Ratio given by the trend analysis provides the overall performance of the company. For instance, in analyzing the net sales over a period of several operating years can give valuable information on how well the company managed to generate the revenue. An increasing trend indicates that the company is making more profit every year. This would allow the management to take advantage to encourage outside parties to invest in the company, given that it has a proven record of the ability to increase the profit each year.
Ratio analysis is not just comparing different numbers from the balance sheet, income statement, and cash flow statement. It is comparing the number against previous years, other companies, the industry, or even the economy in general. Ratios look at the relationships between individual values and relate them to how a company has performed in the past, and might perform in the future.
Ratio analysis also enables the business owner/manager to spot trends in a business and to compare its performance and condition with the average performance of similar businesses in the same industry. Ratios of the company are compared with the average of businesses similar to company. It may provide the all-important early warning indications that allow the business owner to solve business problems before the business lose its competitiveness.
Basically there are three main categories of ratios:
- Profitability ratios
- Short-term liquidity ratios
- Long terms liquidity ratios
The profit value presented in the income statement may provide an indication of the size of the business, but it has limited information of the performance of the company. In order to evaluate the level of profit, it must be compared and related to other aspect of the business, such as the amount of capital invested and the net sales generated. Some of the key profitability ratios are:
- Return on Total Asset (ROTA) – percentage of net profit before interest and taxes against the sum of fixed assets and current assets.
- Return on Capital Employed (ROCE) – percentage of net profit before interest and taxes against the total capital employed.
- Net profit margin – percentage of net profit before interest and taxes against sales revenue.
- Net asset turnover – the ratio of sales revenue by the capital employed.
ROTA measures the ability of the management to utilize the total assets of the business in order to generate profits. Note that the net profit is taken before interest and taxes, because interest and taxes are beyond the control of the management.
Capital Employed (CE) is usually defined as Fixed Assets plus working capital, which are current assets less current liabilities. This reflects the investment required to run the business. Note that ROCE is actually a product of Net profit margin and Net asset turnover.
Net profit margin measures how much the business needs to sell goods and services at a price higher than the cost. A business in an industry that has a higher than average industry value would indicate a good management in the business as the low cost production is able to generate high profit figure.
Net asset turnover gives indication of how much the business must utilize the capital employed to generate sufficient sales volume and revenue to maximize the profit. A very high ratio would indicate over trading, i.e. more sales revenue with little investment. But a very low ratio indicates under trading, i.e. inefficient use of resources invested into the business.
Short-term liquidity ratios include:
- Current ratio – ratio of current assets against current liabilities
- Acid test ratio – ratio of current assets less stock against current liabilities
These ratios measure the ability of the business to meet its short-term financial commitments, indicated by the current liabilities.
Current ratio assumes that all current assets, when converted to cash, can be used to pay all the current liabilities immediately. Experts recommend that the ratio should at least be 2:1, i.e. the current assets are twice the value of the current liabilities, to allow for safety margin. Although this seems logical, but it is hard to realize. The best is to compare against standard industry ratio.
Acid test ratio gives a more prudent measure of short-term liquidity, in the sense that it takes into account only ‘realizable’ current assets that is able to pay the current liabilities, i.e. stocks is not always readily converted into cash at full value.
Long term liquidity ratios concern with the financial structure of the company. It indicates how much the capital employed has been financed either by shareholders and earnings, or through borrowing and financing. The ratios include:
- Gearing ratio – percentage of long term debt against the sum of equity and long term debt.
- Interest cover – ratio of net profit before interest and taxes against interest paid.
Gearing ratio measures the percentage of capital employed that is financed by debt and long-term finance. A higher ratio means high dependence on borrowings and long term financing, thus increasing the financial risk to the business. A lower ratio means high dependence on equity financing. Thus, the business owner must find a balance between these two factors (long-term financing and equity financing) to minimize the risk introduce to the business so as not to jeopardize the profitability.
Interest cover measures the company’s ability to afford the interest introduced by the financing it has committed to.
Home Depot analysis
A1: Based on the information gathered on the 5th August 2002, Home Depot is ranked at 18th, in terms of revenue rank. By looking at the industry rank, in the ‘Specialty Retailers’, Home Depot is ranked at 1st place.
A2: From the information given, it can be said that Home Depot is financially strong, given that the revenue and profits it generated has increased quite significantly from the previous year. Its revenue has increased for 17.1% to rake up at $53,553 millions, and its profits increased by 17.9% to $3,044 millions. (please refer to the attached printouts from the Internet). Its assets showed a stagnant position, worth at $26,394 millions and the stockholder’s equity is worth at $18,082 millions. Currently, the market value of Home Depot, as of 14th March 2002, is valued at $113,300.3 millions of dollars. Besides that, Home Depot has managed to elevate its rank from 23rd place in last year to 18th place in this year.
A3: Comparing the data gathered from the Fortune’s web site, the details are tabled below:
- From the details tabled above, if we look at the profit figure per se, it can be deduced that Home Depot is more profitable from its competitor, Lowe’s. This is because Home Depot has recorded profits amounting to $3,044 millions, almost tripled the profit figure recorded by Lowe’s, $1,023 millions.
But, looking at different angle, in terms of performance, Lowe’s has the advantage over Home Depot, in the sense that Lowe’s has recorded a higher percentage of profit increase than Home Depot’s, which is 26.3% compared to 17.9%.
- Home Depot has the greatest “profits as % of revenues” and “profits as % of stockholder’s equity” with figure of 5.7% and 16.8%, respectively.
“Profits as % of revenues” or known as “Gross profit margin” in the text refers to the degree of profitability in producing and selling goods before taking into account any other expenses. As such, the figure indicates that Home Depot managed to maintain higher profitability than Lowe’s.
“Profits as % of stockholder’s equity” measures the profits that can be generated from the amount invested into the company by the stockholders. High percentage means that the investment made is being used effectively that the company managed to generate higher profit, i.e. its worth the money invested. Low percentage indicates that the investment is not quite favorable in the sense that the money invested is not being able to generate much profit. This term is referred in text by the name of Return On Stock Fund (ROSF) which is the percentage of the profits generated against the stockholder’s equity.
A4: Trend percentage for ‘Net Sales’ and ‘Cost of Merchandise’ for the last four years (please refer to the attached printout of Home Depot’s 10 year summary of financial and operating results). The ‘Cost of Merchandise’ can be interpreted as the ‘Cost of Goods Sold’ which can derive from the following equation:
Gross margin = Sales – Cost of Goods Sold
Cost of Goods Sold = Sales – Gross Margin
From the analysis tabled above, it can be deduced that the growth rate for both accounts is quite similar. The range is between 23% - 27%. However, the ‘Net Sales’ has recorded a higher growth rate compared to ‘Cost of Merchandise’. The growth for ‘Net Sales’ is 27% (from 1998 to 1999), 24% (from 1999 to 2000) and 26% (from 2000 to 2001).
Considering the fact that Home Depot receives quite a stiff competition from the other competitors, it can be said that the growth rate is favorable, very promising, and quite consistent. This would probably attracted other investors to invest into this company thus enabling Home Depot to expand the business.
A5: The number of stores that will be opened in the next month is eight stores (please refer to the attached printout titled ‘Stores Opening Soon’ from the Home Depot web site). Out of these, seven stores will be opened in the United States the one remaining will be opened in Canada. Besides for the next two months or so, Home Depot will also expanding the business aggressively in both countries. This might indicate that in the future, the business will be much better and an increase in revenues is expected.
The increase in revenue can be expected if there is no other dramatic changes in economic environment. Besides that, the revenue that could be generated is also depending on other circumstances, such as the law policy in the Canada that might increase the amount of expenses (i.e. more tax for foreign company), high or low spending power in the Canada, economic downturn in the US, any many other external factors. Although these factors should have been taken into account before Home Depot expands the business, but looking at the opportunities, Home Depot could generate a much higher profit than the previous years.
Bibliography
- Peter Atrill & Eddie Mclaney, “Accounting and Finance for non-specialist”, pg 146-149.
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Biz/ed, “Financial Ratios – General Information on Ratios”,
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Home Depot, “10-year summary of Financial and Operating results”,
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Highlight Investments Inc., “Technical Analysis Glossary: Trend ratio analysis comparisons”,
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Highlight Investments Inc., “Commodities Stock Glossary: Vertical analysis income”,
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Highlight Investments Inc., “Glossary Horizontal Analysis Base investor stock”,