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Before selecting a stock, there are a number of things that you need to consider in order to ensure that you are buying the stock of a high-quality company whose shares are poised to grow in value over time. Some of these concerns include what the company does, its competitive advantages, valuation, dividend payouts and sustainability, and earnings consistency.

Another important thing that you need to consider is the financial condition of the company in question. You want to know if the company is able to continue paying its bills, and how much debt it carries. The balance sheet is one of the most effective tools that you can use to evaluate a company's financial condition. In this article, I will discuss the balance sheets of Home Depot HD and Lowe's LOW, in order to get some clues as to how well these companies are doing.

I will go through the balance sheets of these two companies, reviewing the most important items, and seeing if there are any major differences between the two, making one a better investment than the other. Information that I used on Home Depot can be found here, and information on Lowe's can be found at this link. Note that this article is not a comprehensive review as to whether either of these two stocks should be bought or sold, but rather, just an important piece of the puzzle when doing the proper due diligence.

This article might be a bit too basic for some and too long-winded for others, but I hope that some of you can derive benefit from it.

Background

Home Depot is the world's largest home improvement retailer, based on sales. Like Lowe's, Home Depot sells building materials, home improvement products, and lawn and garden products. They also offer a number of services that are in relation to the products that they sell. At the end of 2012, Home Depot had 2,256 stores in the United States, Canada, and Mexico. 11% of the company's 2012 sales came from outside the U.S.

Lowe's is the world's second largest home improvement retailer. As of Feb. 1, 2013, Lowe's had 1,754 stores, of which 1,715 are in the United States. The other 39 stores are in Canada and Mexico. The company plans to open 10 more stores in the coming year.

Cash and Cash Equivalents

The first line in the Assets column of the balance sheet is for the amount of cash and cash equivalents that the company has in its possession. Generally speaking, the more cash the better, as a company with a lot of cash can invest more in acquisitions, repurchase stock, and pay out dividends. Some people also value stocks according to their cash positions. Some of the larger and more mature companies tend not to carry a lot of cash on their balance sheets, as they might be more inclined to buy back stock with it, or pay out dividends.

Home Depot reported $3.42B in cash and short-term investments on its most recent balance sheet, from Aug. 4, 2013. The short-term investments are in instruments such as money-market funds, that can easily be converted to cash. Over the 12 months prior to that date, Home Depot paid out $2.01B in dividends and spent $5.31B on stock buybacks. During this time period, the company generated $6.07B in free cash flow. So far in 2013, the company has spent $4.3B on buybacks, and they plan to spend another $2.2B on repurchases by the end of the calendar year. During 2011, the company reduced its share count by 5.4%. During 2012, they reduced it further by 3.8%.

As of Aug. 2, 2013, Lowe's had a total of $1.28B in cash and short-term investments. Over the 12 months leading up to that date, Lowe's paid out $716M in dividends and repurchased $3.27B worth of stock, reducing its share count by a whopping 9%. During this period, Lowe's generated $3.35B in free cash flow. This past February, the company authorized a $5B buyback program, and as of Aug. 2, there was still $3B left on it.

The table below illustrates this information pretty clearly. In the case of Lowe's, the free cash flow all but covers both the dividend payments and the buybacks. Home Depot's free cash flow comes up a bit short when compared to the total of dividends and buybacks, requiring the company to either dig into its existing cash position or take on debt to fund those activities.

Symbol

Market Cap.

Cash Position

Dividend Payouts (TTM)

Buyback Amount

Free Cash Flow

HD

$107B

$3.42B

$2.01B

$5.31B

$6.07B

LOW

$50.5B

$1.28B

$716M

$3.27B

$3.35B

Table 1: Cash Positions and What Home Depot and Lowe's Do With Their Cash

Inventory

With retail companies like Lowe's and Home Depot, I like to keep an eye on inventory levels. I usually like to see inventory levels stable or slightly rising from one year to the next. If I see inventory levels rising, then I want to see revenues rising as well, to indicate higher demand for the company's products. I don't like to see rapidly fluctuating inventory levels that are indicative of boom and bust cycles. In some instances, if inventory ramps up without increases in volumes or revenues, then it may indicate that some of the company's products are going obsolete.

As of Aug. 4, 2013, Home Depot had $11.1B worth of inventory, which amounts to 14.2% of the company's sales over the trailing twelve months. At the end of fiscal 2012, this level was at 14.3% of sales, while at the end of fiscal 2011, it was at 14.6% of sales. If you look back to the end of fiscal 2010, this figure was at 15.6% of sales. Both the company's revenues and inventory levels have been increasing over the last few years, and the constant percentages show that both revenue and inventory are growing at about the same rate. I don't see anything here that would indicate boom and bust cycles or the possibility of a large number of their products going obsolete. So, I see nothing to worry about here at this time for Home Depot.

As of Aug. 2, 2013, Lowe's had $9.11B in inventory, which amounts to 17.6% of the company's trailing twelve-month sales. At the end of fiscal 2012, the company's inventory level was equal to 17.0% of sales, and at the end of fiscal 2011, the inventory was equal to 16.7% of company sales. Going back to the end of fiscal 2010, the inventory of Lowe's was equal to 17.0% of sales for that year. As was the case with Home Depot, the inventory levels of Lowe's have been pretty consistent over the past few years, with regard to sales. Sales have been growing, and inventories have followed suit at the about the same rate. I think that Lowe's is in pretty good shape with regard to this metric.

Current Ratio

Another factor that I like to look at is the current ratio. This helps to provide an idea as to whether or not the company can meet its short-term financial obligations in the event of a disruption of operations. To calculate this ratio, you need the amount of current assets and the amount of current liabilities. Current assets are the assets of a company that are either cash or assets that can be converted into cash within the fiscal year. In addition to cash and short-term investments, some of these assets include inventory, accounts receivable, and prepaid expenses. Current liabilities are expenses that the company will have to pay within the fiscal year. These might include short-term debt and long-term debt that is maturing within the year, as well as accounts payable (money owed to suppliers and others in the normal course of business). Once you have these two figures, simply divide the amount of current assets by the amount of current liabilities to get your current ratio.

If a company's operations are disrupted due to a labor strike or a natural disaster, then the current assets will need to be used to pay for the current liabilities until the company's operations can get going again. For this reason, you generally like to see a current ratio of at least 1.0, although some like to see it as high as 1.5.

The current ratio of Home Depot is 1.30, while Lowe's sports a current ratio of 1.17. Both of these figures are good.

Quick Ratio

Most of the time when it comes to short-term liquidity, I usually end the discussion at the current ratio. However, with companies that have a large chunk of their current assets in inventories, one has to wonder whether all of that inventory can quickly be converted into cash in the event that the company suddenly needs it. Some of the inventory might be obsolete, or have to be disposed of for less than it was originally valued at. Given that inventories currently constitute large percentages of the total current assets of both companies, this is a very real concern here.

To address this issue, I calculate what I call the quick ratio. The quick ratio is calculated simply by subtracting the inventory from the total current assets and then dividing the remainder by the current liabilities. I usually like to see a quick ratio of at least 1.0. That way, even if the company's inventory is worthless, they will still have enough other current assets on hand to meet their short-term financial obligations in the event of an unlikely disruption to their operations.

The quick ratio of Home Depot is 0.45. This is far from ideal. As it stands right now, a 36% markdown in the value of its inventory from current levels would bring the company's current assets below the current liabilities, which may raise questions over the company's short-term liquidity.

The picture looks even worse at Lowe's, who sports a quick ratio of 0.19. Here, inventories account for about 84% of the company's current assets. An 18% markdown in the inventory at Lowe's would bring the company's current assets below the current liabilities.

Now, while these numbers don't paint a good picture for either company, remember that both of them have operations spread out across the U.S. at over 1,700 stores. At this point in time, it is hard to envision something that would bring the operations of either company to a grinding halt, requiring the company to expend all of its current assets in order to meet its short-term obligations. How much weight you put behind the quick ratio in your investment decision depends on how you feel about the likelihood of something catastrophic happening to the company. While this metric for both companies is far from ideal, I don't see a need to hit the panic button at this point in time.

Property, Plant and Equipment

Each of these two companies has capital expenditures that are associated with property, plant and equipment. The breakdown of these assets for both Home Depot and Lowe's looks pretty much the same. Roughly half of each company's property, plant, and equipment assets are in buildings, while furniture, fixtures, and other equipment account for 25-30% of each company's PP&E assets. Land accounts for about 20% of each company's assets in this category.

Right now, Home Depot has $23.7B in property, plant, and equipment on its balance sheet. This figure is inline with the $24.1B that it reported at the end of fiscal 2012, as well as the $24.4B that was reported at the end of fiscal 2011.

Lowe's reported $21.0B in property, plant, and equipment on Aug. 2, 2013, versus $21.5B at the end of fiscal 2012, and $22.0B at the end of fiscal 2011.

Neither company reported any meaningful change in this category over the last few years.

Return on Assets

The return on assets is simply a measure of the efficiency in which management is using the company's assets. It tells you how much earnings management is generating for every dollar of assets at its disposal. For the most part, the higher, the better, although lower returns due to large asset totals can serve as effective barriers to entry for would-be competitors. The formula for calculating return on assets looks like this:

Return on Assets = (Net Income) / (Total Assets).

For Home Depot, the return on assets would be $5.11B in core earnings over the last twelve months, divided by $42.2B in total assets. This gives a trailing twelve-month return on assets of 12.1%, which is pretty good in absolute terms. This is slightly above the 11.4% that was reported at the end of fiscal 2012, and well above the 9.58% and the 8.40% that were reported at the ends of fiscal 2011 and 2010, respectively.

For Lowe's, the return on assets over the last twelve months was 6.47%, which is inline with the 6.12% that was reported at the end of fiscal 2012 and above the 5.36% and the 5.93% that were reported at the ends of fiscal 2011 and 2010, respectively.

In the table below, you can see how the returns on assets of both companies have changed over the last couple of years.

Symbolttm201220112010
HD12.1%11.4%9.58%8.40%
LOW6.47%6.12%5.36%5.93%

Table 2: Returns On Assets From Home Depot and Lowe's

Table 2 shows that Home Depot has superior returns on assets when compared to its closest competitor. The growth in this metric is also better at Home Depot. At Home Depot, both core earnings and the company's asset totals have been growing, but earnings have been growing at a faster rate, which is very good. At Lowe's, both earnings and asset totals have been relatively static over the last few years.

Short-Term Debt Versus Long-Term Debt

In general, you don't want to invest in a company that has a large amount of short-term debt when compared with the company's long-term debt. If the company in question has an exorbitant amount of debt due in the coming year, then there may be questions as to whether the company is prepared to handle it.

Home Depot is carrying $1.31B in short-term debt, which should not be a problem for it with its levels of earnings, free cash flow, and existing cash position. The same can be said for Lowe's, which has just $47M in short-term debt.

Long-Term Debt

Long-term debt is debt that is due more than a year from now. However, an excessive amount of it can be crippling in some cases. For this reason, the less of it, the better. Companies that have sustainable competitive advantages in their fields usually don't need much debt in order to finance their operations. Their earnings are usually enough to take care of that. A company should generally be able to pay off its long-term debt with 3-4 years' worth of earnings.

Right now, Home Depot is carrying $11.5B of long-term debt, compared with $9.48B reported at the end of fiscal 2012, and $10.8B that was reported at the end of fiscal 2011. Over the last six months, Home Depot issued $2B worth of long-term debt at rates of 2.7% and 4.2%, and maturities of 2023 and 2043. Of the company's long-term debt, only 32% of it is due within the next five years.

Lowe's currently has $9.02B worth of long-term debt, versus $9.03B from six months before, and $7.04B at the end of fiscal 2011. During fiscal 2012, the company issued $2B in unsecured notes at rates of 1.63%, 3.12%, and 4.65%, with maturities of 2017, 2022, and 2042. Of their long-term debt, only about 25% of it is due within the next five years.

The table below illustrates the long-term debt figures for both companies and how they have changed over the last few years.

SymbolQ2 2013201220112010
HD$11.5B$9.48B$10.8B$8.71B
LOW$9.02B$9.03B$7.04B$6.54B

Table 3: Long-Term Debt At Home Depot and Lowe's

In the case of both companies, the long-term debt has been rising.

In determining how many years' worth of earnings it will take to pay off the long-term debt, I use the average of each company's core earnings over the last 3 years. The average earnings of Home Depot over this period is $3.98B. The 3-year average for Lowe's is $1.93B. When you divide the long-term debt by the average earnings of each company, here is what we find.

Years of Earnings to Pay off LT Debt = LT Debt / Average Earnings

For Home Depot, here is how it looks: $11.5B / $3.98B = 2.89 years

For Lowe's, it looks like this: $9.02B / $1.93B = 4.67 years

Home Depot looks to be in pretty decent shape here, as an amount that is equal to less than three years worth of company earnings could pay off the long-term debt. Lowe's doesn't look quite as good here, with long-term debt that is equal to almost five years worth of company earnings. While most of the long-term debts don't come due until at least 2017, interest rates may be higher by the time that those debts are due, making refinancing a less attractive option than it is now, meaning that these companies will need to find a way to pay for this debt.

As far as who has the edge in this department, I give it to Home Depot.

Debt-To-Equity Ratio

The debt-to-equity ratio is simply the total liabilities divided by the amount of shareholder equity. The lower this number, the better. Companies with sustainable competitive advantages can finance most of their operations with their earnings power rather than by debt, giving many of them a lower debt-to-equity ratio. I usually like to see companies with this ratio below 1.0, although some raise the bar (or lower the bar if you're playing limbo) with a maximum of 0.8. Let's see how Home Depot and Lowe's stack up here.

Debt To Equity Ratio = Total Liabilities / Shareholder Equity

For Home Depot, it looks like this: $26.7B / $15.5B = 1.72

For Lowe's, it comes out this way: $20.3B / $13.1B = 1.55

The table below shows this figure for both companies, and how it has changed over the last few years.

SymbolQ2 2013201220112010
HD1.721.311.261.12
LOW1.551.351.030.86

Table 4: Debt-To-Equity Ratios At Home Depot And Lowe's

Table 4 shows that the debt-to-equity ratios of both companies have been steadily rising over the past few years. In both cases, this is due to rising debt, relative to a shrinking equity position.

In the case of Home Depot, the increases in the debt-to-equity ratio have been brought on by increases in long-term debt and accounts payable, along with the company's share repurchases, which show up on the balance sheet as treasury stock. Treasury stock represents a negative value when the company's equity is computed.

The debt-to-equity ratio of Lowe's has been on the rise due to increases in long-term debt and the company's buyback programs, which have been reducing the company's retained earnings from one year to the next. The shares that have been repurchased by Lowe's do not show up on the balance sheet as treasury stock, because they have apparently been retired, without the possibility of being re-issued at a later date.

To sum up here, the debt-to-equity ratios of both companies are higher than ideal.

Return On Equity = Net Income / Shareholder Equity

Generally speaking, the higher this figure, the better. However, it can be misleading, as management can juice this figure by taking on lots of debt, reducing the equity. This is why the return on equity should be used in conjunction with other metrics when determining whether a stock makes a good investment. Also, it should be mentioned that some companies are so profitable that they don't need to retain their earnings, so they buy back stock, reducing the equity, making the return on equity higher than it really should be. Some of these companies even have negative equity on account of buybacks. However, neither Home Depot or Lowe's is one of these companies.

So, the return on equity for Home Depot over the last twelve months is as follows:

$5.11B / $15.5B = 33.0%

For Lowe's, this figure is: $2.16B / $13.1B = 16.5%

In the table below, you can see how the return on equity has fared over the past couple of years for both companies.

Symbolttm201220112010
HD33.0%26.3%21.7%17.8%
LOW16.5%14.4%10.9%11.0%

Table 5: Returns On Equity At Home Depot and Lowe's

Table 5 shows that Home Depot has superior returns on equity, when compared to Lowe's. The main reason for this difference is the earnings growth that Home Depot has managed, while the earnings at Lowe's have remained relatively stagnant. It should be noted that the returns on equity have been rising at both companies. With Home Depot, the increase is due to a combination of earnings growth and a shrinking equity position. At Lowe's, the increase is almost entirely due to shrinking equity. Since the end of fiscal 2010, the equity at Lowe's has been reduced by almost 28%.

Retained Earnings

Retained earnings are earnings that management chooses to reinvest into the company as opposed to paying it out to shareholders through dividends or buybacks. It is simply calculated as:

Retained Earnings = Net Income - Dividend Payments - Stock Buybacks

On the balance sheet, retained earnings is an accumulated number, as it adds up the retained earnings from every year. Growth in this area means that the net worth of the company is growing. You generally want to see a strong growth rate in this area, especially if you're dealing with a growth stock that doesn't pay much in dividends or buybacks. More mature companies, however, tend to have lower growth rates in this area, as they are more likely to pay out higher dividends.

Home Depot had an impressive $20.0B of retained earnings at the end of fiscal 2012, while Lowe's clocked in with $13.2B in retained earnings. Going back to the end of 2009, Home Depot had retained earnings of $13.2B. So, over the last three years, Home Depot grew its retained earnings at a cumulative rate of almost 52%, which is impressive.

Lowe's on the other hand, has seen its retained earnings shrink from $18.3B at the end of 2009 to $13.2B now. This translates into less money that the company can plow back into its business for more growth. This decline is due mostly to the aggressive share buyback policies being pursued by the management at Lowe's. Since 2009, the company has repurchased about $12.6B worth of stock. With an authorization to repurchase another $3B worth of stock this year, it doesn't seem ready to slow down anytime soon. This drive to repurchase a lot of stock, along with historically-low interest rates, has led the company to add on to their long-term debt position, which could hurt shareholders in the long run, depending on where interest rates go from here.

The table below shows how the retained earnings at both companies have changed over the last couple of years.

Symbol

2012

2011

2010

2009

HD

$20.0B

$17.2B

$15.0B

$13.2B

LOW

$13.2B

$15.9B

$17.4B

$18.3B

Table 6: Retained Earnings At Home Depot And Lowe's

So, as far as growth in retained earnings is concerned, Home Depot definitely wins out here.

Conclusion

After reviewing the balance sheets of both Home Depot and Lowe's, we see that both of these companies have undesirable things in common. They both have low quick ratios, due to inventory levels that account for overwhelming percentages of each company's current assets. In the event of an unlikely (emphasis here) disruption to either company's operations, there may be concerns about whether either company can meet its short-term financial obligations. Both companies have debt-to-equity ratios that are higher than what we'd like to see and are on the rise. For both companies, these increases are due to increases in debt, coupled with reductions in equity.

Overall, I believe that Home Depot is in better financial condition than its smaller competitor. This is due in part to Home Depot exhibiting superior returns on both assets and equity. This superiority results from Home Depot growing its earnings at a time when the earnings at Lowe's have been relatively stagnant. Home Depot's long-term debt is more manageable with respect to its earnings power. And, also, Home Depot has posted impressive increases in their retained earnings, which translates into more money that the company can reinvest for future growth. Lowe's has been moving in the wrong direction in this area.

To find out more about how I read financial statements, please visit my website at this link. It's a new site that I created for fun, as a way to help others make good investment decisions.

Thanks for reading and I look forward to your comments!

Source: Home Improvement Hoedown! Who Has The Better Balance Sheet: Home Depot Or Lowe's?