7327.9626.412. Asset Turnover Ratio = Sales/ Capital EmployedDetails20072006200520042003Capital Employed is equal to Total assets less Current Liabilities3933231699285752448322076Sales9038781511730946481658247Asset Turnover Ratio2.292.572.562.652.643. Gross Profit Margin = Gross Profit/ Sales * 100Details20072006200520042003Gross P rofit2978327320244302058018108Sales9038781511730946481658247Gross Profit Margin (%)32.9533.5733.4231.7531.094. Operating Profit Margin = Operating Profit (Profit before Interest and Tax) / Sales * 100Details20072006200520042003Operating Profits (before Interest and Tax)96739363792668465830Sales9038781511730946481658247Operating Profit Margin (%)10.7011.4410.8410.5610.01B. Asset Turnover Ratios5. Long Term Assets Turnover = Sales/ Long Term AssetsDetails20072006200520042003Long Term Assets3426329136247472111118094Sales9038781511730946481658247Long Term Assets Turnover2.632.802.953.073.22C. Liquidity Ratios6. Current Ratio = Current Assets / Current LiabilitiesDetails20072006200520042003Current Assets1800015269142731332811917Current Liabilities12931127061045595548035Current Ratio1.391.201.371.401.487. Accounts Payable Cover = Current Assets / Accounts PayablesDetails20072006200520042003Current Assets1800015269142731332811917Accounts Payables73566032576651594560Accounts Payable Cover2. 452.532.482.582.61D. Capital Structure, Gearing and Risk Ratios8. Gearing Ratio = Long Term Debt/ Capital EmployedDetails20072006200520042003Long Term Debt11643267221488561321Capital Employed = Total Assets less Current Liabilities3933231699285752448322076Gearing Ratio0.300.080.080.040.069. Shareholders Ratio = Shareholders Funds/ Capital EmployedDetails20072006200520042003Shareholders Funds2503026909241582240719802Capital Employed3933231699285752448322076Shareholders Ratio0.640.850.850.920.9010. Interest Cover = Profit before Interest and Tax/ InterestDetails20072006200520042003Operating Profits (before Interest and Tax)96739363792668465830Finance Charges36581143(42)Interest Cover26.51155662282NA4. Appendix DBalance Sheet of Lowes CompaniesAll figures in Million US Dollars (unless otherwise stated)Description20072006200520042003Long Term Assets1944716851142351222910541Current AssetsInventories71446635585045843968Accounts Receivables (Included in Others)Others11701153101619381600Tot al Current Assets83147788686665225568Total Assets277612463921101