Analysis of Financial Statements

December 4, 2013Usman Riaz

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ContentsCompany Profile...................................................................................................................................................2

Introduction......................................................................................................................................................2

Customers, Product & Services........................................................................................................................2

Competition......................................................................................................................................................3

Financial Statement Analysis................................................................................................................................4

Profitability.......................................................................................................................................................4

ROE...............................................................................................................................................................4

NOPAT, RNOA & Non-Operating Return......................................................................................................5

Net Operating Profit Margin (NOPM)...........................................................................................................5

Net Operating Asset Turnover (NOAT).........................................................................................................6

Credit Analysis..................................................................................................................................................6

Coverage Ratios............................................................................................................................................6

Liquidity Analysis..............................................................................................................................................8

Current Ratio................................................................................................................................................8

Quick Ratio...................................................................................................................................................8

Solvency Analysis..............................................................................................................................................8

Liabilities to Equity Ratio..............................................................................................................................9

Total Debt to Equity.....................................................................................................................................9

Bankruptcy Risk................................................................................................................................................9

Altman Z-Score.............................................................................................................................................9

Notes to Consolidate Financial Statements........................................................................................................10

Revenue Recognition......................................................................................................................................10

Merchandise Inventory..................................................................................................................................10

Goodwill and Other Intangible Assets............................................................................................................10

Employee Benefit Plans..................................................................................................................................11

Future Potential..................................................................................................................................................11

Stock Recommendation......................................................................................................................................12

Appendix.............................................................................................................................................................13

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References..........................................................................................................................................................13

Company Profile

IntroductionHome Depot is an American retailer of home improvement and construction. It is based in

Georgia, Atlanta. Founded in 1978, Home Depot is the largest home improvement retailer in

the United States with 2248. This includes 2256 stores in US and the rest in Canada, Mexico,

China, UK, Argentina and Chile. Home Depot serves three primary customer groups; do-it-

yourself (D-I-Y), do-it-for-me (D-I-F-M) and professional customers. The company offers over

300,000 different products. Home Depot operates in the home improvement and construction

industry. The industry consists of other competitors like Lowe’s in USA which is the main

competitor in term of size. The Average size of Home Depot stores is 105000 ft2 and its largest

store is located in New Jersey.

Customers, Product & ServicesThe D-I-Y customers are the one who buy products to use themselves. These are usually home

owners who can complete their projects themselves. The other main target of Home Depot is

the D-I-F-M segment that consists of consumers who want to get the services with the

products. Home Depot provides customers with services like installation, carpeting, flooring,

cabinets, roofing, windows etc. The third segment is the professional customers. These are

general contractors, repairmen, tradesmen. These customers usually need special delivery

arrangements and Home Depot has a dedicated customer services staff to cater their needs.

The median age group of the customers is 45-50.

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Home Depot deals in all the home improvement products. It includes Home appliances, tools,

hardware, lumber, building materials, flooring, plumbing, paint, garden supplies and plant. On

average a Home Depot store carries 30,000 – 40,000 products. It also offers 600,000 products

online. The products are divided into 4 broad groups; Plumbing, electrical and kitchen,

Hardware and seasonal, Building materials, lumber and millwork, and Paint and flooring. The

percentage sales contribution of these groups for the last 3 years is given below:

February 3,2013

January 29,2012

January 30, 2011

Plumbing, electrical and kitchen 30.8% 30.5% 30.0%

Hardware and seasonal 29.4 29.5 29.4

Building materials, lumber and millwork

20.6 21.1 21.7

Paint and flooring 19.2 18.9 18.9

Total 100% 100% 100%

The figures represent that Plumbing, electrical and kitchen group has consistently been the

major contributor in sales.

CompetitionThe home improvement industry is highly competitive with little product differentiation

advantage. The industry is saturated and consists of other competitors like Lowe’s in USA

which is the main competitor in term of size. The revenues for the year ending Feb 2013, Home

Depot reported revenues of 74,754 Million whereas Lowe’s Revenues were a distant 50,521

Million. Home Depot has a core competency in store locations throughout the country. Home

depot and Lowe’s together make up only 18% of the total industry and the rest of the market

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share is distributed amongst big-box retailers such as Walmart and other small chains and

businesses. The small chains and stores cannot be ignored because Home Depot is not present

in every location so these small stores offer a substitute for people who are not going for a big

purchase or who need something immediately. Notice that the Home Depot and Lowe’s

combined only make 18% of the total industry that leaves a huge incentive for small

competitors to enter. There are some small retailers who beat Home Depot on prices but their

limited size and after sales services is something that cannot match Home Depot. In addition

Home Depot now faces growing competition from online and multichannel retailers too.

Financial Statement Analysis

ProfitabilityROE

Years2013 2012 2011

ROE 25.42% 21.11% 17.44%

Profitability can be measured by calculating the ROE. ROE is the return on equity and is the sum

of the operating return and the non-operating return. The table below summarizes the ROE of

the last three years. The return on equity is increasing steadily for the last three years.

(Calculations in Appendix)

The ROE is improving significantly. The economic reason for this is the industry is coming out of

a recession. The recession that primarily hit the housing market and hurt the sales of houses

and the related industry. Since 2011 the economy is recovering and that can be seen easily on

the ROE of Home Depot.

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NOPAT, RNOA & Non-Operating ReturnFurther disaggregation of ROE will give us a better insight. ROE can be broken down into

operating return and non operation return. The table below shows the component of ROE and

their trend in the last three years.

2013 2012 2011

Net operating profit after tax

(NOPAT)

4846.16 4251.78 3696

Operating Return (RNOA) 18.56% 15.68% 13.30%

Non-operating Return 6.86% 5.43% 4.14%

(Calculations in Appendix)

The figures show that the operating and non-operating returns have increased in the last 3

years. The more significant increase can be seen in the operating return. This is a positive sign

as it depicts that each dollar invested in the operating assets and also the non-operating assets

are now generating a greater return. Beside this, the net operating assets have been decreasing

in the last 3 three years. So in the last 3 years the returns are on a rise.

Net Operating Profit Margin (NOPM)This ratio measures the amount of operating margin a firm earns from each sales dollar. The

profit per dollar is increasing through the last three years and currently at 6.48 cents per dollar.

This could be due to a decrease in the cost, increase in prices or both.

2013 2012 2011NOPM 6.48% 6.04% 5.44%

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(Calculations in Appendix)

Net Operating Asset Turnover (NOAT)This is a measure of the productivity of the company’s net operating assets. It reveals the level

of sales realized from each dollar invested in the operating assets.

2013 2012 2011NOAT 2.86 2.60 2.45

(Calculations in Appendix)

The figures show an improvement in the 2 years. This shows that for each dollar of net

operating assets, Home Depot realizes a gain of $2.86.

Credit AnalysisCoverage RatiosCoverage ratios compare operating profits or cash flows to interest and principal payments. The

ratio is used to assess the company’s ability to generate profits as well as to cover the fixed

charges from debt interest and principal in the future. This is an important ratio as it is

considered by the rating agencies widely.

Times Interest Earned Ratio

2013 2012 2011Times interest earned

12.42 11.01 10.95

(Calculations in Appendix)

The times interest earned ratio reflects the operating income available to pay interest expense.

It is getting better since 2011. At the end of 2013 this figure looks very healthy and shows that

Home Depot is able to payback its debt expenses. This increase is a result of increased

profitability coupled with a drop in interest expense.

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EBITDA Coverage ratio

2013 2012 2011EBITDA Coverage Ratio

14.77 13.59 14.07

(Calculations in Appendix)

This ratio reflects the cash available to cover fixed debt charges as depreciation and

amortization does not require a cash outflow so more cash is available. The ratio has gone

down in 2012 but is up again at a comfortable level.

Cash from Operations to Total Debt

2013 2012 2011Cash from Operations to Total Debt

0.65 0.62 0.47

(Calculations in Appendix)

To analyze the company’s ability to repay the principal instead of the interest in short term we calculate this ratio. The ratio is getting better which shows an increasing ability to pay off the debt if a situation arises.

Free Operating Cash Flow to Total Debt

2013 2012 2011Free Operating Cash Flow to Total Debt

0.52 0.49 0.36

(Calculations in Appendix)

The free operating cash flow to total debt is used to calculate the ability of a company to repay

debt from the cash flows remaining after CAPEX. The table shows the ratios improving. This

improvement has two major drivers. Home Depot had more CAPEX spending and debt before

the recession which dragged the ratios down.

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Liquidity AnalysisLiquidity is amount of cash available and what the company can produce in the short term.

There are two main liquidity ratios; current ratio and quick ratio.

Current Ratio

2013 2012 2011Current Ratio 1.34 1.55 1.33

(Calculations in Appendix)

Current ratio is the ratio of current assets that a company expects to convert into cash in the

next operating cycle to the liabilities that are due in the next year. A ratio of 1 or greater implies

that a company has more cash inflows than outflows. Home Depot is a cash and carry business

so its current ratio cannot be very high. Its current ratio has been above 1 which shows that it is

reasonably liquid.

Quick Ratio

2013 2012 2011Quick Ratio 0.34 0.34 0.16

(Calculations in Appendix)

The quick ratio is a more stringent test of liquidity as it measures the assets likely to be

converted to cash within a relatively short period of time. Again nothing to be worried about

the liquidity here as a quick ratio of less than 1 is very normal.

Solvency AnalysisSolvency analysis considers a company’s ability to repay the periodic interest payments plus the

principal amount borrowed.

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Liabilities to Equity Ratio

2013 2012 2011Liabilities to Equity Ratio

1.31 1.26 1.12

(Calculations in Appendix)

Liabilities to Equity ratio measures the amount of debt financing compared to equity. The

median ratio is 1.0 for publicly traded companies and 1.5 for retailing companies. In comparison

to retailing companies the ratio is reasonable. The ratio has been increasing for the last three

years indicating an increase in the use of debt.

Total Debt to Equity

2013 2012 2011Total Debt to Equity Ratio

0.61 0.60 0.52

(Calculations in Appendix)

Total debt to equity ratio assumes that current operating liabilities will be repaid from current

assets. It does not include the accounts receivables. The ratio shows increased debt but still not

a lot. The ratio is has slightly worsen in the last three years.

Bankruptcy RiskAltman Z-ScoreAltman Z-Score is a model that utilizes five ratios to calculate the bankruptcy risk for any

company. A Z-score of 3 or more is healthy and there is low bankruptcy potential in short term.

A score between 1.80 and 2.99 is Gray area, as the company is exposed to some risk of

bankruptcy. A score less than 1.80 show a company in financial distress and there is a high

potential of bankruptcy.

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Home Depot scored 6.20 on the Altman model that is far beyond the safety mark of 3. This

shows the healthy financial condition and almost no bankruptcy risk in the near future.

(Calculations in Appendix)

Notes to Consolidate Financial Statements

Revenue RecognitionHome Depot recorded revenue of 74,754 Million in FYE 2013. There has been an increase

during the last three years in the revenues. Home Depot recognizes revenue, net of estimated

returns and sales tax, at the time the customer takes possession of merchandise or receives

services. It estimates the liability for sales returns based on the historical return levels.

Merchandise InventoryHome Depot uses First-In-First-out (FIFO) or the market cost whichever is lower to value 81% of

the retail inventory and the remainder under the cost method. Home Depot mentions in the

notes that this method of valuing the merchandise inventory is widely used in the retail

industry. This method keeps the cost of inventory low. Merchandise Inventory grew from 10325

Million in 2012 to 10710 Million in 2013. This can be due to Home Depot’s expectation of

increase in sales because in 2012 they experienced increase in sales that resulted in a decrease

in their merchandise inventory.

Goodwill and Other Intangible AssetsGoodwill is the excess of purchase price or fair value of net assets acquired. Home Depot does not amortize

goodwill but does assess the recoverability of goodwill in the third quarter of each fiscal year, or more often if

indicators warrant, by determining whether the fair value of each reporting unit supports its carrying value.

The fair value is calculated using the present value of expected cash flows. Home Depot amortizes cost of

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other intangible assets over the useful lives. The lives can range up to 10 years. Intangible assets with

indefinite lives are tested in the third quarter each year for impairment. The goodwill of the company is was

1120 Million in 2012 which increased to 1170 Million in 2012. This included the impairment costs to the

intangible assets too. So there was an overall increase in the last year.

Employee Benefit PlansHome Depot has a contribution retirement plan. All employees who fulfill certain criteria are eligible for the

Benefit Plan. The company makes cash contributions each payroll period up to the specified percentages of

associates’ contributions as approved. The company also has a restoration plan for employees who would

have received a higher wage but could not due to the limits under the law. The company funds the

restoration plan through contributions made to the grantor trust which are then used to purchase shares of

the company. The Company’s contributions to the Benefit Plans and the restoration plan were $171 million,

$171 million and $161 million for fiscal 2011, 2010 and 2009, respectively. At January 29, 2012, the Benefit

Plans and the restoration plan held a total of 14 million shares of the Company’s common stock in trust for

plan participants.

Future PotentialHome Depot is a huge company and the future potential for the stock is great. The financial statement

analysis and the ratios all point towards the situation getting better for the company. The economy as a

whole is out of the recession and most importantly the housing sector, that got the biggest hit in the

recession of 2008, is out of the recession and is recovering fast.

The stock is trading at 78.40 as of December 4th 2013. This has been a constant upward since 2009. As soon

as the economy started coming out of the recession, Home Depot’s stock started rising. This is a great sign for

the future potential of a company that was hit badly by the recession. In August 2011, the stock was trading

at around $30 and since then it has been going up. The stock chart shows the strength of the stock.

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The financial statement and the ratios point towards improvement in the coming years. The revenues have

grown in the last three years. The company’s gross profits have impressed the analysts by increasing from

24262 Million to 25842 Million in the last three years. It has outperformed its competitors and Home Depot

apparently has no big threat from any of the rivals. Looking further down the income statement, EBIT is

increasing along with the net income. So the financial statements surely are getting better.

As discussed earlier, the profitability ratios along with solvency and credit ratio all show marked

improvements. The figures have shown steady progress and they seem to be improving further in the coming

years.

Stock RecommendationI will recommend a BUY. The recommendation is fair after reviewing the company’s strategies, doing a

competitive analysis, analyzing the financial statements and footnotes and then computing the key ratios. I

think that the stock is undervalued and still has the potential to grow keeping in mind the growing economy.

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Appendix

2013 2012 2011ROE 4535/((17777+17898)/2)=

25.42%3883/((17898+18889)/2)= 21.11%

3338/((18889+19393)/2)= 17.44%

Tax on Operating Profit

2686+(632*0.37)= 2919.84 2185+(606*0.37)= 2409.22 1935+(530*0.37)= 2131.10

NOPAT 7766-2919.84= 4846.16 6661-2409.22= 4251.78 5839-2131.1= 3696RNOA 4846.16/26104= 18.56% 4251.78/27111.5= 15.68% 3696/27787.5= 13.3%Non-operating Return

25.42%-18.56%= 6.86% 21.11%-15.68%= 5.43% 17.44%-13.30%= 4.14%

NOPM 4846.16/74754= 6.48% 4251.78/70395= 6.04% 3696/67997= 5.44%NOAT 74754/26104= 2.86 70395/27111.5= 2.60 67997/27787.5= 2.45

2013 2012 2011Times Interest Earned

7853/632=12.42 6674/606=11.01 5803/503=10.95

EBITDA Coverage Ratio

(7221+545+1568)/632= 14.77

(6068+593+1573)/606= 13.59

(5273+566+1616)/530= 14.07

Cash from Operations to Total Debt

6975/(1321+9475)= 0.65 6651/(30+10758)= 0.62 4585/(1042+8707)= 0.47

Free Operating Cash Flow to Total Debt

(6975-1312)/(1321+9475) = 0.52

(6651-1221)/(30+10758) = 0.49

(4585-1096)/(1042+8707) = 0.36

Current Ratio 15372/11462= 1.34 14520/9376= 1.55 13499/10122= 1.33Quick Ratio (2994+1395)/11462= 0.34 (1984+1245)/9376= 0.34 (545+1085)/10122= 0.16Liability to Equity 23307/17777= 1.31 22620/17898= 1.26 21236/18889= 1.12Total Debt to Equity Ratio

(1321+9475)/17777= 0.61 (30+10758)/17898= 0.60 (1042+8707)/18889= 0.52

ReferencesUS Securities and Exchange Commission: (http://www.sec.gov/Archives/edgar/data/354950/000035495013000008/hd-232013x10xk.htm)

Financial Statement Analysis and Valuation (3rd Edition) by Easton & McAnally

Bloomberg (www.bloomberg.com)

Morningstar (www.morningstar.com)

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