Financial Analysis of Home Depot Research Paper

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Home Depot is a retailer of home improvement supplies, and Lowe's is its biggest rival. Both are very large companies, and they have a lot of similarities. Both companies competes only in this one industry, focused on big box retailing of home improvements and home finishings. These are considered to be category killers, in that once they enter a market few other firms can exist in that market selling the same items. Both companies compete with low prices, and Home Depot especially tries to deliver a high standard of service as well. Home Depot is the larger of the two, and it also has international operations, something that Lowe's does not have at this point. This paper will compare the financials of these two companies. The income statements and balance sheet data will be attached in Appendix A.

It should be noted that all -- all -- financial data used in this report came from MSN Moneycentral, unless otherwise noted.

The financial ratios for each of these companies are compiled as follows. These figures are applicable to Home Depot for the 2013 fiscal year, which ended January 31, 2013 so is basically the 2012 calendar year. The same is true for Lowe's. No FY2014 quarterly figures were taken into account for this project.

HD

LOW

Gross Margin

34.57%

34.30%

Operating Margin

10.39%

7.05%

Net Margin

6.07%

3.88%

Current Ratio

1.34

1.27

Quick Ratio

0.41

0.15

Cash Ratio

0.22

0.09

Debt Ratio

0.57

0.58

Debt to Equity Ratio

1.31

1.36

Return on Equity

25.51%

14.14%

The formulae for these ratios are as follows:

Gross Margin = Gross Profit / Revenue

Operating Margin = Operating Profit / Revenue

Net Margin = Net Income / Revenue

Current Ratio = Current Assets / Current Liabilities

Quick Ratio = (Current Assets -- Inventories) / Current Liabilities

Cash Ratio = Cash / Current Liabilities

Debt Ratio = Liabilities / Total Liabilities & Shareholders' Equity

Debt/Equity Ratio = Liabilities / Shareholders' Equity

Return on Equity = Net Income / Shareholders' Equity

Ratio Analysis

Profitability Ratios

Each of these ratios can be analyzed to provide some insight into the operations of these two companies. The first that will be examined here is the profitability ratios, which are the gross margin, the operating margin and the net margin. The gross margin is the top line. It reflects the bargaining power of the company. Essentially, the spread between the revenue and the cost of goods sold reflects the degree to which the company has pricing power with customers and with suppliers. The industry at this point is an oligopoly if not an outright duopoly, so the two firms should be pricing in line with each other, because it is typical in a duopoly that firms will base pricing decisions on the actions of each other. The gross margins for these two companies are very similar, 34.57% for Home Depot and 34.3% for Lowe's. Both companies are able to sell their merchandise at roughly three times cost, allowing for a little bit less due to discounts. That both companies are able to operate just like this indicates that they have fairly strong controls over their costs. They are not in a position where they have to do a lot of deep discounting in order to move goods, so the consumer is the price taker, other than the option of going to the competitor. For both companies, this is a strong ratio and there is nothing to choose between them.

The operating margin encompasses not only the gross margin but it also encompasses the operating costs of the company. Even in industries where companies dictate prices, they can differentiate themselves from the competition with superior cost control. Operating expenses should also be more efficient with scale, as the company can employ fewer people per unit of output. In this case, Home Depot has the better operating margin at 10.39%, whereas Lowe's has an operating margin of 7.05%. What this tells us is that Home Depot has the more efficient cost structure. Whether three percent difference is strictly attributable to scale is debatable. It appears that Home Depot has a little bit stronger organization than Lowe's, which allows it to make more money on the same contribution.

The final profitability measure is the net margin. This takes into account the gross margin, the operating costs and other ancillary costs like financing and taxation.

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The company does have control over these costs to some extent, so it can be fairly evaluated on its ability to minimize these costs. Good tax policy, for example, might help a company to shave a percentage point off of is tax burden. In this past year, Home Depot had a net margin of 6.07%, whereas Lowe's had one of 3.88%. These figures are slightly closer than the figures for the operating margin, so if anything Lowe's was able to manage its taxes and interest better than Home Depot. However, this difference is not particularly significant.

The takeaway from this examination of the profitability ratios is that with Home Depot the profitability comes down to operations. The company has a more efficient operation and this flows through all the way to the bottom line, where Home Depot outperforms Lowe's. This occurs despite the fact that Home Depot must maintain an entirely separate management structure for its foreign operations.

Liquidity Ratios

The liquidity ratios reflect the ability of the company to meet its financial obligations for the next year. These figures are usually looked at by lenders, but they can also be useful for anybody in determining whether a company is in danger of becoming insolvent in the coming year.

The first of the liquidity ratios is the current ratio. This looks at the ratio of current assets to current liabilities. The current liabilities are the accounts that are due in the next year. The idea here is that if the company needed to liquidate, could it liquidate its current assets in order to meet these obligations. The current assets category is the largest version of this ratio type and provides this information in general. The current ratio for Home Depot is 1.34 while the current ratio for Lowe's is 1.27. These are both healthy figures, as the benchmark is usually that anything over 1.0 is a healthy ratio because it means that the fi the company sold every current asset at book value it could meet its current liability options.

The second of the liquidity ratios is the quick ratio. This does not reflect that it is quicker to calculate, but that it is calculated using only assets that are quick to sell. Thus, the quick ratio is based on the current assets less the inventories, which can be difficult to sell quickly. Or, if they can be sold, it will be at a deep discount. This is a particularly useful number of retailers because so much of their current assets are tied up in inventories, that it is important for outsiders to understand how much the company could cover if it had to cover quickly. Further, it is important to understand that this ratio is seldom above 1.0, and it usually does not need to be, since the inventories can almost always be sold for something.

The quick ratio for Home Depot is 0.41 while for Lowe's it is 0.15. Herein lies a major difference between these two companies. While there was not much to choose between Home Depot and Lowe's with respect to their current ratios, there is a significant different here with the quick ratio. While Home Depot's number is quite normal, that figure for Lowe's is very low. Almost all of its current assets are in inventories and that puts it in a vulnerable position wherein it will have to liquidate inventories quickly to meet its obligations, where Home Depot might not have to.

The final of the liquidity ratios is the cash ratio. This measures the cash on hand and the ability to use cash to pay current liabilities. Few firms will have high figures here, as there is no incentive for the company to carry excessive amounts of cash on the balance sheet beyond its short-term needs, since cash earns below the cost of capital. While there is financial disincentive to carry too much cash on the balance sheet, this does not mean that the cash ratio should be close to zero -- the company does not want to cut it too close. Home Depot's cash ratio is 0.22 while Lowe's is 0.09. To put this in English, Lowe's carries only one month's worth of cash on hand. This is probably cutting it too close and the company does not want to make a habit of this.

Overall,.....

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