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ODP and Staples: Ratio Analysis case study

Ratio analysis case study – Staples & Office Depot

office_depotStaples-Logo

Staples is one of the largest retailers of Office Supplies in the US. In 1999, its Sales amounted to $7 billion while Net Income was $185 million, up $18 million from the previous year. The firm is known to be one of the pioneers of the office products superstore concept in the US. The company provides office supplies, furniture and technology to consumers and businesses ranging from home-based businesses to Fortune 500 companies in the United States.

Staples is serving its customers through more than 1,100 office superstores, mail order catalogs, e-commerce and a contract business. The company has recently revamped its website to make it more accessible by customers. The management feels that e-commerce is a necessity and so a great deal of investment is being made in this area.

Staples focus is on customer service. Management believes that success in this industry revolves around service. Staples is growing fast — through acquisitions and partnerships — to become a one-stop shopping experience for customers. It also works towards making the system of ordering and delivery as convenient and short as possible.

The current setup allows customers to place orders through a variety of media including retail outlets, catalogs and online ordering; delivery is made the very next day the order is placed.

Staples is targeting small businesses. Management believes that the company can help small firms solve their operational problems. The company aims at moving from the concept of office products supplier to office manager.

The company is also intent on providing adequate discounts and price reductions to its customers. The management intends to leverage its distribution network, business relationships, technology and size to win discounts for customers.

 SPLS: Financial Condition Review

Staples is listed on NASDAQ under the symbol SPLS. Additional financial information is available on the company’s website www.staples.com which is also an important medium for doing business.
A simplified version of the Income Statement and Balance Sheet are provided below:

Staples

Balance Sheet

1998

1999

Assets
Inventory

$1,124,642

$1,340,432

Receivables

$203,143

$221,836

Other current Assets

$458,355

$501,832

Total Current Assets

$1,786,140

$2,064,100

Fixed Assets

$852,722

$1,115,166

Total Assets

$2,638,862

$3,179,266

Liabilities and Equity
Current Liabilities

$982,480

$1,265,332

Long-term Debt

561,897

257,048

Total Liabilities

$1,544,377

$1,522,380

Equity

1,094,485

1,656,886

$2,638,862

$3,179,266

 

Staples

Income Statement

1998

1999

Sales

5,732,145

7,123,189

Lest Cost of Sales        4,377,690        5,396,923
Gross Profit

$1,354,455

$1,726,266

Less: Operating Expense        1,076,793        1,402,635
Operating Income

$277,662

$323,631

Interest

21,955

17,370

Income before taxes           255,707           306,261
Less: Taxes             87,793           120,891
Net Income

$167,914

$185,370

 

The following information comes to light on analyzing the Staple’s financial statements for the past few years:

  1. Net Income has been growing steadily; it grew by nearly $18 million from 1998 to 1999.
  2. Sales grew $1.4 billion between 1998 and 1999.
  3. Gross profits and operating profits have risen from 1998 to 1999. At this point we don’t know whether this increase is proportionate to the rise in Sales.
  4. Current Assets rose by $278 million between 1998 and 1999.
  5. Current liabilities have increased by $283 million between 1998 and 1999. During the same time, the firm encountered a sharp decline in Long-term Debt of $305 million. This decline also had an impact on the interest expense, which experienced a decline.
  6. Equity investment in the firm has increased considerably between 1998 and 1999.

What does all of this information tell us? Well, first of all, Staples is in good financial health.

  • The sales and profits for the firm are rising.
  • The management is also getting rid off long-term liabilities.
  • Equity investment has also increased in the past two years.
  • The company is reducing the level of leverage and is financing its activities through equity.
  • The company enjoys a very good market standing, with market capitalization of $5.6 billion.

Liquidity Ratios – Comparison

SPLS has been doing well in terms of its market price and market capitalization. On the other hand, Office Depot’s market price of shares has been on the downfall. Even though the company is a large retailer of office products, its market capitalization, as compared to Staples is very low. We need to find out reasons for this difference in market capitalization and market sentiment about the two companies.

We turn to our knowledge of ratios to look for answers. A good place to start is liquidity. Liquidity ratios assess whether a firm has enough assets to cover the liabilities of the firm. We need to know whether a firm is in a position to meet its obligations or not.

We will be computing all the ratios of Staples and Office Depot for the year 1998 and 1999. The objective behind this activity is to perform a comparison between the financial health of the two companies. It is advisable at this time to make a thorough study of the financial statements of both SPLS and ODP. We will be computing all the ratios for these two firms, but as you read along make sure that you are able to find the appropriate figures in the statements of these firms and are able to calculate the ratios yourself.

It is important to note that ratios only depict what is happening or has happened. The reasons are not available and can only be deciphered if an in-depth analysis is made. We can follow news items, visit the website of the firm, consult online analysts, obtain their reports and study past financial statements and other published information about the company in order to get a clear picture.

We are concerned with short-term liquidity when dealing with Liquidity Ratios. This is why in the discussion on both the liquidity ratios, only Current Assets and Current Liabilities are considered. The two most common and easily calculable liquidity ratios are:

Ratio

Formula

Current RatioCurrent Assets/Current Liabilities
Quick or Acid-Test Ratio(Current Assets – Inventories)/ Current Liabilities

 

Note: Both the Liquidity Ratios (Current Ratio and Quick Ratio) ignore how long it takes for a firm to collect cash. The time factor is also very important in the issue of liquidity. As the liquidity ratios ignore the time element other ratios have to be calculated to give an overall picture.

Current Ratio

The Current Ratio is calculated by dividing the Current Assets of a firm by its Current Liabilities.

Current Ratio = Current Assets / Current Liabilities

 

1998

1999

Staples

Office Depot

Staples

Office Depot

Current Assets

$1,786,140

$2,780,435

$2,064,100

$2,631,052

Current Liabilities

982,480

1,531,001

1,265,332

1,944,045

Current Ratio

1.82

1.82

1.63

1.35

The Current Ratio tells us how many Current Assets are available to a firm to cover Current Liabilities. From the calculations we can see that the Liquidity Ratio of both Staples and Office Depot has declined.

This tells us that the liquidity condition of both these firms is deteriorating. However, the decline in ODP’s liquidity has been more severe as compared to Staples.

You may want to know what the most ideal figure for the ratio is. Well, the only answer to that question is, “it depends”. The industry average identifies the trend the rest of the industry follows; however, in itself it does not depict an ideal situation.

An extremely low ratio obviously spells out liquidity problems. On the other hand, an excessively high ratio tells us that the firm may be tying up too much of its resources in working capital items that may not be producing a proportionate amount of income.

From a creditor or investor’s point of view, the Liquidity Ratio shows the margin of safety that exists for him as far as payments are concerned.

Quick Ratio

The Quick Ratio, also known as the Acid Test Ratio, also measures liquidity. The most non-liquid or least liquid current asset, which is inventory, is excluded from the total current asset figure when the calculation is made. The rationale behind this action is that in the event of liquidation, inventories are the biggest source of losses.

The Acid Test ratio is calculated as follows:

Quick Ratio =      (Current Assets – Inventory) / Current Liabilities

 

1998

1999

Staples

Office Depot

Staples

Office Depot

Current Assets

$1,786,140

$2,780,435

$2,064,100

$2,631,052

Inventory

1,124,642

1,258,355

1,340,432

1,436,879

Current Assets – Inventory

661,498

1,522,080

723,668

1,194,173

Current Liabilities

982,480

1,487,065

1,265,332

1,944,045

Quick Ratio

0.67

1.02

0.57

0.61

 

The quick ratio also shows a deteriorating liquidity condition for both SPLS and ODP.

However, we see that the ratio for SPLS has declined only by 0.09 while that for ODP has declined by a much larger amount; 0.41.

It is quite possible that ODP may be experiencing cash flow problems that will eventually affect investment and operational decisions being made.

Whatever the case, ODP is expected to suffer greater from the problems associated with a deteriorating liquidity situation.

In SPLS’s case, an increase in current liabilities is the major factor contributing to the decline in liquidity. This increase has been more than the increase in current assets and it has pulled the figure down.

A measure of a firm’s liquidity in order to meet short-term obligations without dependence on sale of inventories is an important consideration, as inventories (and prepaid expenses, if there are any) lead to most losses in the event of liquidation.

Leverage Ratios

Leverage Ratios help assess the debt situation of a firm. The management of any firm has three options when it comes to financing assets: debt, equity or a combination of both. This decision is reflected in the liabilities and equity side of the balance sheet.

The most common leverage ratios that are used in an analysis of the debt situation of a firm are:

Ratio

Formula

Debt to Equity Ratio(Current + Long-term Liabilities)/ Stockholders Equity
Debt to Assets RatioTotal Debts/ Total Assets
Times Interest Earned RatioEBIT/Interest Charge
Fixed Charge Coverage Ratio(EBIT + Lease Payments + Rentals)/ (Interest + Lease payments + Rentals)

 

Debt to Equity Ratio

This ratio is used to see how much of the assets are financed through creditors versus owners.

The Debt to Equity Ratio is calculated by dividing the total amount of debt by the amount of stockholders equity that a firm has.

Debt to Equity Ratio =    (Current Liabilities + Long-term Liabilities) / Stockholders Equity

 

1998

1999

Staples

Office Depot

Staples

Office Depot

Current Liabilities

$982,480

$1,487,065

$1,265,332

$1,944,045

Long-term Liabilities

561,897

509,339

257,048

424,418

Current Liabilities + Long-term Liabilities

1,544,377

1,996,404

1,522,380

2,368,463

Stockholders Equity

1,094,485

2,028,879

1,656,886

1,907,720

Debt to Equity Ratio

1.41

0.98

0.92

1.24

Let’s see what is happening to the debt situation in both companies. Staples’ management has brought about a massive decline in the level of Long-term Liabilities. Although the current liabilities have increased, the ratio of debt to equity has fallen from 1.41 to 0.92.

ODP’s Current Liabilities have increased as well and like Staples, the amount of long-term debt being carried by the firm has declined. The debt to equity ratio for ODP has increased from 0.98 to 1.24. This shows that ODP is becoming increasingly leveraged, while the equity investment in the firm is going down.

Staples’ owners, on the other hand, are increasing their investment in the firm. Although the Current Liabilities are increasing, the massive drop in Long-term Liabilities has outweighed that increase and has brought about a decline in the overall debt that the firm is carrying.

A decline in equity investment can serve as a signal for the market. It can create doubts in the minds of potential investors and analysts as to why the owners of the firm are reducing their investment in the firm. A firm increases its obligations as it takes on more debt. Analysts can always develop concerns as to whether the firm will retain its ability to meet its obligations in the long run.

Firms are getting rid of their long-term obligations, either in favor of short-term liabilities or equity investment.  This is a trend that can be established after viewing the financials of these two firms. Obviously, this trend may become redundant once an analysis of other competitors is made or once the figures are compared to industry averages.

Let’s break down the Liabilities of the two firms into their current and long-term portion and see what is happening to each.

a) Long-term Debt and Equity

It is always possible to play around with the ratios and the formulae provided above. If we calculate the ratio of Long-term Debt to Equity for ODP it would be as follows:

 

1998

1999

Staples

Office Depot

Staples

Office Depot

Long-term Debt

$561,897

$509,339

$257,048

$424,418

Equity

1,094,485

2,028,879

1,656,886

1,907,720

Long-term Debt to Equity

0.51

0.251

0.155

0.222

 

In ODP’s case the ratio of long-term debt to equity is falling. We can see that the level of long-term debt is declining and so is the level of equity. The combined effect has brought about a decrease in the ratio.

Let’s see the situation at Staples. The Long-term Debt of the firm has declined drastically and so has the ratio. This has happenedbecause the level of equity has gone up. The figures above show that Staples’ management has paid off around half of its Long-term Liabilities between 1998 and 1999.

b) Current Liabilities Vs. Equity

What is happening at the level of Current Liabilities and equity?

 

1998

1999

Staples

Office Depot

Staples

Office Depot

Current Liabilities

$982,480

$1,487,065

$1,265,332

$1,944,045

Equity

1,094,485

2,028,879

1,656,886

1,907,720

Current Liabilities to Equity

0.9

0.734

0.76

1.019

 

The Current Liabilities of bothfirms have increased. However, while equity investment in Staples has risen by $562 million, equity investment in ODP has declined by $121 million. In the case of Staples, the increase in equity investment has more than offset the increase in current liabilities, which is why the ratio has declined. However, concerning ODP, Current Liabilities have increased while the equity has declined, thus an increase in the ratio.

The combined effect of Long-term Liabilities to equity and Current Liabilities to equity is shown in the Debt to Equity Ratio.

Debt to Total Assets

The Debt to Assets Ratio shows what percentage of Total Assets is financed by debt (or current or long-term debt, if calculated individually). It is an indicator of the extent to which creditors have a claim on assets.

The Debt to Total Assets Ratio is calculated as follows:

Debt to Assets Ratio =   Total Debt / Total Assets

 

1998

1999

Staples

Office Depot

Staples

Office Depot

Total Debt

$1,544,377

$1,996,404

$1,522,380

$2,368,513

Total Assets

2,638,862

4,025,283

3,179,266

4,276,183

Debt to Assets

0.59

0.49

0.48

0.55

 

It is apparent from the calculations above that the level of debt in Staples has gone down, while that in Office Depot has increased. The ratio for Staples dropped from 0.59 to 0.48, while for ODP it went up from 0.49 to 0.55.

What can we understand from the figures? If the Debt to Assets ratio is very high, then in the event of liquidation owners will be left with very little after the creditors are given back their dues. This is applicable more to ODP than to Staples.

A high Debt to Assets Ratio implies that the risk of default is greater, which means that creditors are taking on more risk when they lend capital to such a firm. Again, this is a situation that is  more applicable to ODP than to SPLS.

As mentioned earlier, the higher the debt the more difficult it may be for the business to pay off all its creditors if required.

Times Interest Earned (Coverage) Ratio

Coverage ratios determine the degree to which a firm’s fixed expenses are covered by operating income. We calculate Coverage Ratios to see whether the firm will be able to pay its fixed financial charges or not.

The TIE ratio helps us in gauging the extent to which operating income can decline before the business is unable to meet its interest charges. If you would like to know the margin of safety within which the business can operate before getting into serious trouble with its creditors, this is the ratio to calculate. Obviously, the higher the TIE ratio the better.

The TIE ratio is computed by the following formula:

TIE Ratio =           EBIT / Interest Charges

 

1998

1999

Staples

Office Depot

Staples

Office Depot

EBIT

$277,662

$404,759

$323,631

$413,373

Interest Charges

21,955

22,356

17,370

26,148

TIE Ratio

12.65

18.1

18.63

15.8

 

Staples had a TIE ratio in 1998 of 12.65. The ratio increased to 18.63 in 1999. This means that the margin of safety for creditors is increasing. The fall in interest charges is in line with the fall in Long-term Liabilities that the firm has experienced. Operating Income has also increased; so reasons for the increase in TIE ratio are twofold in the case of Staples.

In 1998, for ODP, Operating Income or EBIT covered the interest charges 18 times while in 1999 the interest charges were covered only 15.8 times. We see that the operating income has risen, but we also see that interest charges have increased.  This is because the firm has taken on additional debt. The ratio has fallen because the increase in interest is higher than the increase in EBIT.

Fixed Charge Coverage Ratio

The Fixed Charge Coverage Ratio is also a type of coverage ratio. The difference between this ratio and the TIE  is that the Fixed Charge Coverage Ratio includes not only interest charges but also includes all financial charges, both short-term and long-term.

Examples of these kinds of expenses are long-term leases, rental expenses, etc. The Fixed Charge Coverage Ratio provides the same information as the TIE ratio except that it includes long-term fixed obligations as well.

The Fixed Charge Coverage Ratio is computed as follows:

Fixed Charge Coverage = (EBIT + Lease payments + rental expenses) / (Interest + Lease payments + rental expenses

Note: As there are no lease payments and rentals in financial statements of Staples and ODP, the Fixed Coverage Ratio will be the same as the Times Interest Earned Ratio for both 1998 and 1999.

Productivity Ratios

Productivity ratios are also known as Turnover Ratios, Asset Management Ratios and Asset Utilization Ratios. They are used to gauge whether the management of a firm is utilizing assets to their maximum potential.

They first step is to see whether too few or too many assets are being carried on the balance sheet. Second, we need to see whether the assets are being used productively or not.

There are five commonly used ratios that fall in this category

Ratio

Formula

Inventory TurnoverSales/Average Inventory of Finished Goods
Fixed Asset TurnoverSales/Fixed Assets
Total Asset TurnoverSales/Total Assets
Average Collection PeriodAccounts Receivable/(Total Credit Sales/365)
Accounts Receivable TurnoverAnnual Credit Sales/Accounts Receivable

 

Inventory Turnover Ratio

The inventory turnover ratio is a measure of the adequacy of inventory and how well it is being managed. It tells us whether a firm holds excessive stocks of inventory.

We are interested in finding out how many times in a year Staples and ODP are selling their inventory.

A comparison of this ratio to the industry average tells us whether the company is selling inventory slower than the rest of the industry.

This ratio is more significant in industries where products are just purchased and then sold, that is, in merchandising firms like supermarkets, distributors, departmental stores, etc.

Therefore the Inventory Turnover Ratio is very significant for companies like Staples and Office Depot.

The Inventory Turnover Ratio is obtained by dividing Sales by the Average Inventory of finished goods over one accounting period.

Note: Notice that Average Inventory has been used for calculations. This is done because sales occur over the entire year while inventory is usually taken at a certain point in time.

Average inventory is calculated by the following formula:

Average Inventory of Finished Goods = (Beginning inventory + Ending Inventory) / 2

 

1998

1999

Staples

Office Depot

Staples

Office Depot

Beginning Inventory

$813,661

$1,397,266

$1,124,642

$1,258,355

Ending Inventory

1,124,642

1,258,355

1,340,432

1,436,879

Average Inventory of Finished Goods

969,152

1,327,811

1,232,537

1,347,617

The ratio for Inventory Turnover is computed by dividing the figure for Sales by that of Average Inventory. The calculations for SPLS and ODP are given below.

Inventory Turnover =                     Sales / Average Inventory

 

1998

1999

Staples

Office Depot

Staples

Office Depot

Sales

$5,732,145

$8,997,738

$7,123,189

$10,263,280

Average Inventory

969,152

1,327,811

1,232,537

1,347,617

Inventory Turnover

5.91

6.78

5.78

7.62

The ratio for SPLS has declined while the ratio for ODP is increasing from 6.78 to 7.62. We can judge that in 1999 Staples has sold off its inventory at a slower rate in 1999 than in 1998, while in ODP sold inventory at a faster pace in 1999 as compared to 1998.

How much is invested in inventory is an important aspect of managing a business.The size of investment in inventory depends a great deal on the type of business and the timing of Sales. For example if a certain product experiences seasonal demand (for example, the sales of quilts will be higher during the winter) then the inventory should be adjusted accordingly throughout the year.

There are two important points to note with respect to the Inventory Turnover Ratio. Some analysts prefer using the Cost of Goods Sold or the Cost of Sales figure instead of Sales. The reason for this is that sales show the market price of products while the Cost of Sales is a measure of cost; when the latter figure is used, the numerator and denominator become consistent in naturebecause both these figures will then be based on cost. If and when the Sales figure is taken the Turnover Rate would be overstated.

Fixed Asset Turnover

This ratio is computed by dividing Sales by the amount of Fixed Assets that a company possesses.

Fixed Asset Turnover =                 Sales / Fixed Asset

 

1998

1999

Staples

Office Depot

Staples

Office Depot

Sales

$5,732,145

$8,997,738

$7,123,189

$10,263,280

Fixed Assets

$852,722

1,244,848

$1,115,166

1,645,131

Fixed Asset Turnover

6.72

7.23

6.39

6.24

 

The Fixed Asset Turnover Ratio shows us the sales productivity of a firm in terms of utilization of fixed assets like plant, property and equipment.

It focuses on how well fixed assets are being managed in terms of the amount of sales that are being generated.

For ODP, the Fixed Asset Turnover Ratio is declining between 1998 and 1999 from 7.23 to 6.24. Although the level of sales is increasing significantly, the amount of fixed assets needed to generate those sales has also increased.

Notice, however, that the ratio indicates that in 1998 fixed assets were used more efficiently than they were used in 1999 when additional fixed assets were acquired.

In Staples’ case, the Fixed Asset Turnover is also declining. It has gone down from 6.72 to 6.39. However, the decline has not been as severe as it was for Office Depot.

Total Asset Turnover

This ratio tells us whether the Total Assets of the firm are being used properly or not.

The Total Asset Turnover Ratio is calculated like the Fixed Asset Turnover Ratio with the figure for Total Assets being taken instead of Fixed Assets. The calculations are given below:

Total Asset Turnover =                  Sales / Total Assets

 

1998

1999

Staples

Office Depot

Staples

Office Depot

Sales

$5,732,145

$8,997,738

$7,123,189

$10,263,280

Total Assets

2,638,862

4,025,283

3,179,266

4,276,183

Total Asset Turnover

2.17

2.24

2.24

2.40

 

The ratio for ODP and SPLS show us that the efficiency in the overall use of assets is improving. We know that the fixed asset turnover is declining, so the improvement in the utilization of Total Assets is mainly due to an improved usage of Current Assets

If the Total Asset Turnover Ratio is not adequate it tells us that given the level of total investment that has been made, the sales generated are not enough. Under these conditions, the management can either take measures to generate more sales (by using assets more efficiently) or it can dispose of certain assets.

Average Collection Period

This ratio tells us the average period of time, in days, that it takes a firm to collect its dues that have resulted from credit sales. Obviously, if the length of time is too long then it depicts the firm’s lax credit and collection policy, thereby spelling out liquidity problems in the future.

The ratio is calculated as follows:

Average Collection period =        Accounts Receivable / (Total Credit Sales/365)

For the purpose of calculation, let us assume that all sales are on creditfor Staples and Office Depot. The calculations are given below:

 

1998

1999

Staples

Office Depot

Staples

Office Depot

Accounts Receivable

$203,143

$721,446

$221,836

$849,478

Total Sales/365

15,705

24,651

19,516

28,119

Average Collection Period

12.93 days

29 days

11.37 days

30 days

We can see that figure for Average Collection period for Staples declining. In 1998, it took the collection officer nearly 13 days to collect the receivables. In 1999 it took the man only 11.5 days.

Now, look at the figures for ODP. The collection period was 29 days in 1998 and in 1999 the average collection period has gone up to 30 days. A difference of just one day may not be such a big one, but it does identify the diminishing quality of the business’ credit and collection policies.

On the whole, we can see that Staples takes less time in collecting its receivables. One major reason for this is that the amount of receivables that Staples carries is much less than those of ODP.

Accounts Receivable Turnover

The Accounts Receivable Turnover is calculated by dividing the Annual Credit Sales by Accounts Receivable.

Accounts Receivable Turnover =               Annual Credit Sales / Accounts Receivable

Again, we will assume that all sales of Staples and ODP are on credit.

 

1998

1999

Staples

Office Depot

Staples

Office Depot

Annual Credit Sales

$5,732,145

$8,997,738

$7,123,189

$10,263,280

Accounts Receivable

203,143

721,446

221,836

849,478

Accounts Receivable Turnover

28.22

12.5

32.11

12.08

 

The Accounts Receivable Turnover Ratio shows us how many times in a year the receivables were converted to cash. This ratio also reflects upon the credit and collection policies of a firm. Obviously, if the firm has too many resources tied up in receivables it is creating cash flow problems for itself. The higher the turnover rate, the better because it indicates that a company’s receivables are more liquid.

As far as SPLS is concerned we can see that the turnover rate has increased from 28.22 to 32.11. So, the liquidity of receivables of Staples is improving. We can also tell that the firm’s credit policy is becoming more effective.

For ODP, we can see that the turnover rate has declined from 12.5 to 12.08 between 1998 and 1999. The rate at which receivables are being converted into cash is falling, which in turn indicates a deteriorating liquidity condition. This is in line with the information that we obtained from the liquidity ratios themselves.

Profitability Ratios

We can gather the following informationfrom Staples’ Income Statement:

  • Gross Income for the firm increased by $372 million between 1998 and 1999
  • Operating Income increased by $46 million during the same period
  • Net Income increased by around $18 million

ODP’s Income Statement gives us the following information:

  • Gross Profits rose by $299.7 million
  • Operating Profits rose by $8.6 million during the same period and
  • Net Profits rose by $24 million between 1998 and 1999

Why do we have to calculate profitability ratios, when it is apparent that profits have increased for both companies? Well, we need to compare the profits generated by the firm with the level of sales and operations. We need to see whether the rise in profits meets the expectations of the management itself, as well as investors, creditors and analysts.

What do these profitability ratios tell us? They show the profit and earning situation of a business. Profitability ratios are a measure of management’s overall effectiveness and efficiency as shown by returns generated on sales, investments and equity. They show the combined effects of liquidity, leverage and turnover ratios. It is the management of all these aspects, or should I say the ‘proper management’, that actually leads to the generation of desirable profits. Therefore, all these aspects of operation and financial management have implications on the earnings of a firm.

 

Various individual ratios that are a part of the set of profitability ratios are given below:

 

Ratio

Formula

Gross Profit MarginGross Profit/Sales
Operating Profit MarginOperating Profit/Sales
Net Profit MarginNet Income/Sales
Return on AssetsNet Income/Assets
Return on EquityNet Income/ Equity
Basic earning power ratioEBIT/Total Assets

 

Gross Profit Margin

The Gross Profit Margin is obtained by dividing the figure of Gross Profit by Sales. Gross Income or Profit is obtained by subtracting the Cost of Sales from the Total Revenue or Sales of a business.

Gross Profit Margin =     Gross Profit / Sales

Where,

Gross Profit =                    Total Revenue – Cost of Sales

 

1998

1999

Staples

Office Depot

Staples

Office Depot

Gross Profit

$1,354,455

$2,513,274

$1,726,266

$2,812,970

Sales

5,732,145

8,997,738

7,123,189

10,263,280

Gross Profit Margin

0.24 or 24%

.28 or 28%

0.24 or 24%

.27 or 27%

 

For SPLS, the Gross Profit Margin has remained constant at 24%. This means that Sales and Cost of Sales have increased in the same proportion.

On the other hand, the Gross Profit margin for ODP has gone down by 1 percentage point. Sales have increased between 1998 and 1999; however, the cost of sales has increased at a higher proportion, which is why the margin has declined.

The gross profit margin ratio gives us an insight into what percentage of each dollar of sales is left for covering the rest of the expenses (operating, interest) and taxes to yield a profit. We can see that ODP was left with only 28% in 1998 and 27% in 1999 of Total Revenues for expenses, taxes and profits.

Staples is left with only 24% in both 1998 and 1999 to cover the rest of the expenses.

Profits are shrinking for ODP! This tells us that the management is losing control over its costs. Why could the Total Cost of Sales be moving upwards? Maybe vendors of office supplies have increased the per unit price? Maybe the delivery and shipping charges are increasing? Whatever the reason, it is apparent that the management has experienced a higher cost of sales in 1999 as compared to 1998.

It is important to note here that Staples has experienced a lower Gross Profit margin than ODP in both the years. However, we must keep in mind that Staples has lower sales and a smaller financial structure than ODP. This can be one reason why the gross profit margin is comparatively lower.

Operating Profit Margin

Operating profits are obtained after deducting the cost of operations from sales. Operating expenses include administrative, marketing and sales and other such expenses.

The Operating Profit Margin is calculated as follows:

Operating Profit Margin =            Operating Profit / Sales

Where,

Operating Profit =            Sales – Cost of Sales

 

1998

1999

Staples

Office Depot

Staples

Office Depot

Operating Profit

$277,662

$404,759

$323,631

$413,373

Sales

5,732,145

8,997,738

7,123,189

10,263,280

Operating Profit Margin

0.048 or 4.8%

0.045 or 4.5%

0.045 or 4.5%

0.040 or 4%

 

Take a look at the figures for Staples. The Operating Profit Margin has dropped from 4.8% to 4.5%. Implying that there is a need for management to focus its efforts on controlling operating costs and expenses.

We can see that although operating profits have increased, the rise is smaller in proportion than the rise in Sales.

The Operating Profit Margin is declining in the case of ODP as well. Sales have increased considerably and operating profits have also shown an increase of around $8 million. However, the operating profit has increased at a lower proportion as compared to Sales, which is why the ratio has declined. What does this tell us? It says that the management has not controlled operating costs effectively, which is why they have risen and caused a dent in the profitability of the company.

On closer look at the income statement of Office Depot, we see that all operating costs have increased except “Merger and Restructuring Costs”. Considering Office Depot strategy of cutting down on the number of stores that it has already and is opening in the coming years, a new operating expense is being incurred, which is “Store Closure and Relocation Costs”.

From the financials, we can see that advertising expenses have increased considerably. This is due to the increasing competition that the company is facing as well as the management’s efforts towards entering new markets.

The ratio tells us that the managements of both Staples and Office Depot have to do a better job of controlling operating expenses as rising operating costs are having serious repercussions on profitability.

Net Profit Margin

The Net Profit Margin ratio depicts the percentage of each dollar of sales that is available as profits for the company.

Net Profit is the bottom line that is obtained in the income statement after deducting all expenses from the sales figure. When we express the net income or net profit as a percentage of sales, we arrive at the figure for Net Profit Margin.

Net Profit Margin =         Net Income / Sales

 

1998

1999

Staples

Office Depot

Staples

Office Depot

Net Income

$167,914

$233,196

$185,370

$257,638

Sales

5,732,145

8,997,738

7,123,189

10,263,280

Net Profit Margin

0.029 or 2.9%

0.026 or 2.6%

0.026 or 2.6%

0.025 or 2.5 %

 

For both Staples and ODP, the Net Profit Margin has declined. The decline for ODP has been smaller for ODP than for Staples.

However, the question that arises here is:why is the ratio declining even though Net Profit has increased for both businesses? The answer is that although net profits are increasing, the rise is not proportionate to the overall increase in sales, which is why the margin has declined slightly.

So, we can now deduce what profitability ratios tell us: to view the figures for net profit, gross profit or operating profit in isolation is incorrect. When viewed in isolation, these figures can be misleading. However, when the profits are seen in relation to sales and are compared to past performance, the true situation of a company comes to light.

So let’s move on and see what the rest of the profitability ratios tell us about Staples and ODP.

Return on Assets (ROA)

Return on Assets (ROA) tells analysts the amount of return that has been achieved by the operations of the firm in relation to the amount of assets that the firm possesses. In short, it shows how much profit has been generated per dollar of assets, which in turns tell us how well assets have been utilized.

ROA is calculated by dividing the Net Income by the figure for Assets that is present in the Balance Sheet. This figure can either be Total Assets, Current Assets or Fixed Assets. It depends on the relationship between what two variables the analyst would like to see.

Return on Assets (ROA) =            Net Income / Assets

 

1998

1999

Staples

Office Depot

Staples

Office Depot

Net Income

$167,914

$233,196

$185,370

$257,638

Assets

2,638,862

4,025,283

3,179,266

4,276,183

Return on Assets (ROA)

0.064 or 6.4%

0.058 or 5.8%

0.058 or 5.8%

0.060 or 6%

 

The figures for Staples tell us that the return on assets is going down; it was 6.4% in 1998 and it dropped to 5.8% in 1999. Although the Net Income has increased, the Total Assets of the firm have increased by a higher amount.

For ODP, the ratio has risen from 5.8% to 6.0% between 1998 and 1999. This is in line with the Total Asset Turnover ratio (ratio of sales to total assets), which also showed an increase. Both these ratios collectively show that the utilization of assets has improved.

Return on Equity (ROE)

The Return on Equity tells us how well the firm has performed, both in terms of profits and in relation to the investment that owners have made. It depicts how much profit as been earned per dollar of equity.

The Return on Equity is simple to calculate. You can divide the figure available for Net Income by that of Stockholders’ Equity to arrive at the figure.

Return on Equity =          Net Income / Equity

The ROE for the two years, 1998 and 1999 are given below for Staples and ODP:

 

1998

1999

Staples

Office Depot

Staples

Office Depot

Net Income

$167,914

$233,196

$185,370

$257,638

Equity

1,094,485

2,028,879

1,656,886

1,907,720

Return on Equity

0.153 or 15.3%

0.115 or 11.5%

0.112 or 11.2%

0.135 or 13.5%

The Return on Equity for Staples is declining. It has declined from 15.3% to 11.2%. The reason for this is not that Net Income has fallen; we know that it has grown. The reason is that the amount of equity investment has risen considerably as we have seen earlier.

On the other hand, ROE has risen from 11.5% to 13.5% for ODP. Although the net profit has risen in reality, a major portion of this increase has been due to the decline in the level of equity that the firm has.

Basic Earning Power Ratio

The ratio shows the raw earning power of the firm’s assets, before the influence of taxes and interest, and it is useful for comparing firms with different tax situations and different degrees of leverage (debt).

The Basic Earning Power ratio is calculated by dividing the Earnings before Interest and Taxes (EBIT), also known as Operating Income, by the amount of Total Assets that are available with the firm.

 

Basic Earning Power ratio =          EBIT / Total Assets

 

1998

1999

Staples

Office Depot

Staples

Office Depot

EBIT

$277,662

$404,759

$323,631

$413,373

Total Assets

2,638,862

4,025,283

3,179,266

4,276,183

Basic Earnings Power ratio

0.105 or 10.5%

0.101 or 10.1%

0.102 or 10.2%

0.097 or 9.7%

 

For SPLS, the Basic Earning Power of Assets has declined from 10.5% to 10.2%. In the case of ODP, the Basic Earning Power of Assets has also declined, from 10.1% to 9.7%. This reflects negatively on the management of both companies as it shows that the operational aspects of the firm are not being controlled efficiently, which is leading to high expenses.

Ratio analysis case study: Conclusion

There is enough evidence to justify the treatment of ODP versus Staples by the market.

Firstly, the liquidity condition of Staples is much better than that of ODP even though the overall liquidity of both firms is declining. However, the fall in liquidity is more severe in the case of ODP than that in Staples.

Second, the ratio of Debt to Equity has declined drastically for Staples while it has increased for ODP. For Staples, a major driving force is the sharp drop in the level of long-term liabilities and the simultaneous increase in equity. This shows that owners are looking forward to better prospects in the future and therefore want to increase their investment in the company.

Third, when we look at the coverage ratios we can see that Staples ratio is rising while that of ODP is falling. For investors and creditors the margin of safety in being paid is higher, which inspires more confidence in the company.

Next, despite having a smaller base level of sales, Staples has managed to achieve higher overall profitability percentages than ODP. If we consider the gross profit level, we can see that the margin for ODP is considerably higher. However, at the level of Operating Profits, Staples and ODP have more or less the same ratios, which means that Staples’ management is doing a better job of controlling operating costs than ODP.

Return on Assets is slightly higher in the case of Staples. On the other hand Return on Equity is considerably higher. This is why investors are highly attracted to Staples shares.

We can now say for sure that the facts and figures discussed and listed above give us enough evidence as to why the market capitalization of ODP is so much lower than that of Staples.

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