Ratio Analysis Master Case – Office Depot: Industry review and ratios

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Concept Title: Industry Analysis

Let’s get an overview of the office supplies industry as a whole. The industry is growing at the rate of 6% to 10% annually. In the United States, three major players dominate the sector: Office Max, Staples and Office Depot.

The industry is highly diverse and competitive, with all players looking for new and more innovative ways to reach the customer. Online ordering and marketing through web sites is a recent industry trend. Distribution by large retailers is dependent on efficient trucking systems and warehouses that are strategically located all over the country. The idea behind such a setup is to cut down on costs and to promote efficiencies through economies of scale.

The end user or buyer of office supplies has a very strong influence on the way this industry operates. As mentioned earlier, buyers are looking for convenience, not only in terms of location but also in terms of how much time has to be spent on buying office supplies.

The market for office supplies is sizeable with growth being driven by new office construction and the continued transition from a manufacturing- to a service-centered business economy. The industry, in the eyes of many analysts, is suffering from saturation. New stores that have been opened by the players have not been able to meet their revenue forecasts.

While Office Depot and Office Max are cutting down on the number of new stores, Staples is continuing to follow its policy of opening new retail outlets; it opened 174 in the last year. Office Depot is planning to open 80 instead of the 100 that were planned earlier. There has also being a growing trend amongst competitors to enter markets that are traditionally known to be strongholds of specific competitors. An example of this is Staples entering Office Depot’s main territory of Florida and Office Depot gaining access to Staple’s stronghold markets of Manhattan and Boston.

Increasing service area, in terms of square footage, is also a strategy that all players are following. However, the tactics are different in each case; while Staples and Office Depot are focusing on international expansion, Office Max is concentrating its efforts on establishing efficient distribution warehouses and bringing in advanced technology. Also, due to the lack of complexity in the office supplies environment, new players like Dell are being attracted to the industry, which means more competition and price challenges can be expected in the future.

Although you will find that most of the calculations have been done, it will be easier for you to understand what is going on if you do the calculations yourself as well. So armed with the tools (an understanding of ratio analysis) we can move ahead in our attempt to break down ODP’s statements and make sense of them all.

We will be computing various ratios for 1998 and 1999 to explain how ratios are calculated and what they say. It would also help us understand the changes in ODP’s financial condition between the two years. 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 performed. We can follow news items, visit the firm’s web site, consult analysts, obtain their reports and study past financial statements and other published information about the company in order to get a clearer picture.

Liquidity ratios portray the ability of a firm to meet its short-term obligations. The two most common 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 amount of Current Assets that a firm has available to it by the Current Liabilities.

Current ratio =    Current Assets / Current Liabilities

Current Assets 2,780,435 2,631,052
Current Liabilities 1,531,001 1,944,045
Current Ratio 1.81 1.35

The ratio, as mentioned earlier, shows how many current assets are available to cover the current liabilities. The current ratio for ODP is falling, which indicates a deteriorating liquidity condition. A reason for this can be that there is a simultaneous increase in current liabilities and fall in current assets

Depending on your outlook, the same ratio can be interpreted differently. An excessively high ratio may indicate that a business is investing extravagantly in working capital items that may not be producing a proportionate return. For a creditor, the current ratio measures the margin of safety in being paid. Obviously, the higher the current ratio the better an investor’s margin of safety will be.

Quick ratio

The quick ratio, known as the Acid test ratio, is also a measure of liquidity. However, it excludes the relatively non-liquid current asset, which is inventory, from the total current asset figure when the calculation is made.

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

  1998 1999
Current Assets 2,780,435 2,631,052
Inventory 1,258,355 1,436,879
Current Assets – Inventory 1,522,080 1,194,173
Current Liabilities 1,487,065 1,944,045
Quick Ratio 1.02 0.61

The quick ratio also shows a deteriorating liquidity condition, which spells out trouble for ODP. Management may be experiencing cash flow problems that will eventually affect the investment and operational decisions that will be made today and in the future

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.

Concept Title: Leverage Ratios I

Leverage ratios indicate the level of debt that has been taken on by a firm and also give an insight into how well a firm is managing that debt.

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

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

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

  1998 1999
Current Liabilities 1,487,065 1,944,045
Long Term Liabilities 509,339 424,418
Current Liabilities + Long-term Liabilities 1,996,404 2,368,463
Stockholders Equity 2,028,879 1,907,720
Debt to Equity Ratio 0.98 1.24

The ratio tells us how much of the assets are financed through creditors versus owners.

In the case of ODP, the debt to equity ratio has risen from 0.98 to 1.24, which means that either the level of debt is increasing or that the level of equity is declining, or both. We can see stockholders equity has declined between 1998 and 1999 by $121 million. The total debt of the firm, on the other hand, rose by $372 million.

a) Long-term debt and Equity

It is always possible to play around with the ratios and the formulae provided above. For example, only current liabilities or only long-term liabilities may be taken in the numerator to establish meaningful relationships. If we calculate the ratio of long term debt to equity for ODP it would be:

  1998 1999
Long Term Debt 509,339 424,418
Equity 2,028,879 1,907,720
Long Term Debt to Equity 0.251 0.222

In the case of ODP 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.

b) Current Liabilities and Equity

Let’s check and see what is happening to the ratios of current liabilities to equity.

  1998 1999
Current Liabilities 1,487,065 1,944,045
Equity 2,028,879 1,907,720
Current Liabilities to Equity 0.734 1.019

c) Debt to Total Assets

The debt to total assets ratio is calculated as follows:

Debt to Total Assets ratio =    Total Debt / Total Assets

  1998 1999
Total Debt 1,996,404 2,368,513
Total Assets 4,025,283 4,276,183
Debt to Assets 0.49 0.55

The above ratio shows what percentage of total assets are financed by debt (or current or long-term debt, if calculated separately). This ratio is an indicator of the extent to which creditors have a claim on assets. If the Debt to Assets ratio is very high, in the event of liquidation owners will be left with very little after the creditors obligations are settled.

The debt to assets ratio is 0.49 in 1998 and 0.55 in 1999. We can see that nearly 50% of assets are financed through debt in 1998 while around 55% are financed through debt in 1999. The thing to remember is that just looking at the Debt to Asset ratio is not enough to decide if this level of debt appropriate or not.

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

Again, different variants of the same ratios can be used. For example, instead of taking the figure for Total Debt, you may be interested in studying how much of the assets are financed only through Long-term debt or short-term (current) liabilities.

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