Assessment of Home Depot’s Financial Status

Introduction

Risk assessment is one of the valuable tools in accounting and for investors. The evaluation of financial reports can give insights into potential risks and opportunities in a company and industry. The present and past financial performances of an organization are valuable in making investment decisions. They give investors confidence that their undertakings are worthwhile and profitable (Milenković, Pjanić & Ostojić, 2011). The profit investors get from their investments is heavily dependent the efficiency of a company in utilizing its resources to generate income.

Financial statements provide data about the performance of a company within a period, usually one fiscal year. Most of the firms publish their financial statements in their annual reports, which contain the balance sheet, consolidated income statement, consolidated cash flow statement, and shareholders’ equity statement. The assessment of these materials yields information about how a company spends and earns. It also outlines potential threats and opportunities in internal and external business environments and how the company manages to utilize them. This paper analyzes financial statements of Home Depot for the year ending 2016.

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Company Background

Home Depot is the largest retailer in the home improvements industry worldwide. It is the second largest retailer in the US after Walmart. The firm retails a broad range of building items, home improvement products, and services. Home Depot focuses on three groups of consumers that include do-it-yourself (DIY), do-it-for-me DIFM, and professional customers. At the end of January 2017, the company had about 2278 stores across the US and Puerto Rico, Canada and Mexico. Consumers can also access from of Home Depot through the online platforms. Home Depot also offers services such as clinics and workshops to impart project knowledge among its customers.

Home Depot has made significant improvements in expanding its market share, increasing its revenues and assets. The company entered the China’s booming market in 2006 and acquired Chinese home improvement retailer with 12 stores. Home Depot first entry into the global market was in 1995 when it started operating in Canada. The company expanded its operations to Mexico. Although 90% of Home Depot retail stores are located in the US, the firm has more than 300 stores across the border (Walters, 2017). A look into the revenues of the company over the years also indicates positive improvements in its financial well-being. The calculation and interpretation of financial ratios using its financial statements provide more insights its financial status.

Financial Analysis

The analysis of financial statements involves an evaluation and a review of a company’s financial data. The analysis enables a company to gain a deeper understanding of its financial health, hence making more effective decisions. The assessment of financial statements method helps in the determination of a company’s past, current, and future performance. To analyze the Home Depot financial statements one can use horizontal analysis, vertical analysis or ratio analysis. The horizontal analysis involves the comparison of the financial performance of a company between two years or more than two years. Lastly, the ratio analysis takes into account the statistical relationship between data.

The financial statement analysis will allow one to identify the trends of Home Depot across multiple time periods. This will aid in the calculation of the company’s profitability, cash flow, efficiency, and liquidity. The balance sheet will provide the financial data of Home Depot assets, shareholder’s equity, and liabilities. This information will help in the analysis of the company’s debts and assets. The income statement starts with sales and ends with net income. This will provide one with net profit, operating profit, and gross profit (Taylor, 2010).

This paper will adopt a ratio analysis approach. This approach calculates the relative size of one number in comparison with another. Following the calculation of a ratio in one period it is compared with a calculated ratio for a prior period to help understand whether Home Depot Company performs according to the expectations of the public. Financial ratios are grouped into categories that evaluate various aspects of Home Depot’s financial well-being. The categories of the financial ratios are liquidity, activity, leverage and profitability ratios (Subramanyam, 2009).

The balance sheet of Home Depot is a valuable tool for investors since it enables them to determine the financial position of the company before channeling the resources into the company. Investing in a company should consider the risks involved as well as returns. The balance sheet provides information that investors can use to track spending and earning of an organization (Kumar, 2017). The data presented in this financial statement yields insight into organizational performance within a three-year period in most cases. Therefore, investors can use the balance sheet to project their earnings from the resources they inject into an enterprise.

Balance sheets indicate the values of assets, liabilities, and shareholder’s equity of a firm during a given fiscal year (Kumar, 2017). Assets represent the value of properties, equipment and other items an organization possesses. Equity is the amount of cash a company owes its shareholders. Liabilities are resources that the company owes its debtors. The comparison between liabilities and assets of a firm indicates its financial health.

Liquidity ratios

Liquidity and solvency ratios are determined using data in this financial statement. They help investors to evaluate the ability of a company to settle its obligations. The inability of a firm to settle its debts may reduce the return on investments, thereby, disappointing investors. The analysis of data in the balance sheet enables individuals to evaluate the chances of an organization being bankrupt. For instance, the value of assets of Home Deport exceeds its liabilities. Therefore, this company can liquidate its assets to settle its obligations. Liquidity ratios measure the ability of an organization to address its margin of safety and debt obligations. Some of the ratios that measure liquidity include; cash coverage ratio, current ratio, liquidity index and quick ratio.

Cash coverage ratio

This ratio is used in the determination of the amount of cash available to interests Home Depot owes its debtors. The ratio must be more than the ratio of 1:1 to demonstrate the company’s ability to meet borrowed funds. It is obtained by dividing the sum of income before taxation and non-cash expenses by the interest paid.

2017: (12491+1754)\ 972= 14.65

2016: (11021+1690)/919= 13.83

2015: (9976+1690)/830= 14.05

All the ratios in the three years were above 1 meaning that the company is able to meet its debts. In 2017 the company posted the biggest ratio meaning its ability to settle debts have improved.

Current ratio

Investors can use this ratio to evaluate the company’s ability to settle debts in the near future. It informs the creditors on whether to lend funds to an organization. It is measured by dividing current assets by current liabilities.

2017: (17724\14133) = 1.25

2016: (16484/ 12524) = 1.32

The sudden increase in Home Depot assets shows that the company has increased its operations. There is also an increase in the current liabilities meaning that the company has borrowed more. This is the reason why the ratio has decreased from 1.3 to 1.2 meaning that the company payment period to its debtors has increased due to a large number of operations.

Leverage ratios

They show the extent to which a company relies on its debts to fund its operations as well as its ability to meet its debts. Such ratios include; debt to equity ratio, fixed charge coverage and debt service coverage ratio.

Debt to equity ratio

It is used to ascertain the riskiness of investment practices and financial policies of a company. It is closely followed by creditors and lenders since it provides insights into the compliance of Home Depot to its obligations. It is also used to inform company owners on when to use debts to buy back debts to increase the return on investment to shareholders. When this ratio is low, it indicates financial stability of Home Depot. A higher debt to equity ratio would mean that the business operations are risky for creditors since the investors will not have funded enough. When the ratio is 1, it indicates uncertainties in Home Depot’s ability to meets its debt obligations. At such point, the value of assets of the company is the same as its liabilities. It is calculated as follows; (Long-term debts + short-term debts + leases)/equity.

2017: (22349+ 710) \ 4333= 5.32

2016: (20789+ 6565)\6316= 4.3

In both years the company has a high debt to equity ratio. However, in 2017 the ratio is higher. This means that the lenders and creditors confidence for the company to pay debts will increase. In general, the company is in a better position since the investors have a large stake in the company compared to borrowed funds.

Activity ratios

This ratio is used to check how well the management has used the company resources. It measures the ability of the company to convert its capital, assets, and liabilities into sales or cash. The faster the conversion ability, the more efficient the business is. Such ratios include accounts payable turnover ratio, inventory turnover ratio, accounts receivable ratio, average collection period and fixed asset turnover ratio.

Average collection period

This financial tool evaluates the efficiency of Home Depot in collecting payments from its customers. When the ratio is low, it shows that Home Depot is more efficient. The average collection period represents the number of days the company takes to collect payments for items bought on credit. It is determined by multiplying the dividend of account receivables and the number of days in a year.

2017: (2029/ 94595) * 360 = 7.72 days i.e. 8 days

2016: (1890\ 88519) * 360 = 7.68 days i.e. 8 days

This shows that the customers are able to pay back the merchandises on time. In both years, the customers have paid on an average of 8 days.

Market value ratios

Market value ratios are another category of financial ratios. They analyze the financial health of a company in the market by focusing on the valuation of the firm’s stock. Market value ratios determine whether the shares of an organization are undervalued, overvalued or valued fairly. Earnings per share is an example of market value ratio that determines the returns that investors get from their shares in the company. For the case of Home Depot, earnings per share in 2014, 2015, and 2016 are $4.74, $5.49 and $6.47 respectively. This trend indicates that the value of Home Depot in the market is improving with time. Therefore, the returns of investors have high changes of increasing every year. It will be worthwhile investing in the company. However, there is the need for comparing the EPS of Home Depot with that of other companies in the industry before making investment decisions.

Market value ratios also enable investors to assess the safety of their share in the event that Home Depot settles its obligations by calculating book value per share. It is obtained by dividing total shareholders’ equity with total outstanding shares. For the case of Home Depot, book value per share was $2.16 in 2016. This value indicates that the shares of investors are safe even when the company has settled its obligations. Therefore, they will profit from their resources in the company.

Price-earnings (P/E) ratio compares the current price of shares of Home Depot with its per-share earnings. This financial tool enables investors to estimate the amount of money they need to invest in Home Depot for them to earn one dollar of the income of the company. P/E of Home Depot has been increasing for the last three years. The company recorded 20.18, 23.15, and 23.32 P/E in 2014, 2015 and 2016. For the case of 2016, an investor must be willing to pay $23.32 in order to earn $1 of Home Depot’s income. The P/E for this company is close to that of its competitors, indicating that investing in the company is worthwhile.

Recommendations

Based on the financial analyses above, I would recommend potential individuals to invest in the Home Depot. The company is profitable. The income statement indicates continuous improvements in Home Depot’s revenue with time. Therefore, interested individuals can make long-term investments to benefit more. The investments in the company are safe as indicated by the liquidity and solvency ratios. Home Depot can settle its obligations without issues by liquidating its assets. Improvements in the market value of Home Depot stock is a guarantee that investors will benefit significantly from their resources in the company. However, before making investment decisions, people should seek professional opinions concerning their interest and the company’s performance. Experts can also provide more accurate future projections due to their experience in the field.

 

References

Kumar V. (2017). Balance Sheet Made Easy. Vinod Kumar.

Milenković, N., Pjanić, M., & Ostojić, S. (2011). Analysis of credit risk based on financial statements as the decisive factor influencing the risk of investors. In International Symposium Engineering Management and Competitiveness.

Subramanyam, K. R. (2009). Financial statement analysis. New York: McGraw-Hill.

Taylor, M. (2010). Financial statement analysis. 1-9.

Walters M. (2017). Global Strategies and Markets – The Home Depot, Retrieved on 3 December 2017 from https://sites.google.com/a/email.vccs.edu/bus100mwalters/home/strategies-for-reaching-global-markets-1