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Profitability

Trimester II

Financial Analysis

Lecture XI


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Financial Analysis: Group-work II

Report on The Home Depot Inc.

Part I of Report (Case Study)Already circulated in a case on The Home Depot. The case wasprepared in the 80s, less than a decade after the company was setup in 1978. There are 4 questions at the end of the case. Theanswers should be submitted in hard copy to me by 5.30 pm on30th November 2012

Part II of ReportUsing information available on the internet including the companywebsite, please submit a report in hard copy to cover the aspectsmentioned in the next slide to me also by 5.30 pm on 30thNovember 2012

Main Reference

https://corporate.homedepot.com


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Part II of Report

The Home Depot Inc. today

Home Improvement Industry in the US

Major players in the industry and their marketpositioning/share

Financial Position of The Home Depot

Financial and Operating Performance of the companyduring the last fiscal

SWOT analysis of the company

Strategy of the company

Main Reference

https://corporate.homedepot.com/wps/portal


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Profitability Measures

Exclude items of income notarising from

normal operations

Discontinued operations

Extraordinary items


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Net Profit MarginNet Income after excluding non-recurring items

= --------------------------------------------------------------

Net Sales

Also referred to as return on sales

Reflects net income generated by each dollar ofsales

Potential distortion can be caused by other incomeor loss, as these do not relate to net sales i.e. thedenominator

Other income or loss can times be significant


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Total Asset Turnover

Measures the activity of the assets and the

ability of the firm to generate sales through

the use of the assets

Potential distortion

Investments

Construction in progress

Other assets that do not relate to net sales

Net SalesAverage Total Assets


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Return on Assets

Net Income after excluding non-recurring items= --------------------------------------------------------------

Average Total Assets

Measures the ability to utilize assets to create

profits

Average total assets Internal analysis: month-end amounts

External analysis: beginning and ending amounts


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Concept of Dupont Return on Assets

The Net Profit Margin, the Total Assets

Turnover and the Return on Assets are

usually reviewed together because of the

direct influence that the first two ratios

have on Return on Assets

Please see the next slide

When these ratios are reviewed together, it

is called the Dupont Return on Assets


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DuPont Return on Assets(Concept of Minority Interest explained in next slide)

Return on Assets = Net Profit Margin Total Asset Turnover

Net Income Before Net Income BeforeMinority Share of Minority Share of Earnings and Earnings and

Nonrecurring Items Nonrecur=

Average Total Assets

ring Items Net Sales

Net Sales Average Total Assets


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Minority interest Minority interest represents shares owned by third parties when Company A

acquires Company B. In other words, minority interest represents the equity

interest of outside shareholders in consolidated subsidiaries. Under US GAAP, if Company A owns 50% or more of Company B, the two

companies are treated as if they were one for financial statement purposes.

Thus an account- namely, minority interest - must be presented to indicate

that not all the assets and liabilities are related to Company A, the parent

company. Minority interest ordinarily appears on the balance sheet between liabilities

and shareholders equity. On the income statement, minority interest in the

income of a consolidated subsidiary is shown as a deduction of

consolidated net income.

If Company A has a minority interest of less than 50% in Company B, thenminority interest does not appear on the balance sheet or income statement

of Company A, and other methods are used to account for its minority

interest


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DuPont Return on Assets (contd) DuPont analysis separates return on assets into net profit margin and total

asset turnover

Separating the ratio into the two elements allows evaluation of the causesfor the change in return on assets

Return on Net Profit Total AssetAssets = Margin Turnover

Firm AYear 1 10% = 4.0% 2.5Year 2 8% = 4.0% 2.0

FIRM BYear 1 10% = 4.0% 2.5Year 2 8% = 3.2% 2.5


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DuPont Analysis Variation

Consider only operating assets and income Operating assets exclude

Construction in progress Long-term investments

Intangibles Operating income includes only

Net sales Operating expenses

Operating ratios may give significantlydifferent results from Net earnings ratios insome cases

Reflective of ROA from primary business


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Operating Income Margin

Use operating income in the numerator

Operating IncomeNet Sales


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Operating Asset Turnover

Measures the ability of operating assets to

generate sales revenue

Net SalesAverage Operating Assets


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Return on Operating Assets

Measures the ability of operating assets to

generate operating income DuPont analysis of the return on operatingassets:

Operating IncomeAverage Operating Assets

DuPont Return Operating Operatingon = Income Asset

Operating Assets Margin Turnover


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Sales to Fixed Assets

Measures the ability to make productive use

of property, plant, and equipment bygenerating sales

Exclude construction in progress

Some possible distortions/differences

Old fixed assets

Labor-intensive vs. Capital-Intensive industry

Net SalesAverage Net Fixed Assets


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Return on Investment (ROI)

Measures the earnings on investment (Long-

term liabilities + Equity) and indicates how

well the firm utilizes its asset base Evaluates earnings performance of the firm

without regard to the way the investment is

financed

Net Income Before Minority Share ofEarnings and Nonrecurring Items+ Interest Expense 1-Tax Rate

Average Long-Term Liabilities + Equity


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Return on Common Equity

Measures the return to the common stockholder Common equity:

Total stockholders equity less preferred

capital

Net Income Before Nonrecurring Items- Preferred Dividends

Average Common Equity


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Gross Profit Margin

Sales Cost of Goods Sold

= Gross Profit

Beginning Inventory+ Purchases of Inventory

Ending Inventory

Gross ProfitNet Sales


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Gains and Losses from Prior Period

Adjustments as per US GAAP

Charged directly to retained earnings

Changes in accounting principles

Correction of errors originating in prior periods


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Comprehensive Income as per US GAAP

Following items are not included in net income but reported as a

separate component of stockholders equity

Foreign currency translation adjustments

Unrealized holding gains and losses from available-for-

sale marketable securities Changes to stockholders equity resulting from

additional minimum pension liability adjustments

Unrealized gains and losses from derivative

instruments


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Ratios for the Investor

Financial Analysis

Lecture XII Part I


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Financial Leverage

The use of debt (financing with a fixed charge

such as interest) is referred to as financial

leverage

Interest as related to debt financing A contractual obligation

Must be paid regardless of entitys current profits

Contrast with dividends which are discretionary Interest is tax deductible

Reduces taxable income, and therefore

Reduces income tax


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Operating Leverage The existence of fixed operating costs is referred to as

Operating Leverage which also affects earnings

The higher the percentage of fixed operating costs,the greater the variation in net income as a result of

variation in sales (revenue) Interest (on most debt) is a fixed charge, which is

dependent on the amount of financial principal andrate of interest; as such, financial leverage can be

easily computed from published financial statements On the other hand, operating leverage cannot be

readily computed from published financialstatements


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DOWELL COMPANY (Exhibit 9-1)Financial Leverage

Partial Income Statement to Illustrate Magnification Effects

20% Decrease 10% Increasein Earnings in Earnings

Base Year Before Interest Before InterestFigures and Tax and Tax

Earnings before interest and tax $1,000,000 $ 800,000 $1,100,000Interest (200,000) (200,000) (200,000)Earnings before tax 800,000 600,000 900,000Income tax (40%) (320,000) (240,000) (360,000)Net income $ 480,000 $ 360,000 $ 540,000

Percentage change in net income [A] 25.0% 12.5%Percentage change in earnings before

Interest and tax [B] 20.0% 10.0%Degree of financial leverage [A B] 1.25 1.25

Net income increase [A] is greater than change in EBIT [B] due to

the fixed nature of interest expense

The concept of Degree of Financial Leverage is clarified further

in the next slide

Financial Leverage and Magnification Effects


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Computation of the Degree of

Financial Leverage% Change Net Income

% Change EBITThe degree of financial leverage is themultiplication factor by which the net

income changes in respect to changes

in EBIT

Degree of financial leverage

calculations should exclude

Nonrecurring items


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Earnings per Share

Required disclosure for corporate incomestatements

Pertains only to common stock

Per-share amounts are disclosed (as per USGAAP) for

Income from recurring items

Discontinued operations

Extraordinary items

Net income


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Basic Earnings per Share

Net Income - Preferred DividendsWeighted Average Number ofCommon Shares Outstanding

Earnings pertain to an entire fiscal period

Average of common shares outstanding is used forcomputation of the EPS

What is computed is a weighted average, as shown in

the next slide


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Weighted Average Common Outstanding

Months Shares Shares Fraction of Year WeightedAre Outstanding Outstanding Outstanding = Average

JanuaryJune 10,000 6/12 = 5,000JulySeptember 12,000 3/12 = 3,000OctoberDecember 15,000 3/12 = 3,750

11,750

Think as to why we compute such a

weighted average!

What do we do in case of stockdividends and stock splits? This is

explained in the next slide.


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Stock dividends and Stock splits

In the event of Stock dividends and stock

splits

Retroactive recognition must be given to these

events for all comparative earnings per sharepresentations

Stock dividends and stock splits only change the

number of outstanding shares EPS should be related to the outstanding

common stock after these events


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EPS: Examples of Potentially dilutive securities:

ESOPS

Other Options on stocks

RightsWarrants

Convertible debentures

Convertible debt

Convertible preferred equity


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Price/Earnings Ratio

Measures the relationship between the market

price of a share of common stock and that stockscurrent earnings per share

Use of diluted earnings per share gives a higher PE Ratioi.e. a more conservative price/earnings ratio

Investors view the PE ratio as a gauge of future earningpower of the firm

It therefore stands to reason that the PE ratio should becomputed using diluted EPS for continuing/recurring

earnings per share

Market Price per Share

Diluted Earnings per ShareBefore Nonrecurring Items


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Price/Earnings Ratio (contd)

Compare with

Industry competitors

Industry average

Exchange (e.g., NSE) average

Interpretation

High-growth-potential firms have higher P/E

ratios


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Percentage of Earnings Retained

Reflects the proportion of current earnings

retained for internal growth Trend analysis is improved by exclusion of

nonrecurring items

Higher percentage typically found in

New firms Growing firms and firms perceived as growth firms

Net Income Before Nonrecurring

Items - All DividendsNet Income BeforeNonrecurring Items


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Dividend Payout

Measures the portion of current earnings percommon share being paid out in dividends

A stable dividend policy is developed byconsideration of recurring earnings

The term Diluted EPS is explained in the next slide

Lower payout typically found in New firms

Growing firms and firms perceived as growth firms

Dividends per Common ShareDiluted EPS Before Nonrecurring Items


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Dividend Yield

Indicates the relationship between the

dividends per common share and the marketprice per common share

The yield is a function of

The firms dividend policy Market price

Often around 1-2%

Dividends per Common ShareMarket Price per Common Share


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Book Value per Share

Market value vis--vis book value

Book value reflects past unrecovered asset costs

Market value reflects the potential of the firm

MV of securities does not approximate the BV

MV of some stocks may be below BV when investorsview it as lacking potential or when investors aregenerally pessimistic

There are times when many stocks are selling at morethan 5 to 6 times BV

Total Stockholders' Equity- Preferred Stock Equity

Number of Common Shares Outstanding


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Stock-Based Compensation

May be awarded through the use of

Stock options

Restricted stock

Stock appreciation rights(Explained in the next few slides)

Firms vary in their use of these methods ofgranting stock-based compensation

Select a single method Use two of the three methods

Use all three in combination


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Non-compensatory plans

A Non-compensatory plan attempts toraise capital or encourage widespreadownership by officers & employees

Officers and employees purchase thestock at a slight discount from fair valuesay up to 5%

These have issues relating neither tosubstantial dilution of existing stocks norto substantial compensation


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Valuation of Stock Options

Stock option is an option to buy the stock at a

predetermined price in accordance with the

vesting period

Stock option at fair value

Expensing is required at time of grant

Allocate option fair value to the service period

From date of grant through vesting date


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Restricted Stock

Sometimes offered to employees in lieu of

stock option plans

Restrictions

Employee cannot sell stock for a specified period

of time

Employee may forfeit the shares if they leave

employer Awards may be linked to financial goals


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Stock Appreciation Rights

Some firms grant key employees StockAppreciation Rights instead of or in additionto stock options

The employee receives compensation incash or stock or a combination of the two atsome future date based on the

Difference between the market price of thestock as on the date of exercise over a pre-established price


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Ratio Analysis

Banks Financial StatementsFA Lecture XII Part II


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BASIC ANALYSIS OF NET INCOME OF BANKS

NI [Net Income]= Net Interest Income i.e. NII (Interest incomeinterest expense)

+/- Gains(Losses) from investments

- Burden (Non interest expense non interestincome

- Provisions for Loan losses

- Taxes

The banks strategy can be inferred from thecontributory factors to net income

R ti f B k


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Ratios for Banks Many traditional ratios do not work for banks

Some important workable ratios for banks Return on assets (ROA)

Return on equity (ROE)

Capital Adequacy ratio (CAR)

Profitability related ratios

Net Interest Margin (NIM) = Net Interest Income/

Average Earning Assets

A key measure of bank profitability

Indicates managements ability to control the

spread between interest income and interest

expense

Profitability related ratios for Banks


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Profitability related ratios for Banks ..

Contd. Spread= (Interest Income/ Average

earning assets) - (Interest Expense/

Average interest bearing liabilities)

Burden ratio = (non interest expenseless non interest income)/ Average

Total Assets

Efficiency ratio= Non interest expense/(Net interest income + Non interest

income)

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