Team 5

Lowes vs. Home Depot

Maria Arteaga Jammie Abrego Jordan Blankenship Danielle Chenier Jonathan Klein Luke Rafla-Yuan

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Table of Contents

Questions 1-8.Pages 3-35

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Introduction Through vertical, horizontal, and ratio analysis of Lowes Companies, Inc. consolidated financial statements, at, the years 2005 through 2009, swe intend to ascertain the profitability, liquidity, and financial stability of Lowes Companies, Inc. In order to determine Lowes standing in its market, an analysis will be taken to assess the major strengths and weaknesses in its performance comparative to Home Depot. The report will then recommend actions that Lowes management can take to improve its future performance and competitive advantage against Home Depot. Vertical Analysis of the Balance Sheet Vertical analysis of the balance sheet shows each entry in assets, liabilities, and equities as a proportion of the total account. Through vertical analysis of Lowes balance sheet, this report will show: Lowes largest assets and how its used to operate its largest liabilities and how its incurred as well as changes in and sufficiency of cash and cash equivalents at the end of years 2005 through 2009. From 2005 to 2009, Lowes two largest assets were property and inventory and net of accumulated depreciation, constituting over 90% of its total assets. In 2005 and 2006, its third largest asset was short-term investments, which consists of investments (excluding cash equivalents) with a stated maturity date of one year or less from the balance sheet date, or investments that are expected to be used in current operations. Lowes also includes trading securities in short-term investments. Long-term investments became the third largest asset in 2007 and in 2008; its third largest asset became other assets. In 2009, cash and cash equivalents which includes short term investments with original maturities of three months or less, cash on
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hand and demand deposits, became its third largest asset at 1.9%, giving Lowes much needed liquidity in the struggling economy. Lowes Three Largest Assets

Lowes largest asset is property, which consists of land, buildings, equipment, leasehold improvements, and construction in progress. Lowes is a retail merchant and relies heavily on property as a place to store and display its products for consumers to purchase while also necessitates having inventory to be able to sell which is why inventory is its second largest asset. In 2005, cash and cash equivalents constituted 1.7% of Lowes total assets, making it its fourth largest asset. Cash and cash equivalents continued to decline as a percentage of total assets through 2008 where it hit a low of 0.8% of total assets. In 2009 cash and cash equivalents became the third largest asset at 1.9% of total assets.

2009 Cash and cash equivalents 1.9%

2008 0.8%

2007 0.9%

2006 1.3%

2005 1.7%

*This is where we will assess the sufficiency of cash at the end of each of the years. Not sure what to put yet input would be helpful. Between 2005 and 2009, Lowes two largest liabilities were long-term debt and accounts payable, with the third largest liability shifting from other current liabilities in 2005 and 2006 to other long-term liabilities for the remaining three years. Lowes Three Largest Liabilities

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Lowes largest liability, accounts payable, is the amount due to suppliers. Accounts payable increases when Lowes orders from suppliers on credit. Long-term debt, which is consistently Lowes second largest liability, includes mortgage notes, debentures, notes, medium-term and senior notes and capital leases. Lowes third largest liability during 2005 and 2006 was other current liabilities. For Lowes this includes extended warranty claims and the current portion of self-insurance liabilities such as workers compensation, automobile, property, and general and product liability claims. From 2007 through 2009, other long-term liabilities became Lowes third largest liability. Included other long-term liabilities is; extended warranty deferred revenue, deferred rent revenue and the long-term portion of self-insurance liabilities. Despite the change in Lowes third largest liability from current to long term, the proportion of current liabilities to total liabilities has stayed fairly consistent, as has the proportion of total liabilities to stockholders equity.

The proportion of total liabilities compared to total stockholders equity has fluctuated slightly from 2005 to 2009. In 2007, total liabilities hit a high of 47.9% and stockholders equity hit a low of 52.1%. Since 2007, Lowes has continued to decrease its liabilities and increase its stockholders equity. Furthermore, based on the fact that creditors have been lending money to Lowes, which have been decreasing its liabilities, it would be logical that creditors will continue to see Lowes as a sound investment. The two main components of stockholders equity are contributed capital (common stock) and retained earnings. Retained earnings have gone up every year from 2005 to 2009.
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Retained earnings increases when net income increases, decreases when net income decreases, and when dividends are declared. Contributed capital accounts change when the company issues or buys back stock.

Horizontal Analysis of the Balance Sheet Using a horizontal analysis of Lowes balance sheet, it becomes apparent that cash and cash equivalents has decreased every year from 2005 to 2008, with a large rise of 158% in 2009.

Lowes current and quick ratios have fluctuated over the years from 2005 to 2009. Both ratios hit a low in 2007, both increasing in 2008 and 2009, and almost reaching the same ratio in 2005. The current ratio shows Lowes ability to pay its short-term liabilities. With a ratio consistently over 1, Lowes would be able to pay off its short term liabilities. The quick ratio measures the extent to which Lowes can pay current liabilities without relying on the sale of inventory. Since Lowes is a retail operation, the quick ratio should be lower than the current ratio. In order to pay its short-term liabilities Lowes would have to rely heavily on the sales of inventory.

Merchandise inventory increased each year from 2005 to 2009, however, each year it rose by a small percentage because Lowes is not purchasing as much inventory. According to the annual report, Lowes planned inventory purchases more conservatively; specifically, in seasonal categories, in order to decrease the amount of markdowns. Property has also increased
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every year by a smaller percent, except in 2009 when it decreased by 1%. This decrease in property reflects Lowes not purchasing as much property or opening as many stores. In 2009, due to the continuing decline of the economy, Lowes sold some of its property and abandoned certain store openings.

Accounts payable has increased every year from 2005 to 2009, with a peak increase of 24.4% in 2006, and then a smaller percent of increase each year thereafter. This suggests that Lowes is purchasing less from suppliers, which is shown in the smaller percentage of increase in merchandise inventory. Long-term debt increases each year from 2005 to 2007 then decreases in both 2008 and 2009, showing that Lowes began to pay off more of its debt. The percentage that retained earnings have increased each year has increased and decreased in the years 2005 through 2009. The percentage that retained earnings increased began at a high of 26.5% in 2005 and hit a low of 3.3% increase in 2007. The most recent financial statements in 2009 reported a 7.4% increase in retained earnings, which will increase cash and cash equivalents, giving Lowes the opportunity to buy back more stock. Vertical Analysis of the Statement of Earnings Cost of sales for Lowes includes: purchase costs net of vendor funds, freight expenses associated with moving merchandise inventories from vendors to retail stores, costs associated with operating the companys distribution network (including payroll, benefit costs and occupancy costs), costs associated with inventory shrinkage and obsolescence, costs of installation services, and the costs associated with the delivery of products by third parties directly to the customer from the vendor.
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Cost of sales as a percentage of net sales has steadily declined every year from 65.8% in 2005 to 65.4% in 2007. In 2008, there was a slight rise to 65.8%; however, it decreased again to 65.1% in 2009.

Cost of sales as a percentage of net sales decreases when net sales increases and cost of sales either stays the same or decreases. Conversely, cost of sales as a percentage of net sales increases when net sales drops and cost of sales increases or stays the same. If there is a change in cost of sales percentage, gross profit will be inversely affected. Lowes two largest expenses are consistently, selling, advertising, general and administrative expenses (SG&A) and depreciation expenses. SG&A expenses consist of: payroll and benefit costs for retail and corporate employees, occupancy costs of retail and corporate facilities, costs associated with delivery of products from stores to customers, third party in-store service costs, tender costs (including bank charges, credit card interchange fees and amounts associated with accepting the companys proprietary credit cards), self insured plans and premium costs for stop-loss coverage and fully insured plans as well as advertising costs. SG&A expenses also include long-lived asset impairment losses, gains/losses on disposal of assets, and other administrative costs such as supplies, travel, and entertainment.

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The total percentage of Lowes two largest expenses has been increasing every year for the past 5 years. As expenses increase, net earnings decreases.

The total percentage of cost of sales and SG&A expenses for Lowes dropped slightly in 2006 as a result of a small drop in cost of sales. The total increased every year thereafter due to cost of sales staying fairly consistent while SG&A expense increased. The total for Home Depot has risen every year since 2005, which is also due to a rise in SG&A expenses. Horizontal Analysis of the Statement of Earnings Horizontal analysis shows the percentage rate of change from one year to the next for each item on the statement of earnings. Showing the changes between years in percentage form highlights the significance of the changes taking place. Through horizontal analysis of Lowes statement of earnings this report will: show the percentage rate of change in net sales compared to cost of sales and selling, general and administrative (SG&A) expenses, analyze the rates of change in comparison to one another, compare the impact of the rate of change in net sales on net earnings and gross profit to that of the impact of SG&A expenses on net earnings and gross profit, as well as compare the rate of change in net earnings for Lowes to that of Home Depot.

From 2005 to 2007, net sales grew at a faster rate than cost of sales. During 2008, net sales dropped .1% while cost of sales grew .5%. In 2009, cost of sales dropped 3.1%; a full percent more than the drop in net sales. SG&A expenses have grown at a faster rate than net
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sales every year from 2005 to 2009, except in 2006, when net sales grew .5% more than SG&A expenses. While SG&A expenses have increased every year, its doing so at a much slower rate. Each year that net sales increased so did gross profit. Gross profit dropped 1.4% from 2007 to 2008 because net sales dropped while cost of sales still increased. Although net sales continued to decrease in 2009, cost of sales dropped a full 1% more causing a much smaller drop in gross profit of .2%. Net earnings increased in 2005 and 2006 as a result of an increase in net sales and decreased in 2008 and 2009 as a result of a decrease in net sales. Net earnings decreased in 2007 even though net sales still increased. This was caused by a greater increase in SG&A expenses than the increase in net sales.

Net earnings for both Lowes and Home Depot were greatly affected by the downturn in the economy, specifically in the housing market. The percentage rate of change in net earnings shows that each company was affected in different years. Home Depots net earnings began to drop in 2006 with a major drop of 48.6% in 2008. Home depot began to show signs of recovery in 2009 with an increase in net earnings of 27.7%. Lowes net earnings began to decline a year after Home depot in 2007 and along with Home Depot, experienced the largest percentage drop in net earnings in 2008. However, net earnings for Lowes only declined 21.9% in 2008, less than half the percentage amount that Home Depot declined that year. While Lowes still shows a decline of net earnings in 2009, the decline has slowed to 18.1% and will presumably continue to slow and eventually recover in the ensuing years. This slowing decline in net earnings puts Lowes in a better position for full recovery than Home Depot because while Home Depot may be recovering it experienced a much larger drop in net earnings. From 2005 to 2009, net

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earnings for Home Depot dropped a total of 54.4 while Lowes net earnings only dropped 18.1%.

Horizontal Analysis of the Statement of Cash Flows Horizontal analysis of the statement of cash flows shows the percentage rate of change for net cash provided by operating activities, net cash used in investing activities, and net cash used in or provided by financing activities. Through horizontal analysis of Lowes statement of cash flows, this report shows: the percentage rate of change in net cash flows from operating activities for both Lowes and Home Depot for the years 2005 through 2009, the percentage rate of change in net cash flow from investing and financing activities, the explanatory change in these percentage rates over the years and identify specific events that have an impact on cash flows, distinguish what caused the difference between net earnings and cash flow from operating activities for Lowes in 2009, present a table showing the dollar amount of net cash flow from operating activities and cash paid out for fixed assets acquired and the cumulative total of both for the past five years as well as compare the dollar amounts for the years 2005 through 2009.

Net cash flow from operating activities (OCF) for Lowes increased in 2005 and 2006, but has decreased every year with the largest drop of 5.2% in 2008. Home Depot has had a decrease in OCF every year from 2005 to 2009; except for 2006, when net cash flows increased 15.7%. In 2009, Lowes OCF was $4,054 million dollars while net earnings were only $1,783
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million. OCF is recorded in cash flow timing, which means amounts are recorded as cash is brought in or paid out while net earnings are recorded in accrual timing meaning amounts are recorded as each earned or incurred. The large difference between net earnings and net cash flows is caused mainly by depreciation and amortization expenses, which are non-cash expenditures, being added back to net earnings in order to get OCF.

The percentage rate of change for Lowes investing activities fluctuates over the years from 2005 to 2009. However, from 2005 to 2007, Lowes used more cash in investing activities each year; while in 2008 and 2009, Lowes used a great deal less cash in investing activities and specifically less in the investments in property. Lowes has used cash in financing every year from 2005 to 2009. The fluctuation in the percentage rate in change is a measure of how much cash outflow there is in financing activities from year to year. In 2005, Lowes spent 73.7% less on financing activities than in 2004, whereas in 2006, it spent 207.6% more on financing activities than it did in 2005. The large fluctuation in the percentage rate of change for net cash flows from financing is due to the fluctuation in proceeds from issuance of long-term debt, its issuance of dividends, and the repurchasing of common stock.

Cumulatively, the amount spent on fixed assets is lower than the amount of net cash flow from operating activities (OFC). Every year from 2005 to 2009, OCF has been more than the amount of cash paid out for fixed assets. In 2005, OCF was only 463 million more than cash paid out for fixed assets acquired; while in 2009, Lowes generated 2,255 million more in OCF

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than what was paid out in cash for fixed assets acquired. The most noticeable difference is caused by Lowes purchasing less property in 2009 than in previous years. Financial Analysis Ratios There are several different classes of financial ratios used to analyze a companys financial position. This report will focus on four classes of ratios, specifically profitability, liquidity, solvency and market test ratios. Profitability Ratios Profitability ratios measure a companys ability to utilize its resources to generate profit. This report will focus on Lowes return on equity and return on assets ratios, financial leverage percentage, basic earnings per share, quality of income, profit margin, and fixed and total asset turnover ratio in order Lowes competency in using its resources to generate profit. Return on Equity (ROE) measures Lowes profitability by calculating how much profit is generated with the money that shareholders have invested. This is done by dividing net income by averages shareholders equity. Lowes ROE has steadily declined from 2005 to 2009, while net income has increased from 2005 to 2006. Shareholders equity is also increasing by a greater percentage and causing a decline in ROE. From 2007 to 2009, net income steadily decreased mostly as a result of an increase in expenses, while shareholders equity increased. Furthermore, Lowes has been generating less income with the money shareholders are investing. Return on assets (ROA) is calculated by dividing net income plus interest expense by average total assets. Adding interest expense to net income shows operating costs before cost of borrowing. ROA illustrates how efficient Lowes is at using assets to generate earnings. Lowes
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ROA has declined from 2005 to 2009 which is caused by both a decrease in net income and a rise in average total assets. The financial leverage percentage measures the difference between ROE and ROA showing how many dollars of assets are used for every dollar of shareholders equity. This difference is positive when a company borrows at an interest rate that is lower than the rate of return will receive that on its assets. While Lowes financial leverage percentage has stayed positive, it has decline each year from 2005 to 2009 as a result of ROE declining at a faster rate than ROA. In effect, Lowes is using more dollars of shareholders equity for every dollar of assets each consecutive year. Basic earnings per share (EPS) is a measure of return on investment, meaning how much of the companys profit is allocated to each share of common stock. EPS is calculated by dividing net income by average number of shares of common stock outstanding. Lowes EPS increased from 2005 to 2006 but has declined each year since. The rise in EPS was caused by a rise in net income combined with a drop in the average number of shares of common stock outstanding. The decline was caused by a faster rate of decline in net income than in the average number of shares of common stock outstanding. Quality of income shows how many dollars of net income come from cash generated by operating activities. A ratio over one indicates a high quality of income. Lowes quality of income has consistently been over one and has increased every year from 2005 to 2009 as a result of net income decreasing at a faster rate than cash flow from operating activities. Profit margin is calculated by dividing net income by net sales which shows what portion of income is derived from sales. Lowes profit margin increased from 46.4% in 2005 to 6.6% in
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2006 due to larger rise in net income than in sales revenue. This indicates that in 2006 more of Lowes income was generated by sales than in 2005. Since 2006, Lowes profit margin has steadily decreased due to a lower net income as compare to sales revenue showing that Lowes has made a smaller percentage of income from sale is each year from 2007 to 2009. Fixed asset turnover ratio is an indicator of how well a company is able to generate sales from its fixed asset investments, specifically property plant and equipment. This ratio is calculated by dividing net sales revenue by average fixed assets, which are long-term tangible assets. Lowes fixed asset turnover ratio has decreased every year since 2005 because of a larger rise in fixed assets than sales revenue. Total asset turnover ratio is the amount of sales revenue divided by total assets and is a measure of the amount of sales generated for every dollar worth of assets. Lowes total asset turnover ratio has been declining every year as well. Because property is consistently Lowes largest asset, it has the greatest impact on the total asset turnover ratio. As Lowes invests more money in property and generates less in revenue, the ratio declines. Liquidity Ratios Liquidity ratios measure a companys ability to pay off its short-term debt obligations. This report will look at Lowes current, quick and cash ratios, inventory and accounts payable turnover, and the number of days supplies are in inventory and the number of days to pay back suppliers. In addition, The first three ratios measure Lowes ability to pay its short-term debt obligations with its most liquid assets. The biggest difference between the three ratios is the types of assets used in the calculation. Each ratio includes current assets but the quick and cash ratios exclude some current assets that are not necessarily easily converted into cash.
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The cash ratio is the most stringent of the short-term liquidity ratios. It is calculated by dividing cash and cash equivalents by current liabilities. The cash ratio does not take into account inventory or receivables because there is no guarantee that these can be converted into cash in time to pay current liabilities. Very few companies will have enough cash and cash equivalents to fully cover current liabilities because a company that maintains a high level of cash assets in order to cover current liabilities would be utilizing assets poorly as the cash could be used to generate higher returns elsewhere or returned to the shareholders. Lowes cash ratio declined in 2005, 2006 and 2007 due to a decrease in cash and cash equivalents and an increase in current liabilities. In 2008, both cash and cash equivalents and current liabilities dropped but cash dropped a larger percentage than current liabilities, causing another decline in the cash ratio. In 2009, there was the largest rise in the cash ratio to .09 because of a rise in cash and cash equivalents and a drop in current liabilities. The quick ratio is calculated by dividing quick assets, which are cash and near cash equivalents including short-term investments and accounts receivable net of allowance for doubtful accounts, by current liabilities. By excluding inventory, the quick ratio focuses on the more liquid assets of a company. If the current ratio is significantly higher than the quick ratio, it is an indication that the companys assets are dependent on inventory. Since Lowes does not have accounts receivable and does not have a large percentage of total assets tied up in shortterm investments, the quick ratio mirrors the cash ratio, declining every year except 2009 when it increased. The current ratio is a measurement of the proportion of current assets available to cover current liabilities. Lowes current ratio follows the same trend as the quick and cash ratios, declining from 2005 to 2008 and then rising in 2009. The current ratio is significantly higher
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than the quick and the cash ratios, indicating that inventory is a large percentage of Lowes current assets. Because inventory is such a large percentage of Lowes total current assets, the current ratio is not a good measure of liquidity owing to the fact that there is no assurance as to when the inventory will be converted into cash. The inventory turnover ratio can be calculated two ways, either by taking sales divided by inventory or by taking cost of goods sold divided by average inventory. This report will use the calculation with cost of goods sold because sales are recorded at market value while inventories are usually recorded at cost and average inventory minimizes seasonal factors. The inventory turnover ratio determines how many times inventory is sold and replaced over a period of time. Average inventory for Lowes increased every year for the past five years. Cost of goods also increased every year from 2005 to 2008, but at a much slower rate causing the inventory turnover ratio to decrease. The largest drop in inventory turnover was in 2009 when cost of goods sold declined as well. Days supply in inventory is a measure of how many days it takes a company to sell its inventory. This is calculated by dividing the inventory turnover ratio into days in the fiscal year, which for Lowes is 365 days. Because the inventory turnover is decreasing, days supply in inventory is going up, meaning that it is taking Lowes longer to sell its inventory. The accounts payable turnover ratio is a measure of short-term liquidity used to gauge the rate at which a company pays its suppliers. It is calculated by dividing the cost of supplies by average accounts payable amount. Lowes accounts payable turnover ratio is decreasing every year from 2005 to 2009. This is because while cost of supplies has increased every year except 2009, average accounts payable has increased at a faster rate.
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Days to pay suppliers ascertains how many days it takes a company to pay its suppliers by dividing the accounts payable turnover ratio into days in the fiscal year. Days to pay suppliers is effect inversely by the accounts payable turnover ratio, meaning that as Lowes accounts payable turnover ratio decreases the days that Lowes takes to pay its suppliers increases. Solvency Ratios Solvency ratios are used to asses companies' abilities to meet its long-term obligations. This report with focus on times interest earned, cash coverage, debit to equity and capital acquisition ratios in order to determine Lowes ability to meet its long-term obligations. Times interest earned (TIE) is a measure of a companys ability to meet its debt obligations. TIE is calculated by taking earnings before interest and taxes (EBIT) and dividing it by the interest payable on debt. This ratio determines how many times a company can cover its interest charges on a pretax basis. Failing to meet these obligations could force a company into bankruptcy. While having enough to pay is vital, a high ratio can demonstrate that a company is not financing with a desirable amount of debt or that the company is paying down too much debt with earning that could be more useful elsewhere. Lowes TIE ratio increased in 2005 and 2006 as a result of a decrease in interest expense coupled with an increase in EBIT. Lowes TIE ratio decreased in each consecutive year thereafter. While interest expense increased, each year net income decreased in 2007, 2008 and 2009. Cash coverage ratio is determined by dividing cash flows from operating activities (OCF) before interest and tax by interest paid and measures a companys cash generated as compared to its cash obligations. For Lowes, the cash coverage ratio increased in 2006 because of a greater
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increase in OCF than in interest paid. For the remaining 3 years, the cash coverage ratio decreased due to a rise in interest paid and a drop in OCF. The debt to equity ratio measures what portion of equity and debt a company is using to finance its assets. A high debt to equity ratio denotes that a company has been aggressively financing its growth with debt. This can cause unstable earnings as a result of the additional interest expense incurred from acquired debt. Lowes debt to equity ratio has stayed fairly stable over the past five years but has remained under one during that time period. The capital acquisitions ratio is calculated by dividing net cash flows from operating activities (OCF) by cash paid for fixed assets. This ratio illustrates a companys ability to finance purchases of fixed assets from internal sources. While Lowes capital acquisition ratio remained more or less consistent from 2005 to 2008, there was a dramatic increase in 2009 caused by a dramatic drop in cash paid for fixed assets. The drop in the cash paid for fixed assets was due to a slowing in store expansions as well as the abandonment of certain store openings. Market Test Ratios The price earnings ratio (P/E) shows how much investors are willing to pay per dollar of earnings and is determined by dividing current market price by earnings per share. A high P/E usually means that investors are expecting a higher return on its investment. In order to interpret a companys P/E ratio it should be compared to that companys previous P/E ratios, other similar companies P/E ratio or P/E ratios of the market in general. Lowes P/E ratio has fluctuated during the past five years with a low of 12.18 in 2008 and a high of 18.17 in 2009. That means that in 2009 for every dollar investors put into Lowes, it expects $18.17 in return. A faster drop
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in current market price than drop in earnings per share caused the decreases in Lowes P/E ratio. The increase in the P/E ratio in 2009 was caused by a decrease in earnings per share in combination with an increase in current market price. In order to calculate the dividend yield ratio, dividends per share is divided by market price per share.

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