Accounting Basics for Managers - Essay Example

Accounting Basics for Managers Financial Statement Ratios Analysis The financial ratio analysis is conducted in this paper which analysis the financial outlook and performance of the company for the financial years 2011 and 2010. The analysis is divided into three main categories namely Profitability, Liquidity and Gearing ratios. These ratios identify how well the company is performing financially and gives an idea about its future financial outlook by presenting the historical trend. Profitability ratios focus mainly on net profit and gross profit and what are the ratios of these profits in comparison with the sales level. Liquidity ratios identify the level of liquid assets available with the company in order to discharge its current liabilities. Gearing ratios, on the other hand highlights the capital structure of the company (Investopedia.com (2011). Operating Performance of the Home Depot In the financial year 2012, Home Depot shows impressive growth both financially and operationally. In the financial year 2011, Home Depot revenue increased by 3.53% to a striking $ 70,395 million which has resulted in the operating profit increase by 14.08%. Following its operational growth strategy, Home Depot has introduced diversity in its business. The company is showing interest in covering all the horizons of the globe by opening more and more stores in various areas of the globe as it planning to serve a diverse range of customers   2011 2010   Profitability Ratios Gross profit margin 34.47% 34.27% Net profit margin 9.48% 8.61% ROI 9.58% 8.32% ROCE 21.70% 17.67% Gross profit margin is one of the key profitability ratio indicators which indicate how well a company is in the process of utilizing its working capital in earning the desired level of profit. In order to calculate the gross profit margin ratio, the gross profit (i.e., sales less the cost of sales) is divided with the revenue of the company. As apparent, the gross profit of the company has increased slightly from the previous financial year which could be due to the fact that the cost of sales of the company increased with a bigger percentage as compared to the percentage in the revenue of the company. This could be due to increased raw materials prices from the supplier which the company could not recover from the customers through increased selling price. The next profitability indicator is the net profit margin. The net profit margin is calculated by dividing the net profit (i.e., gross profit less administrative and selling expenditure) with the total revenue. The net profit margin follows almost the same historical pattern as the gross profit margin. This is due to the fact that operating expenses of the company increased only by 0.78% during the current financial year. This shows that the company is able to curtail its expenditure and generate profits. The ROI, which is calculated by dividing the net profit for the year with the total assets of the company, shows an increase in 2011 as compared to the previous financial year. The total assets of the company increased by 393 million during the current financial year and also the net profit of the company has also increased which has caused the return on investment ratio during the current financial year. The ROCE showed massive increase in the financial year 2011 due to the fact that the operating profit in the financial year 2011 increased although no significant changes were observed in the shareholder’s equity figure. Through prudent resource management, the company has able to report higher ROCE in the current financial year. 2011 2010 Liquidity Current ratio 1.59 1.37 Acid test ratio 0.49 0.32 Working Capital 5,574.00 3,756.00 Current ratio is one of the significant ratios in the liquidity ratio analysis. The ratio puts into consideration the current assets and current liabilities of the company and analyses them. A current ratio greater than 1 presents the fact the company is able to meets its current liabilities and shows a stable and sound financial outlook. As enumerated in the table above, the current ratio of the company has always remained greater than 1 in all of its previous two financial years. This shows that the company has enough liquid funds to discharge its current liabilities for the year. The asset test ratio, or the quick ratio, of the company utilizes the same formula as the current ratio but it does not include the inventory into consideration as inventory takes considerable longer period of time to be converted into cash. The asset test ratio of the company has also followed the current asset ratio format and it has shown marginal increase as compared to the prior financial year. The working capital ratio of the company is calculated by deducting the current assets from the current liabilities of the company. The working capital of the company in both of the financial year is positive which shows that the current assets of the company were greater than the current liabilities of the company. Increase in the net working capital figure shows that the company has increased its trading volume which is also reflected in the increase in the revenue and the cost of sales. 2011 2010 Gearing Ratios Equity ratio 0.44 0.47 Debt ratio 0.56 0.53 Debt : equity ratio 0.44:0.56 0.47:0.53 The companies who have high equity ratios portray a much more stable and strengthened financial outlook. (Investopedia.com (2012). As apparent form the capital structure of the company, the company is mostly financed through debt and has tried its best to keep the debt as minimum as possible. During the past two financial years the debt of the company has increased slightly. However, the financial outlook still appears to be stable. Operating Performance of the Lowes   2011 2010   Profitability Ratios Gross profit margin 34.56% 35.14% Net profit margin 6.53% 7.29% ROI 5.48% 5.96% ROE 11.12% 11.10% The gross profit margin of the company has increase as the sales of the company have increased by 1,393 million (2.85%) during the current financial year as compared to the previous year. The cost of sales of the company has increased by 1,195 million (3.77%) which shows that the trade volume of the company increased during the financial year 2011. Net profit margin of the company has decreased during the current financial year as the operating expenses of the company escalated by 3.54% during the current financial year. This increase in the operating expenses has caused major impact on the net profitability of the company. As the net profit of the company has decreased during the current financial year, it has also adversely affected the return on investment of the company during the current financial year. Overall, the total assets of the company (including both current and non-current assets) have decreased by 140 million which is around negative 0.42% decrease. This is a negative sign for the financial outlook of the company. Return on equity of the company has shown marginal increase during the current financial year, which is due to the fact that the shareholder’s equity figure in the financial statement of the company had decreased. 2011 2010 Liquidity Current ratio 1.28 1.4 Acid test ratio 0.22 0.23 Working capital 2,181.00 2,848.00 The current ratio of the company has also decreased which is a negative sign of the company. Although, since the current ratio is greater than 1 it shows that the company would be able to discharge its current liabilities in the future, but a decrease in the ratio shows that current liabilities of the company at a greater pace as compared to the increase in the current assets of the company. Stock and spares constitute a major portion of the current assets of a company. In the financial year 2011, stocks of the company constitute around 83% of the current assets of the company. Due to the overall decrease in the current assets and current liabilities of the company, the acid test ratio of the company has also decreased. The working capital of the company has also decreased during the current year which also justifies the fact that current assets of the company has decreased. The company’s revenue has increased but the investment in the working capital does not appear to increase which is a sign that the company is overtrading. 2011 2010 Gearing Ratios Equity ratio 0.49 0.54 Debt ratio 0.51 0.46 Debt : equity ratio 0.49:0.51 0.54:0.46 If we analyze the capital structure of the company it appears that the company is almost equally financed through equity and debt. In the financial year 2011, the equity percentage has decreased from 54% to 49% which shows that the company is shifting towards financing its assets through debt. Debt is generally not considered good for the capital structure of a company as it put extra burden on the income statement of the company in the form of markup expense. Analysis If we analyze the profitability ratios analysis of the above two companies, it is apparent that Home Depot is doing much better as compared to Lowes. The net profit margin, ROI and ROE of Home Depot is considerably greater than that of Lowes which shows that the company has a greater revenue and profit generating ability. Home Depot Lowes   2011 2010 2011 2010   Profitability Ratios Gross profit margin 34.47% 34.27% 34.56% 35.14% Net profit margin 9.48% 8.61% 6.53% 7.29% ROI 9.58% 8.32% 5.48% 5.96% ROCE 21.70% 17.67% 11.12% 11.10% In addition to profitability, the liquidity of the company home depot is also greater than the lows, which is another positive financial outlook for the company. The working capital investment of Home Depot is also greater than the other company which shows that the trade volume is greater than Lowes. Home Depot Lowes 2011 2010 2011 2010 Liquidity Current ratio 1.59 1.37 1.28 1.4 Acid test ratio 0.49 0.32 0.22 0.23 Working Capital 5,574 3,756 2,181 2,848 The capital structure of both the companies is almost the same. However, the capital structure of Lowes is slightly better as majority of its assets are financed through equity. Home Depot Lowes 2011 2010 2011 2010 Gearing Ratios Equity ratio 0.44 0.47 0.49 0.54 Debt ratio 0.56 0.53 0.51 0.46 Debt : equity ratio 0.44:0.56 0.47:0.53 0.49:0.51 0.54:0.46 Share Price Movement As apparent from the above share price movement, the share price of Home Depot has always remained higher as compared to that of Lowes. Recommendation The financial analysis shows that Home Depot is managing its resources prudently and effectively. The company is making every possible effort to reduce the amount of debt in its capital structure as much as it is possible so that it does not have to bear excess cost of interest charge in its income statement. In addition, the company has enough liquid assets through which it can easily discharge it liabilities in the near future. The share price pattern of the company is also strong. Apart from slight fluctuations, the share price of the company has always remained strong and it has always awarded its shareholder with competitive dividends. Based on the above financial analysis it is apparent that the share price of Home Depot is likely to spike in the coming future and the current shareholders of the company can benefit by holding the share now and disposing off the shares in the near future. By disposing off the shares in the future the current shareholders can earn capital gain. Investors who are looking for lucrative venture to invest in should consider investing in Home Depot as from its financial outlook; it appears that the company will pay good dividends in the near future. Reference Investopedia.com (2012) Financial Ratio Tutorial | Investopedia. [online] Available at: http://www.investopedia.com/university/ratios/ [Accessed: 27 Mar 2013]. Appendix Financial Statements Home Depot 2011 2010 in million $ Sales 70,395.00 67,997.00 Cost of Sales 46,133.00 44,693.00 Gross Profit 24,262.00 23,304.00 Operating Expenses 17,601.00 17,465.00 Operating Profit 6,661.00 5,839.00 Other income 13.00 15.00 Profit before interest 6,674.00 5,854.00 Finance expense 606.00 581.00 Taxation 2,185.00 1,935.00 Profit for shareholders 3,883.00 3,338.00 Dividends - - Retained profit / (loss) - - Non-Current Assets 25,568.00 26,247.00 Current Assets Stock 10,325.00 10,625.00 Trade and other receivable 1,245.00 1,085.00 Other 1,393.00 1,623.00 Cash 1,987.00 545.00 14,950.00 13,878.00 Total assets 40,518.00 40,125 Current Liabilities Trade and other payable. 4,856.00 4,717.00 Overdrafts - - Other 4,520.00 5,405.00 9,376.00 10,122.00 Non-Current 13,244.00 11,114.00 Liabilities Total Liabilities 22,620.00 21,236.00 Net Assets 17,898.00 18,889.00 Equity Share Capital (£1 nominal) 7,053.00 6,642.00     Retained Profits 10,845.00 12,247.00 17,898.00 18,889.00 Debt and equity 40,518.00 40,125.00 - - Lowes 2011 2010 in million $ Sales 50,208.00 48,815.00 Cost of Sales 32,858.00 31,663.00 Gross Profit 17,350.00 17,152.00 Operating Expenses 14,073.00 13,592.00 Operating Profit 3,277.00 3,560.00 Other income - - Profit before interest 3,277.00 3,560.00 Finance expense 371.00 332.00 Taxation 1,067.00 1,218.00 Profit for shareholders 1,839.00 2,010.00 Dividends - - Retained profit / (loss) - - Non-Current Assets 23,487.00 23,732.00 Current Assets Stock 8,355.00 8,321.00 Trade and other receivable 234.00 330.00 Other 469.00 664.00 Cash 1,014.00 652.00 10,072.00 9,967.00 Total assets 33,559.00 33,699 Current Liabilities Trade and other payab. 4,352.00 4,351.00 Overdrafts - - Other 3,539.00 2,768.00 7,891.00 7,119.00 Non-Current 9,135.00 8,468.00 Liabilities Total Liabilities 17,026.00 15,587.00 Net Assets 16,533.00 18,112.00 Equity Share Capital (£1 nominal) 635.00 688.00     Retained Profits 15,898.00 17,424.00 16,533.00 18,112.00 Debt and equity 33,559.00 33,699.00 - - Ratios Formulae Ratio Formulae Gross profit margin Gross profit/Sales Net profit margin Net profit/Sales ROI Net Profit/Total assets ROE Net Profit/Shareholder's Equity Current ratio Current Assets/Current Liabilities Acid test ratio Current asset(except inventory)/Current Liabilities Equity ratio Shareholders Equity/Total Assets Debt ratio Total liabilities/Total Assets Read More