Running header: ANNUAL REPORT EVALUATION

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Running header: ANNUAL REPORT EVALUATION

Evaluating Dick’s Sporting Goods Annual Report

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Dick’s Sporting Goods

“Dick’s Sporting Goods is a full-line sporting goods retailer offering an assortment of brand name sporting goods equipment, apparel and footwear in a specialty store environment” (“Business Summary,” 2009). The company operates stores in 40 states, primarily in the eastern half of the United States and includes 340 Dick’s stores, 79 Golf Galaxy stores and 15 Chick’s stores. The company divides the stores into customer-specific environments, including the Pro Shop and the Footwear Center, and carries such brands as Adidas and Nike. Dick’s Sporting Goods uses financial statements to communicate information to its investors and other stakeholders.

Understanding Annual Reports

Companies use annual reports to prepare for changing market conditions, examine competitors in their core markets, and provide timely information for investors, lending institutions, and other users of financial information. Useful information is provided by accounting information released by companies in their annual reports and investors can use various ratios to examine the overall financial health of various organizations. In the examination of Dick’s Sporting Goods annual reports for the previous two years the researcher needs to use general tools of analysis, such as ratios, consider measures of liquidity and credit risk, financial leverage, and examine the cost of capital and other financial incentives for the company.

Ratio Analysis

Companies use calculations between different sets of data on the annual report to determine the short-term financial health and long-term financial health of the firm. Ratios also provide the changes in a company caused by internal and external factors often not displayed in individual financial statement information, such as the cost of goods sold. “A ratio is a simple mathematical expression of the relationship of one item to another,” according to Williams, Haka, Bettner, and Carcello (2006, p. 674). Different ratios provide different information to different financial information users, including the company.

Current Ratio

The current ratio evaluates financial liquidity and short-term debt paying ability for a company. The formula for calculating the current ratio is current assets/current liabilities = current ratio. The 2006 current ratio for Dick’s Sporting Goods was 1.30:1 while the 2007 current ratio was 1.53:1. The 2006 ratio of 1.30:1 means that for every dollar of current liabilities, Dick’s Sporting Goods has $1.30 of current assets. Dick’s Sporting Goods current ratio increased in 2007 and is consistent with the industry standard of 1.8, meaning Dick’s Sporting Goods appears to be reasonably liquid.

Acid-test (Quick) Ratio

The quick ratio (acid-test ratio) provides a view of the company’s short-term liquidity and is calculated by the following equation: [pic]. The quick ratio complements the current ratio because the quick ratio examines components of short-term liquidity not examined by the quick ratio; also, the inventory displayed on the balance sheet may not be available for current sale. The quick ratio for 2006 was 0.1:1 and increased in 2007 to 0.3:1. Given that the industry average is 0.3:1, Dick’s Sporting Goods quick ratio seems adequate.

Inventory Turnover Ratio

Inventory turnover is “the number of times on average the inventory is sold during the period” (Weygandt, Kieso, and Kimmel, 2005, p. 697). This ratio measures the liquidity of the inventory and is calculated by the equation cost of goods sold/average inventory = inventory turnover. Dick’s Sporting Goods inventory turnover ratio declined from 3.8 in 2006 to 3.6 in 2007, thereby identifying less cash tied up in inventory and decreased chance of inventory obsolescence. The industry average in the Sport Goods & Bicycle Shops industry is 3, so Dick’s inventory turnover rate is above average.

Debt Ratio

The debt ratio “indicates what proportion of debt a company has relative to its assets” (Investopedia, 2009). The ratio is found by dividing total liabilities by total assets. In examining this ratio, Dick’s Sporting Goods had a debt ratio of 0.56 for 2007, which is lower than the 2006 debt ratio at 0.59. Even though the debt ratio is lower, the company still displays it has more assets than debt and this can be attractive for potential investors and lenders, thus providing increased leverage against its competitors. If the debt ratio were closer to 1 or over 1 a company might be struggling in satisfying its debt re-payments and this could hurt said company’s chances of attracting future capital.

Net Profit Margin Ratio

“The profit margin tells you how much profit a company makes for every $1 it generates in revenue” (Kennon, 2009). The net profit margin, also known as Return on Sales, evaluates the company’s operational efficiency. Most companies agree the higher the profit margin against their competitors, the better for said companies. Calculating Return on Sales involves dividing net income, after taxes, from sales and the equation is: net income/sales = ROS. In examining the annual reports for Dick’s Sporting Goods and taking the values necessary for 2006 and 2007, the ROS for 2006 is 3.6 percent and the ROS for 2007 is 4.0 percent. Thus the profits for Dick’s Sporting Goods have increased 0.4 percent in the past year and the net profit margin results are slightly higher than the industry average of 3.4 percent.

Return on Investment

Investors want an assurance that the company in which they invest will efficiently manage their financial resources. One method of determining such efficiency is with the use of the return on investment ratio. The formula used is: [pic]. Using the data from the annual report, Dick’s Sporting Goods had a ROI of 7.4 percent in 2006 and 7.6 in 2007. The percentages are higher than the industry average of 6.6 percent (MSN Money, 2009); the higher percentage means investors will be attracted to Dick’s Sporting Goods as an investment opportunity.

Return on Equity

Return on Equity is a profitability ratio that defines the amount of profit a company generates from shareholder investments. The formula for ROE is: net income/shareholders’ equity. Using this formula on the annual reports from Dick’s Sporting Goods, the company’s ROE is 18.1 percent in 2006 and 17.4 percent in 2007. The ROE for Dick’s Sporting Goods is higher than the industry average of 15.0 percent, meaning the company is managing its equity better than other competitors in the sporting goods sales industry.

Price-to-Earnings Ratio (P/E Ratio)

The price-earnings ratio is “the relationship between the market price of common stock and earnings per share” according to Williams, Haka, Bettner, and Carcello (2006, p. 674). The P/E ratio decreased from 13.4:1 in 2006 to 10.4:1 in 2007, meaning the company is experiencing issues with the earnings per share and also lower stock prices. The industry average for the P/E ratio is 11.0 and this indicates that Dick’s Sporting Goods is just under the industry average for the sporting goods sales industry.

Working Capital Management

In examining the previous ratios, the information came from either the balance sheet or the income statement; however, the cash-flow statement should be examined to provide an overall picture of health for a company. Tergesen (2001) says the cash-flow statement adds new items in addition to data provided by the balance sheet and income statement (p. 1). Cash from operating activities, cash from investing activities, and cash from financing activities are the three sections that comprise the cash-flow statement. Debt can be paid down internally if the balance of the operations section is positive and the other two sections display negative balances.

Starting with net income and the items that cause a difference between income and cash flow, states Tergesen (2001, p. 2). In 2006, Dick’s Sporting Goods reported cash from operating activities of $139.61 million (Dick’s Sporting Goods, 2008) and reported $262.83 million in 2007.

Dick’s Sporting Goods is optimizing its accounts payable by reducing the accounts payable from $24.44 million in 2006 to $12.34 million in 2007. Inventories on the cash-flow statement align with the inventory turnover ratio because the company reduced the ratio in 2007, thereby controlling its inventory levels.

In examining the cash-flow statement, Dick’s Sporting Goods is not optimizing its cash cycle because the financing section has a positive balance, even with the company lowering the amount in 2007. The company needs to sell more stock because more of the company’s investors chose to exercise their stock options in both 2006 and 2007. Dick’s Sporting Goods is moving toward controlling financing and investment activities but the company needs to ensure more investors or potentially buying back stock to ensure a balance between the amount of cash going to payment of debt and the amount of cash paid to the company.

Debt and Equity: Finding the Right Balance

Dick’s Sporting Goods uses a combination of debt and equity to finance current operations and long-term projects. The debt is comprised of $172.5 million senior convertible notes (bonds) with an interest-bearing rate of 2.375 percent of the issue price, paid semiannually, with $1,000 face value paid on maturity. The notes are convertible into common stock at the discretion of the holder of the note. Other debt includes capital lease obligations, such as a note payable, due in monthly installments of approximately $4, including interest at 4 percent, through 2020 and (b) note payable, monthly installments of $5, interest at 11 percent, through 2018. Such debt allows the company to fund various projects and operations.

Equity differs from debt because shareholders provide the capital to the company in exchange for financial instruments, usually common stock. Dick’s Sporting Goods issued 200,000,000 shares of common stock, with $.01 par value per share, and 40,000,000 of Class B common stock with a par value of $.01 per share. The current amount of capital received in the sale of stocks was $1.06 million in 2006 and $1.1 million in 2007, as issued and outstanding shares of common stock were 79,382,554 in 2006 and 84,837,642 in 2007, while issued and outstanding shares totaled 26,787,680 in 2006 and 26,307,480, meaning the company might be buying back shares of its stock.

Weighted-Average Cost of Capital

The weighted average cost of capital, also known as WACC, involves a “calculation of a firm’s cost of capital in which each category of capital is proportionately weighted” (“Weighted Average Cost of Capital – WACC,” 2009). Every type of financial instrument used to finance and fund operations and projects is included in the WACC and includes (a) common stock, (b) preferred stock, and (c) debt. The equation for WACC involves the cost of each component, multiplied by its weight, and then adding the sum of both debt and equity:

[pic]

In estimating the WACC, a company looks to optimize its current capital structure. In the case of Dick’s Sporting Goods, the following figures represent the current cost of capital, given the capital structure for the company:

[pic]

Entering in the totals for 2006 and 2007, with respect to total debt and total equity, Dick’s Sporting goods has a weighted average cost of capital at 6.6 percent in 2006 and a weighted average cost of capital of 6.3 percent in 2007. Given that the table displayed a WACC of 6.9 percent, the company is depending on the buyback of stock to increase its WACC; in addition, too much debt may provide difficulties for Dick’s Sporting Goods if the company utilizes too much debt to finance operations and long-term projects.

Comprehensive Analysis

Examining the different items on the financial statements by using ratio analysis and WACC allows the researcher to understand Dick’s Sporting Goods’ financial structure and whether investment in the company is properly balancing its debt and equity mix. Given the various ratios, Dick’s Sporting Goods is meeting or exceeding industry standards. The company should look to reduce its cost of equity and increase its cost of debt to provide the company with a better overall capital cost structure. Even with the buyback of its shares, Dick’s Sporting Goods should increase the amount of debt to increase financial leverage.

Recommendations

In viewing the ratio data, Dick’s Sporting Goods remains a good buy; however, the current economic downturn may change the attractive quality of the stock as investors continue their nervous trend of selling stocks. One point for investors to watch is the financing from operating activities, as Dick’s Sporting Goods does not have to report its operating leases on any financial statements; this could possibly give an inflated view of operations and offset any new revenue generated by the company. The current economic environment and the increase in debt financing caused a decrease in the valuation of the stock but Dick’s Sporting Goods is handling its sales and financing according to current market trends, thus causing a recommendation in purchasing stock in Dick’s Sporting Goods.

References

Dick’s Sporting Goods. (2008). 2007 Annual Report. Retrieved January 8, 2009, from the Web site:

Investopedia. (2009). Weighted Average Cost of Capital – WACC. Retrieved January 8, 2009, from the Web site:

Kennon, J. (2009). Net Profit Margin: Investing Lesson 4 – Analyzing an Income Statement. Retrieved January 8, 2009, from the Web site:

MSN Money. (2009). Dick’s Sporting Goods Inc: Key Ratios. Retrieved January 8, 2009, from the Web site:

Tergesen, A. (2001, January 22). The ins and outs of cash flow: These reports offer clues about companies’ health. Business Week, 102 – 104.

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