Financial Statements Analysis of Competitors

Financial Statements Analysis of Competitors The two U.S. companies Lowes and Home Depot are two leading competitors on the DYI market who are both listed on the U.S. stock market. You are to carry out a financial statement analysis of these two companies covering the period 2002 to 2006. Specifically, you are to: 1. Analyze and evaluate the balance sheet for assets and liabilities that are not recorded. Kohlbeck (2004) argues that, using the case of banks, few firms disclose the value of their intangible assets, and few provide any information enabling investors to make an informed judgement as to the value of these assets. As such, given that companies will tend to categorise and record the value of all their tangible assets, actually quantifying the value of any assets that are not recorded on the balance sheet is likely to be very difficult. Bodenhorn (1984) argues that non recorded assets can have a value assigned to them from the future value of the cash flows that they will generate. However, again companies rarely assign cash flows to intangible assets, such as branding, further making this difficult. As such, the analysis and evaluation will need to take on a qualitative nature. Both Lowe’s (Shareholder.com, 2008) and Home Depot (SEC, 2008) provide details of cash and cash equivalents, short-term investments, and inventory in their current assets, and land, buildings, equipment, leasehold improvements and construction in progress in their fixed assets. However, Lowe’s does not include any trade receivables in their current assets. This could mean that the company does not have any trade receivables, or it could imply that the company is being prudent, and not recognising these receivables until they have been paid. In addition, Lowe’s does not record any goodwill, which could mean that the company has either not made any acquisitions, that it has only paid market value for them, or that it is not recording the goodwill as it does not see it as a reasonable asset: maybe the value of the goodwill will need to be downgraded. Neither company has recorded any asset value for brand value, employee skills and knowledge, or customer loyalty. Whi lst this is in accordance with international accounting standards, it nevertheless fails to acknowledge what could be a significant source of value for the companies (Quick, 2002). In terms of liabilities that are not recorded, the only potential items which may not have been recorded are pension liabilities, with neither company including them as an item of their annual reports. Whilst the FASB issues Statement No 158 in 2007, which made it a requirement for employers to move pension liabilities onto the balance sheet (Miller and Bahnson, 2007a), this requirement may not yet have impacted on these accounts. Other than this, modern accounting standards generally require that all liabilities be kept on balance sheet, hence there are unlikely to be any other liabilities which are not recorded by the balance sheets. 2. Analyze and evaluate the balance sheet for the current value of assets and liabilities. When determining the current value of assets and liabilities, it is necessary to consider both their balance sheet value and their liquidity (Allen and Carletti, 2006). For example, if inventory has to be sold off quickly, it will rarely achieve its full valuation, and items such as goodwill will have no immediate current value. In contrast, banks can often call in loans and other liabilities at their full value. Applying this to the two balance sheets: Cash and cash equivalents can be counted at full value Short-term investments will be counted at 80% of value, to reflect losses and penalties on disposal Receivables will be counted at 90%, as bad debts will likely increase in the event of a quick sale Merchandise inventories will be counted at 20% to reflect the difficulty in disposing of them Other current assets, deferred income taxes, and goodwill will be excluded, as they have no tangible saleable value. Property and associated fixed assets will be counted at 50%. Long term investments and notes will not be counted, as it may not be possible to recover this money in short order. Lowe’s: ItemBook valueCurrent value Cash and cash equivalents281281 Short-term investments249200 Merchandise inventory7,6111522 Deferred income taxes2470 Other current assets2980 Property, less accumulated depreciation21,36110,681 Long-term investments5090 Other assets3130 Total assets30,86912,684 Total liabilities14,77114,771 Net value16,098(2,087) Home Depot ItemBook valueCurrent value Cash and Cash Equivalents445445 Short-Term Investments129 Receivables, net1,2591,133 Merchandise Inventories11,7312,346 Other Current Assets1,2270 Net Property and Equipment27,47613,738 Notes Receivable3420 Goodwill1,2090 Other Assets6230 Total assets44,32417,671 Total liabilities26,61026,610 Net value17,714(8,939) Whilst this analysis is somewhat basic, and the assumptions contained within it have not been rigorously tested, it demonstrates that, in the event that either company’s full liabilities became payable at short notice, both companies could have difficulty raising enough money to cover them. However, this is unlikely as both companies have a significant amount of their liabilities in the form of long term loans, which are unlikely to become due immediately. 3. Analyze and interpret the effect on financial results and ratios of the companies choices of accounting methods and assumptions made under these accounting methods. In accordance with the US GAAP, both companies declare that they use estimates for determining the carrying value of assets and liabilities which cannot be otherwise determined (Miller and Bahnson, 2007b). As such, both companies acknowledge that the value they have applied to some of their assets and liabilities may be different from their actual value, which would depend on the circumstances in which these items were valued. This has had an effect on the financial results because, if the estimated value is incorrect, it will potentially have an impact on profits and net asset values, and hence affect all ratios which depend on these items. Furthermore, the companies have both declared cash and cash equivalents to be made up of actual cash, cash in deposit accounts, and investments with maturity dates of less than three months from the date of purchase. In addition, they have classified payments made by credit or debit card around the time of preparation of the accounts as being cash equivalents, as they will generally be paid within two or three business days. This has impacted on the value of cash and cash equivalents, and also on the value of trade receivables and short term investments. As such, whilst it will not have affected the value of current assets, choosing different criteria would have led to a different value for cash and cash equivalents, and would thus have affected the quick ratio. When recording merchandise inventory, both companies record the value of their inventory at the lower value of the cost to purchase or the market value, based on the first-in, first-out (FIFO) method of inventory accounting. As such, and as demonstrated by Bruns and Harmeling (1991), the value of inventory recorded in the financial accounts will be different than in another method, such as LIFO, was used to calculate the value of the inventory. This will affect the value of current assets, and also of total and net assets, thus affecting the majority of ratios related to the balance sheet. Lowe’s also records an inventory reserve, which is to be used to cover any loss associated with selling off inventory at less than its book value. This reserve will affect the value of inventory, and will also presumably affect the value of cash and cash equivalents if it is made up of liquid investments which are not held as such. As such, this may further affect several of the company†™s ratios. Finally, both companies use the straight line method to depreciate assets over their useful economic lives. As such, they will produce different values for fixed, total and net assets than they would under different methods of depreciation accounting, which will affect most ratios based on these values. 4. Interpret indicators and determine the companies earnings quality. According to Richardson (2003) some of the primary indicators of a poor earnings quality include an increase in trade receivables; a link between growth in earnings and a reduction in the effective tax rate; capitalising interest payments; and a large number of significant one off items. In addition, an positive correlation between cash flow and earnings, as well as a higher gross margin, indicate a high quality of earnings (Bao and Bao, 2004). Applying this to Lowe’s, there are no figures given for trade receivables in either of the past years. This can be taken to indicate that the company is not owed any significant receivables, thus implying a high quality of earnings. Over the past three years, there has been no noticeable change in the tax rate experienced, however, whilst post tax earnings grew from 2006 to 2007, they fell from 2007 to 2008, which may indicate further future falls in earnings. There is no evidence of a capitalisation in interest payments by the company, and nor are there any major one off items, with the profit and loss account remaining fairly consistent from year to year. Gross margin has also consistently increased, going from 34.2% to 34.64%. However, there has been a larger increase in general expenses, which has caused a fall in overall earnings. There has also been an increase in cash flow over the three years, further indicating high earnings quality. Home Depot has experienced a significant fall in trade receivables over the past two years, and has had no significant change in its tax rate. However, its revenues have decreased over the past three years to a much greater degree than Lowe’s. Whilst part of this can be attributed to a fall in sales over the past two years, it is also due to a significant increase in selling and general expenses, which may also threaten earnings quality. Again, there is no evidence of capitalisation of interest payments or of major one off items. However, whilst Lowe’s has grown its gross margin, Home Depot has experienced no changes in margins, and its cash flows from operating have fallen more significantly than its earnings over the past two years. As such, Home Depot appears to have a much lower quality of earnings when compared to Lowe’s. 5. Discuss which of the two companies think produce more reliable financial reporting and discuss which of them you would choose to invest in. You have to use many ratios (the most common ratios), you have not a limited number of ratios to use in your analysis. From the examination of the financial statements discussed above, there does not appear to be much difference between the reliability of the financial reporting methods of both companies. Both companies follow US GAAP regulations and standards, and both appear to interpret the rules in the same way. Both are publicly listed companies, and both sets of accounts include statements that they have followed accounting standards, been audited, and are Sarbanes-Oxley compliant. As such, the main differentiator between the two companies will need to be the ratio analysis of their financial accounts. The ratio analysis, detailed in the appendix below, reveals that both of the companies are very similar in their financial performance, which is probably largely due to the fact that they operate in the same industry and very similar markets. In terms of liquidity, Home Depot has a better current ratio and quick ratio, due to its trade payables. However, Lowe’s has a better operating cash flow, a fact which was commented on in the previous section regarding earnings quality. Home Depot has a higher rate of turnover for all five ratios, indicating that it is better at using its inventory and assets to generate sales, however Lowe’s higher gross margin and net margin (return on sales) indicates that Lowe’s is better at generating profits from these sales. In addition, Lowe’s has a lower debt to equity and debt ratio, as well as higher interest cover, which indicates that Lowe’s is better placed to withstand any falls in revenue and profit, which were also remarked on in the earnings quality section. As such, in conclusion, I would avoid investing in either of these companies based on the current falls in their earnings and the concerns about the wider performance of the US economy (Emerging Markets Monitor, 2008). However, if I were forced to choose between the two companies I would choose to invest in Lowe’s. This is because Lowe’s has shown itself to have better quality earnings, higher margins and lower debt ratios that Home Depot. As such, Lowe’s looks better placed to withstand any earnings shocks or economic issues in the US market and provide sustained long term value. In addition, Lowe’s is not carrying any goodwill or trade receivables on its balance sheet, which makes it less vulnerable to defaults from its debtors and enforced goodwill writedowns. References Allen, F. and Carletti, E. (2006) Mark-to-Market Accounting and Liquidity Pricing. Working Papers Financial Institutions Center at The Wharton School; Preceding p. 1-31. Bao, B. H. and Bao, D. H. (2004) Income Smoothing, Earnings Quality and Firm Valuation. Journal of Business Finance Accounting; Vol. 31, Issue 9/10, p. 1525-1557. Bodenhorn, D. (1984) Balance Sheet Items As The Present Value Of Future Cash Flows. Journal of Business Finance Accounting; Vol. 11, Issue 4, p. 493-510. Bruns, Jr., W. J. and Harmeling, S. S. (1991) LIFO or FIFO? That Is the Question. Harvard Business School Cases; p. 1. Emerging Markets Monitor (2008) US: A Recession In All But Name. Datamonitor Emerging Markets Monitor; Vol. 14, Issue 5, p. 1-2. Higgins, R. C. (1997) Analysis for Financial Management: 5th Edition. Irwin / McGraw Hill. Kohlbeck, M. (2004) Investor Valuations and Measuring Bank Intangible Assets. Journal of Accounting, Auditing Finance; Vol. 19, Issue 1, p. 29-60. Miller, P. B. W. and Bahnson, P. R. (2007a) Pension Accounting. Journal of Accountancy; Vol. 203, Issue 5, p. 36-42. Miller, P. B. W. and Bahnson, P. R. (2007b) Refining Fair Value Measurement. Journal of Accountancy; Vol. 204, Issue 5, p. 30-36. Quick, C. (2002) Can You See The Value? Accountancy; Vol. 130, Issue 1308, p. 47-48. Richardson, S. (2003) Earnings Quality and Short Sellers. Accounting Horizons; 2003 Supplement, Vol. 17, p. 49-61. Shareholder.com (2008) Lowe’s Investor Relations. http://www.shareholder.com/lowes/edgar.cfm?DocType=AnnualYear= Accessed 15th June 2008. SEC (2008) Home Depot Incorporated: HD. http://secure.secfilings.com/company/checkout.php?step=2_offer_id=1CIK=354950fid=50002 Accessed 15th June 2008. Appendix Ratio Analysis (Higgins, 1997) RatioCalculation methodLowe’sHome Depot Current RatioCurrent Assets1.121.15 Current Liabilities Quick RatioCash + S/T Inv + Receivables0.070.14 Current Liabilities Operating Cash FlowCash Flows from Operations0.560.45 Current Liabilities Inventory TurnoverCost of Goods Sold / Inventory4.154.38 Receivables Turnover Sales / Accounts ReceivablesN/A61.44 Payables TurnoverSales / Accounts Payables13.0014.40 Fixed Asset TurnoverSales / Fixed Assets2.172.61 Total Asset TurnoverSales / Total Assets1.561.75 Debt to EquityTotal Liabilities0.921.50 Shareholders’ Equity Debt RatioTotal Liabilities / Total Assets0.480.60 Interest CoverageProfit before income and tax63.9710.41 Interest Expense Gross Margin(Sales – COGS) / Sales34.64%33.61% Return on SalesNet Income / Sales5.82%5.68% Return on AssetsNet Income / Total Assets9.10%9.92%