Qualitative
Dollar Tree has consistently done a good job of disclosing much of their accounting information in their 10-K. They openly talk about their operating leases, goodwill, inventory, and write offs of inventory. It should be noted though that the transparency of their 10-K reporting has declined over the years. For example, they used to list the intangible assets (Non-competition agreements, Favorable Lease Rights, and Goodwill) individually on the balance sheet, but they are now only disclosed as combined intangible assets. A possible reason that they would have gone to this form of accounting policy is to follow the similar reporting procedures as of their competitors in the industry. However, Dollar Tree does disclose most of this information in the notes to the financial statements. A specific example of something being disclosed in the notes is goodwill. Also, it should be noted that Dollar Tree’s managers do have some incentive for altering their financial statements. Dollar Tree provides its managers with stock options; so the better the financial statements look, the higher the stock price is leading to more money money cashed in from these stock options. Also, Dollar Tree is involved in a revolving credit facility where they have a huge credit balance with an outside lender. They must keep certain financial ratios up in order to continue having this credit balance to borrow from. These incentives may also be one of the reasons for the declining amount of transparency in the financial statement because they need the room to alter the statements in order to keep the ratios up.
Quantitative
Quantitative approaches in general vary greatly. Some act as “screening” ratios. Others predict future stock returns. Quantitative approaches play a more important role in security analysis today than they did a decade or two ago. (Palepu 9-5)
the reported revenue and expenses. Quantitative analysis is a useful tool in predicting or measuring different aspects reported in a company’s financial statements.
Revenue diagnostics
Revenue diagnostics include: net sales/cash from sales, net sales/net accounts receivable, net sales/unearned revenues, net sales, warranty liabilities, net
sales/inventory. Notice that in each one of these ratios reported net sales is the numerator. The reason for this is that these ratios determine whether or not the varying denominator entries support the reported sales.
Net sales ratio: (net sales/inventory)
This revenue diagnostic ratio determines the extent to which net sales is supported by inventory. A bigger ratio is better but companies want it to remain constant. A large spike in the net sales ratio would be a red flag. This would indicate that the inventory is not supported by the reported net sales.
Net Sales / Inventory
0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00 2001 2002 2003 2004 2005 2006 Dollar Tree 99 Cents Only Family Dollar Dollar General
This ratio is important in the discount variety industry because when dealing with commodities it is essential to maintain the lowest inventory possible. This will prevent working capital from being clogged up by inventory. Family Dollar, Dollar Tree, and
Dollar General had a steadily increasing ratio. However in 2005, Dollar Tree maintained the highest position. This means that they led the industry in being more efficient with their inventory. Dollar Tree has implemented an inventory management method which allows them to keep an efficient level of inventory. The sudden spike in Dollar Tree’s ratio was due to a sudden drop in sales from 2001 to 2002. In 2003, net sales went back up to the normal range. They do not keep an excess of inventory which would translate into extra warehousing inventory related expenses. 99 Cents Only Store has experienced volatile net sales to inventory ratio. The sudden drop in net sales could be justified due to a shortage of inventory.
Conclusion
The only revenue diagnostic ratio that applies to Dollar Tree is the net sales ratio, because they do not have any accounts receivable, unearned revenue, or warranty liabilities to speak of. Also most other companies in the discount variety industry do not have the above mentioned accounts.
Expense diagnostic ratios
Much like the revenue diagnostic ratios, the purpose of expense diagnostic ratios is to assess the believability of the numbers reported on the financial statements. Expense diagnostic ratios include: Asset Turnover, Changes in CFFO/OI, Changes in CFFO/NOA, Total accruals/Change in sales, Pension expense/SG&A, Other employment expenses/SG&A. The expense ratios tell analysts and investors how well a company manages its expenses.
Asset Turnover: (Net sales/Total Assets)
The asset turnover ratio is computed by dividing net sales by the average of the total assets from the current year and the previous year. This ratio helps to determine if the reported total assets support the reported net sales. A higher asset turnover
means that the firm is very efficient is using its assets. Also, a company with a very high asset turnover tends to have a low profit margin.
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Asset Turnover (Sales/Assets)
0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 2001 2002 2003 2004 2005 2006 Dollar Tree 99 Cents Only Family Dollar Dollar General Dollar Tree Revised
Discount variety stores normally operate under operating leases rather than capital leases. A capital lease would normally appear as an asset in the balance sheet when compared to operating leases which are expensed to rent expense in the income statement. The asset turnover ratio tells us how well a company uses its assets to increase its revenue. Dollar General operates more stores than any of its direct
competitors. This explains why their sales are more than the other stores. This tells us that their assets contribute to increasing net sales. Also, it can be seen from this graph that Dollar Tree is catching up with their competitors and one reason for this steady growth in this ratio could be explained by the new mergers and acquisitions which Dollar Tree had in the recent years. Upon revision to Dollar Tree’s books from Capital Lease corrections, our asset turnover ratio declined. This can be attributed to an increase in Total Assets.
Cash Flows From Operations (CFFO): CFFO/NOA
Cash flows from operations are the cash that is generated from operating activities. This is calculated using revenues and expense from the balance sheet.
Expenses are subtracted from the revenues; this yields the number know as Operating Cash flow on the statement of cash flows. Essentially this is the cash that pays a company’s bills. (www.investopedia.com)
Operating assets include things in the line item Plant, Property, and Equipment on the balance sheet. The ratio, CFFO/NOA, shows investors how well PPE are utilized in relation to cash flows. As ratios increase, this indicates the firm is increasing the utilization of its PPE.
CFFO/NOA 0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 2001 2002 2003 2004 2005 2006 Dollar Tree 99 Cents Only Family Dollar Dollar General Dollar Tree Revised
Change in CFFO/NOA (0.20) (0.10) 0.00 0.10 0.20 0.30 0.40 2001 2002 2003 2004 2005 2006 Dollar Tree 99 Cents Only Family Dollar Dollar General Dollar Tree Revised
By looking at the graphs we can infer that both Dollar Tree and Dollar General allocate their PPE to cash flows well. The steady increase in their CFFO is a reflection
of an increase in cash flow due to the acquisition of new buildings. Once Dollar Tree’s books were revised the CFFO/NOA increased the ratio. The ratio reflects the change in CFFO as a result from the change in Net Income.
Cash Flows From Operations/Operating Income: (CFFO/OI)
CFFO, once again, is the cash that is generated from operating activities and it is found on the balance sheet. Operating income is also known as EBIT, earning before interest and taxes. Operating income is found on the income statement. This can be used to measure and firm’s profitability. CFFO/OI will tell investors if a firm’s reported operating income matches up to their reported cash generated by operating activities.
Change in CFFO/OI (1.20) (1.00) (0.80) (0.60) (0.40) (0.20) 0.00 0.20 0.40 0.60 0.80 2001 2002 2003 2004 2005 2006 Dollar Tree 99 Cents Only Family Dollar Dollar General Dollar Tree Revised CFFO/OI 0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 2001 2002 2003 2004 2005 2006 Dollar Tree 99 Cents Only Family Dollar Dollar General Dollar Tree Revised
Throughout the past five years the discount variety sectors, CFFO divided by operating income have been relatively steady. However in 2005, 99 Cent Only Stores have experienced a rapid succession of increased CFFO. This could be the result of a low operating income. Revisions to the Dollar Tree books yielded a increase in CFFO from net income and inherently changed the ratio to a higher number.
Total Accruals/Change in Sales:
Accruals are expenses for which invoices have not been received at the end of an accounting period (moneyterms.co). Accruals reported on the financial statements include: accounts payable, accounts receivable, goodwill, future tax liability and future interest expense, among others. Accrual based accounting provides a better, more accurate view of a firm’s financial standing at a given point and time. It allows a company to account for expenses which have not actually been paid and revenue that has not yet been received. These accrued revenues and expenses will take place within a year.
This ratio will help explain if a company does a lot of business in terms of credit. Investors might view a higher number of accounts receivable and accounts payable as a bad thing.
Total Accruals/Change in Sales
-0.80 -0.70 -0.60 -0.50 -0.40 -0.30 -0.20 -0.10 0.00 0.10 2002 2003 2004 2005 2006 Family Dollar Dollar Tree Dollar General 99 Cent Only Store
Through the five year period Dollar Tree has had a decrease in accruals/change in sales. This means that the firm is selling less to customers on credit and making more sales in cash. As compared with the industry, Dollar Tree’s ratio is average. This is a good thing because the nature of the industry requires that most purchases by
customers be made on a cash basis.
Potential “Red Flags”
Part of analyzing financial statements includes the daunting task identifying detrimental information within the companies’ financial statements. The only significant accounting item that can be classified as a “red flag” for Dollar Tree is that of operating leases. According to the company’s 10K, the operating leases are amortized on a straight line basis over the term of these leases. Other possible “red flags” are so
irrelevant that they need not be corrected. Intangibles, like goodwill, have increased by $14.6M in the year 2006. However, this increase can be justified by the 138 Deal$ stores that were acquired during the year. This looks like a potential “red flag”, but it can be justified.