Financial Statements Analysis of Competitors

Financial Statements Analysis of CompetitorsThe two U.S. companies Lowes and kin Depot are two trail competitors on the DYI market who are both listed on the U.S. stock market. You are to carry out a monetary statement analysis of these two companies back the period 2002 to 2006. Specifically, you are to1. Analyze and evaluate the balance sheet for assets and liabilities that are non show uped.Kohlbeck (2004) argues that, using the case of banks, few firms disclose the re care for of their nonphysical assets, and few provide every 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 truly difficult. Bodenhorn (1984) argues that non recorded assets can have a value assigned to them from the future value of the specie flows that they will gene order. 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. twain Lowes (Shareholder.com, 2008) and topographic point Depot (SEC, 2008) provide details of cash and cash equivalents, short- destination investments, and size up in their online assets, and land, buildings, equipment, leasehold improvements and construction in progress in their persistent assets. However, Lowes does not include any trade receivables in their current assets. This could mean that the political party does not have any trade receivables, or it could allude that the company is being prudent, and not recognising these receivables until they have been paid. In addition, Lowes does not record any gracility, 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 reco rding the grace of God 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 node loyalty. Whilst this is in symmetry with international accountancy standards, it nevertheless fails to acknowledge what could be a significant source of value for the companies (Quick, 2002).In endpoints 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 largely 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 withdraw quickly, it will rarely make 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 exchange and cash equivalents can be counted at full valueShort-term investments will be counted at 80% of value, to reflect losses and penalties on disposalReceivables will be counted at 90%, as bad debts will likely increase in the event of a quick saleMerchandise inventories will be counted at 20% to reflect the problem in disposing of themOther current assets, defe rred income assesses, 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.LowesItemBook value up-to-the-minute valueCash and cash equivalents281281Short-term investments249200Merchandise inventory7,6111522Deferred income taxes2470Other current assets2980Property, less accumulated depreciation21,36110,681Long-term investments5090Other assets3130 fall assets30,86912,684Total liabilities14,77114,771Net value16,098(2,087)Home DepotItemBook valueCurrent valueCash and Cash Equivalents445445Short-Term Investments129Receivables, net1,2591,133Merchandise Inventories11,7312,346Other Current Assets1,2270Net Property and Equipment27,47613,738Notes Receivable3420Goodwill1,2090Other Assets6230Total assets44,32417,671Total liabilities26,61026,610Net value17,714(8,939)Whilst this analysis is somewhat basic , and the assumptions contained indoors it have not been rigorously tested, it demonstrates that, in the event that either companys 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 handling 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 use to some of their assets and liabilities may be polar from their actual value, which would depend on the circumstances in which th ese 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 necessitate 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 ad 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 in any case on the value of trade receivables and short term investments. As such, whilst it will not have furbish uped the value of current assets, choosing different criteria would have led to a different value for cash and cash equivalents, and wou ld thus have affected the quick ratio.When recording merchandise inventory, both companies record the value of their inventory at the note 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 utilize to calculate the value of the inventory. This will affect the value of current assets, and in addition of total and net assets, thus affecting the majority of ratios related to the balance sheet. Lowes 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 companys ratios.Finally, both companies use the straight line method to depreciate assets over their useful economic lives. As such, they will crap 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 net profit quality.According to Richardson (2003) some of the primary indicators of a poor earnings quality include an increase in trade receivables a link between offset in earnings and a reduction in the effective tax rate capitalising arouse payments and a large number of significant one off items. In addition, an positive correlation between cash flow and earnings, as well as a in high spiritser gross brim, indicate a high quality of earnings (Bao and Bao, 2004).Applying this to Lowes, 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 give backs in earnings. There is no reason of a capitalisation in interest payments by the company, and nor are there any major one off items, with the profit and loss account be 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 revenue s have decreased over the past three years to a much greater degree than Lowes. 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 Lowes 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 deject quality of earnings when compared to Lowes.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 abo ve, 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 exertion and very similar markets. In terms of liquidity, Home Depot has a better current ratio and quick ratio, due to its trade payables. However, Lowes 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 Lowes higher gross margin and net margin (return on sales) indicates that Lowes is better at generating profits from these sales. In addition, Lowes has a lower debt to equity and debt ratio, as well as higher interest cover, which indicates that Lowes 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 admonisher, 2008). However, if I were forced to choose between the two companies I would choose to invest in Lowes. This is because Lowes has shown itself to have better quality earnings, higher margins and lower debt ratios that Home Depot. As such, Lowes looks better placed to withstand any earnings shocks or economic issues in the US market and provide continue long term value. In addition, Lowes 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.ReferencesAllen, F. and Carletti, E. (2006) Mark-to-Market business relationship 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 pay Accounting Vol. 31, moment 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, sheer 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) Lowes 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=354 950fid=50002 Accessed 15th June 2008.AppendixRatio Analysis (Higgins, 1997)RatioCalculation methodLowesHome DepotCurrent RatioCurrent Assets1.121.15Current LiabilitiesQuick RatioCash + S/T Inv + Receivables0.070.14Current LiabilitiesOperating Cash FlowCash Flows from Operations0.560.45Current LiabilitiesInventory TurnoverCost of Goods Sold / Inventory4.154.38Receivables Turnover Sales / Accounts ReceivablesN/A61.44Payables TurnoverSales / Accounts Payables13.0014.40Fixed Asset TurnoverSales / Fixed Assets2.172.61Total Asset TurnoverSales / Total Assets1.561.75Debt to EquityTotal Liabilities0.921.50Shareholders EquityDebt RatioTotal Liabilities / Total Assets0.480.60Interest CoverageProfit before income and tax63.9710.41Interest ExpenseGross Margin(Sales COGS) / Sales34.64%33.61%Return on SalesNet Income / Sales5.82%5.68%Return on AssetsNet Income / Total Assets9.10%9.92%