Judy Christensen

Betsy Eldridge

Jack Orimoto

Acc 660

The Home Depot competed in the do-it-yourself (DIY) segment of the home improvement industry (about $80 billion) by using a warehouse retailing concept. Home Depot basically competed with the following strategies:

1. Low prices, high volume, lower margin and higher inventory turnover:

2. Depth of merchandise:

3. Excellent sales assistance:

4. Aggressive advertising:

As FY 1985 ended, The Home Depot faced some critical issues that would affect the company’s market share, growth, competitive advantage and profitability in the future.

1. Heated competition in the industry

2. Financing challenges

Requirements	Details
1. Net worth	$163,774,929 net worth (213,165,000 = 150,000,000 * (1 + 9.18%)4
2. Debt to tangible net worth ratio	No more than 2 to 1
3. Current ratio	Not less than 1.5 to 1
4. Ratio of earnings before interest expense and income taxes to interest expense (net)	Not less than 2 to 1

Therefore, it is crucial to evaluate the effectiveness of The Home Depot’s polices in operations, investment and financing. In other words, we can evaluate if the company’s expansion strategy was feasible and able to deliver better performance for its shareholders.

Return on equity shows how well managers are using the funds from the firm’s shareholders. Illustrated above is the make up of return on equity. The Home Depot’s net profit margin is half in FY 1995 of what it was in FY 1994 while asset turnover and financial leverage declined slightly. The big change in net profit margin affected the return on assets, and in turn, the return on equity. Net profit margin, or return on sales (ROS) shows how much profit the company makes per dollar of sales. Asset turnover shows how many sales dollars the company generates per dollar of asset. Return on assets shows how much profit the company makes per dollar of assets. And financial leverage shows how many dollars in assets each stockholder dollar produces.

Compared to the historical values of return on equity of 10.5% in FY 1983 (ended January 29, 1984 for The Home Depot), 12.4% in FY 1984 (ended February 3, 1985), and 9.6% in 1985 (ended February 2, 1986), The Home Depot is above or close to the average (Palepu, Healy, & Bernard, 2000, p. 9-22). Bernard Marcus, The Home Depot’s chairman and chief executive officer, stated that the drop in profits was due to the addition of 20 stores that year (Palepu, 1988). This is shown in the income statement by a 59% increase in gross profit but a 82% increase in operating expenses, which caused a 41.8% drop in net earnings from 1985 to 1986. Pre-opening expenses alone increased by 292%.

Asset management consists of working capital management and long-term assets management. Various ratios, as illustrated above, depict the well-being of these areas. The Home Depot’s working capital is low due to the lower earnings for the year. With almost a 16% decrease in operating working capital and an increase in sales of nearly 62% the operating working capital-to-sales ratio declined by almost half. Accounts receivable turnover has declined, though it is very good with receivables collected on average every 11 days. Inventory turnover declined slightly and the average number of days inventory is on hand has gone from 96 days to 107 days. This is due to the 82% increase in inventories in anticipation of the larger future sales from the 20 new stores The Home Depot opened during FY 1985.

Financial leverage is the borrowing of money or creation of liabilities such as accounts payable to increase assets. It can positively affect return on equity as long as the cost of the borrowing is less than the return from the investments (Palepu, Healy, & Bernard, 2000, p. 9-14). The two parts of financial leverage are current liabilities and short-term liquidity, and debt and long-term solvency (Palepu, Healy, & Bernard, 2000, p. 9-15,16). In terms of current liabilities and short-term liquidity The Home Depot’s quick and cash ratios plummeted from FY 1984 to FY 1985. This is due to the large increase in inventories. Once these inventories are taken out of the ratio, as from the current ratio to the quick ratio, the numbers change drastically from one year to the next. This is also the reason for the plummet from 1.10 to .12 for the cash ratio. To be in compliance with the FY 1986 credit agreement, The Home Depot would be required to keep current ratio no less than 1.5 to 1.

In terms of debt and long-term solvency, the biggest changes come in the net-debt-to-equity and interest coverage ratios. These changes are due to the 463% increase in other long-term debt and the 77% increase in current liabilities. A large portion of the long-term debt, $88,000,000, arises from a new revolving credit agreement. However, it is extremely important for The Home Depot to maintain the debt to tangible-net-worth figure below 2 to 1, which is required in the covenants of the revolving credit agreement.

Sales per square foot declined slightly from FY 1984 to FY 1985. This may be due in part to the average square footage per store increasing from 77,419 square feet to 80,000 square feet. This also caused net earnings per square footage to decrease. However, sales per number of stores increased during this period.

Much of Home Depot's strategy can be determined by taking a closer look at the company's cash flows. After a breakdown of the cash flow statement, there are a few areas of concern that need to be addressed. At present the company has weak internal cash flow generation. Cash flow from operations is negative. This probably is a result of the company's policy of rapid expansion. However, the company will not be able to maintain its pattern of growth without generating more positive cash flow. Rapid increases in the amount of inventory (approx. $68.7 million in FY 1985) on hand seem to be the main reason for depleting operating cash flow. With a lack of cash the company may have trouble meeting its short-term financial obligations. The company runs the risk of default as portions of its long-term debt become due.

The company also has invested large amounts of capital into property and equipment. The company has had to rely on external financing for this purpose. In FY 1984 and FY 1985 very little new stock was issued. The company mainly relied on debt financing to aid in its expansion. This policy could cause several problems for the company in the future. As the company takes on greater levels of debt its interest obligations will rise. The company will have greater difficulty in financing future expansion when more cash needs to be diverted to pay for interest expense. It also should be noted that the company currently does not pay any dividends. If at some future time the company decides to pay dividends it will need more internally generated cash. At some point there will be a limit as to what creditors allow the company to borrow.

The overall result of the company's growth strategy on the cash flow statement is that a trend can be seen developing. At the present rate the company is not raising enough cash to finance its policy of expansion. Without some strategy changes the company will not be able to maintain its present growth rate.

The cash flow analysis prepared in below also gives some valuable insights into the company's strategy. As is consistent with a firm in a growth stage the company is experiencing a net negative cash flow. In order to grow inventory levels need to be increased and property for new stores is developed.

The company has a negative cash flow available to debt and equity of $136 million in FY 1985 and $93 million in FY 1984. This means that at the present time the company has had to borrow funds just to pay for its interest obligations. If this situation is allowed to continue the company could be in serious financial trouble. This situation would be analogous to taking out a loan just to pay off another. However there is a bright spot in that the company is generating a cash surplus before working capital investments are taken into account. This surplus has grown each year from 1983-1985. The business seems to be profitable and the company's focus on product diversification seems to be working.

When comparing Home Depot's and Hechinger's cash flows several major differences are immediately evident. Its seems that Hechinger is not following a strategy of rapid expansion. Accounts receivable and inventory rise at much lower rate than in Home Depot's case. The company has positive cash flow from operations. It does not have to rely on external financing to pay off interest obligations. Hechinger also seems to have a history of paying dividends to stockholders unlike Home Depot. This could be a sign that the company has been in existence for a relatively long time. It is no longer investing all of its capital into expansion, but giving some dividends instead.

Another difference is that unlike Home Depot a much larger portion of Hechinger's financing comes from equity rather then debt sources. In FY 1986 $28.9 million of common stock was issued in addition to the $13.4 million issued in 1984. Only in FY 1985 was a large amount of debt issued. Hechinger's cash flow statement seems consistent with a strategy of slow and steady growth. The company probably is not undergoing a period of rapid expansion at the present time. It is consistently adding only 10-14 new stores a year, compared to Home Depot who is adding an increasing number of stores in each additional year. This can be seen by the fact that in 1982 the company added only 2 new stores, compared with 1985 when 19 new stores were added.

In order to remain as a viable company, there are several steps that Home Depot should take. In order to improve its cash flow position the company should slow its pace of growth. In the short term the company needs adequate cash funds to pay for operating expenses such as salaries or advertising. By slowing its pace of growth the levels of inventory and accounts receivable will remain relatively stable. This will leave more working capital to be available for investment in long term assets and debt/equity financing.

In the short term slowing the rate of expansion should create a positive level of cash from operations. This may help to boost the company's stock price and in turn attract new investors. This is critical since the company should probably try to look to more equity rather than debt financing in the near future. Interest expense will continue to rise as more debt is incurred. In addition, there will come a point when all of the company's credit lines have been exhausted.

Additional equity financing leaves open the possibility of the company taking on more debt at some point in the future. This would be important if the company decides to buy out a competitor in the future, or if it decides to once again expand into other areas in the future and needs a large amount of financing very quickly. The key is to find an acceptable balance between debt and equity financing that allows the company to grow responsibly.

Kieso, D., Weygandt, J., & Warfield, T. (2001). Intermediate Accounting. New York: John Wiley & Sons, Inc.

Palepu, K. (1988). The Home Depot, Inc. In Palepu, K., Healy, P., & Bernard, V. (Authors), Business Analysis & Valuation (pp. 9-32 to 9-58). Cincinnati: South-Western College Publishing.

Palepu, K., Healy, P., & Bernard, V. (2000). Business Analysis & Valuation. Cincinnati: South-Western College Publishing.