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Evaluation of credit rating Memorandum: Credit Rating assignment: Home Depot, Inc. After analysing the financial statements of Home Depot, we have allocated a “C” rating of credit risk. The proposal is to start with the “C” rating and then to either upgrade to a “B” rating or to be down graded to a “D” rating. The reason for such a decision is discussed below. Home Depot has a current ratio of 1. 19 to 1 which means that it’s current assets covers it’s current liabilities by 1. 19 times. This is the lowest that it had been for the last 10 years against an average of 1. 61.
A current ratio of 2 or higher would usually be a qualifier for good credit risk. The low current ratio of Home Depot will increase the credit risk. Working capital is another measure that can be used to analyse credit risk in conjunction with the current ratio. The working capital for 2005 was $ 2. 445 million and $ 3. 818 million for 2004. This shows that the company has excess monetary recourses to cover the liabilities that are to be paid in the short term. The quick ratio of Home Depot is 1. 13 to 1 for 2005 and 1. 31 to 1 for 2004 respectively. The calculation includes the inventory.
It was included because the operating cycle of Home Depot was calculated to be 13 days (Annexure 3 point 7), which is very quick. The quick ratio for Home Depot is affecting the credit risk positively as analyst view this ratio from 1. 0 and upwards to be satisfactory (Williams, Haka, Bettner, Carcello, 2008). The dept ratio is another very important ratio which must be analysed as it indicates the long term risk of creditors. The dept ratio for Home Depot is 40% for 2005 and 38% for 2004 respectively. The rule of thumb is that the dept ratio should be below 50%, (Williams et al, 2008).
In the case of Home Depot this is within the required range impacting positively on the credit rating. The gross profit percentage for the last 3 years had been stable at around 33%. For most merchandising companies like Home Depot the rule of thumb is to be between 20 and 50% (Williams et al, 2008). Considering the various ratios, Home Depot is in line with most of the industry averages. The impact of the low current ratio on credit risk is countered by the fact that current assets cover the current liabilities and the short operating cycle of 13 days.
It is thus advised that a low credit limit be assigned to Home Depot that is extended for only 30 days. This credit limit should be reviewed every 90 days and orders above the credit limit must only be accepted on a cash basis. 2. 2 Part III a. Calculation of required ratios 20052004 1) Percentage change in net sales 81 511 – 73 094 73 09473 094 – 64 816 64 816 11. 52%12. 77% 2) Percentage change in net earnings 5 838 – 5 001 5 0015 001 – 4 304 4 304 16. 74%16. 19% 3) Gross profit rate 27 320 – 24 430 24 43024 430 – 20 580 20 580 11. 83%18. 71% 4) Net income as a % of sales 5 838 81 5115 001 73 094 . 16%6. 84% 5) Return on assets 9 3637 926 41 75136 729 22. 43%21. 58% 6) Return on equity 5 8385 001 25 53323 282 22. 86%21. 47% b. Analysis and conclusion i)Analysis In this section the trends observed from the ratios as calculated above will be discussed. Change in Net Sales: The average year on year increase in net sales for the past 10 years was 18. 1% (given). Sales increased between 1996 and 1999, with a sharp decline between 1999 and 2002. It started to increase steadily since 2002 and is perceived to have reached a stage where it is fairly stable at around 12% for the past 2 years.
Change in Net Earnings: The average year on year increase in net earnings over the past 10 years was 23. 1% (given). The same trend as described under net sales can be seen here. Net earnings indicate a significant increase between 1996 and 1999 with a very sharp decline during 2000. However, Home Depot started to increase the year on year average of earnings with a steadily growth since 2000. The increase in net earnings from 16. 2% in 2004 to 16. 7% in 2005 indicates that the company might be in a growing phase, which could have a positive effect on the situation of the company.
Gross Profit Rate: The average year on year increase in gross profit rate over the past 10 years was 19. 85% (Annexure 2, Table). This indicator peaked in 1999 at 32. 54% and gradually reduced over the past 6 years and ended at 11. 83% for the 2005 financial year which is the lowest over the last 9 years. This is of major concern as it seams that the company can’t stop the deterioration in the gross profit rate. Net income as a percentage of sales: The average year on year increase in net income as a percentage of sales over the past 10 years was 5. 1% (Annexure 2, Table). This is the one indicator that Home Depot has managed to keep stable for the past 10 years. It had shown steady growth over the years and the 7. 20% achieved in 2005 is the highest in the 10 year window period. ii Conclusion After calculating and analyzing the ratios and their trends the following conclusion regarding the profitability of Home Depot can be made: •Growth in Net Sales reduced with 1. 3% between 2004 and 2005 while cost of sales increased with 1. 4% over the same period resulting in a reduction in the gross profit rate. In order to conclude on the net earnings, a trend was calculated with regards to the return on invested capital (assets). The trend, as computed from the table and graph in annexure 2, shows a very stable growth since 2001. Since most successful companies are earning a return in excess of 15% it can be concluded that Home Depot is successful in using their assets to generate optimal income (Williams et al, 2008). • A company is perceived to be successful by business world standard when obtaining a net income of between 5 and 15% of sales.
Measured against this standard we can conclude that Home Depot is successful, because they obtained a net income of more than 5% since 1998 (Williams et al, 2008). Home Depot is a company that is successful with regards to its profitability. It is however evident from the trend analysis (Graph 1, Annexure 2) that they are not as successful as in 1999. A slight upward trend can be seen in recent years indicating that Home Depot is slowly recovering and moving towards the peak that they realized in 1999. If the company does not act now they might experience more serious problems in future.