a. Describe the industry in which these two companies operate and assess the competitive environment. What current economic factors affect the companies operations? Who are the main competitors in this industry? How are the two companies similar? How are they different? b. Consider the income statements of both companies. Are there any unusual or nonrecurring items that need to be considered in your analysis? That is, are the earnings of high quality? Are the earnings persistent? Describe and quantify the impact of any such items to your analysis. c. Prepare common-sized income statements and balance sheets for each company for fiscal 2013 and 2012. To common size the income statement, divide each item by net sales for that year. To common size the balance sheet, divide each item by total assets at the end of that year. Comment on the similarities and differences in balance sheet composition of the two companies noted from the common-size balance sheets. Note: analysis of the common-size income statement will be conducted in part e. A companys financial performance can be analyzed in many ways. Return on equity (ROE) is a widelyused measure of financial performance that compares the profit the company made during the period (net income) to the resources invested and reinvested in the company by shareholders (stockholders equity). The DuPont model systematically breaks ROE into components. One form of the DuPont model is illustrated with the following two equations: Where: NI is net income reported on the income statement. EBT is earnings before income tax expense. EBIT is earnings before interest expense, net, and income tax expense. Interest expense includes any costs for debt issuances or repurchases and is net of interest income on financial assets. EBIT is sometimes referred to as pre-tax operating profit. Sales are reported on the income statement. Total assets are reported on the balance sheet. Stockholders equity is reported on the balance sheet and excludes any reported minority interest or non-controlling interest. Note that once the common terms cancel in the second equation (the DuPont model), the right-hand side of the ROE equation collapses to the first equation: Net income divided by the firms stockholders equity. Reading from left to right in the second equation, the first right-hand side ratio represents the fraction of pretax earnings that the shareholders keep. One minus that ratio is the average tax rate so the ratio decreases as the tax rate goes up. The second ratio represents the fraction of EBIT (i.e., operating profit) that the firm keeps after financing costs so the ratio decreases as the net cost of debt increases. The third ratio represents operating return on sales or the operating profit earned on each unit of revenue. The fourth term is the asset turnover ratio, a measure of overall efficiency in asset use. The product of the third and fourth terms is operating return on assets. The final ratio captures the leverage of the firma measure of how the firm has paid for its assets. The ratio increases as the firm takes on more debt (that is, for a fixed level of equity, more assets must mean more debt). Note that the final term is equal to 1 + (Average total liabilities / Average stockholders equity). Normally, analysis of the financial statements begins with operating return on sales and asset turnover (thus, operating return on assets). Then it turns to leverage (liquidity and solvency) and the cost of leverage. Finally, a review of the tax burden is conducted. The ROE analysis can be followed up with an analysis of the companys cash flows. d. Compute return on equity (ROE) for both companies for fiscal 2013 and 2012. Calculate the five components of ROE and verify that their product equals ROE. Remember to use average total assets and average stockholders equity in your ratio calculations. The 2012 balance sheet (with comparative 2011 information) is included as the last page of the financial statement excerpts to allow for computation of average balances for the 2012 ratios. e. Refer to the common-sized income statement you prepared in part c and your ROE decomposition from part d i. What trends do you notice in the expense line items as a percentage of sales and in ROE subcomponents for each firm over time? ii. Which firm is more profitable? Consider profitability in terms of overall ROE, operating return on sales (and insights from common-size income statements), and operating return on assets (that is, Sales / Average total assets). f. Assess the companies asset efficiency. Which firm is more efficient in its use of assets? Consider efficiency in terms of total asset turnover, receivables turnover (and average collection period), inventory turnover (and average holding period), payables turnover (and average time to payment), cash conversion cycle (i.e., receivables days + inventory days payables days), and fixed asset turnover. As in part d, the fiscal 2012 comparative balance sheet will be useful in computing average balances for 2012 needed in the turnover metrics. g. Assess the companies liquidity and solvency. Are the companies likely to meet their debts as they come due? Consider ratios such as the current ratio, the quick ratio, the debt-to-assets ratio and the liabilities-to-equity ratio. Also consider interest costs and the times interest earned ratio. Is there any off-balance-sheet financing that will constrain future cash flow? You should explicitly consider operating leases at both companies. Assume that the appropriate discount rate for capitalizing the operating leases is 7.0% for both companies. Further, assume that the lease payments due after 2018 will be paid evenly over 20 years for The Home Depot and evenly over 6 years for Lowes. h. Assess the cash flow of each company. Are cash flows from operations a source or a use of cash? How are operations and investments being financed? What similarities and differences do you note? i. As a potential investor, would you be interested in seeking additional information about either of these companies? What sort of information would you want? Would you invest in either company