The other three industries also utilize a relatively

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relatively certain and stable and, as a result, utility companies can support a higher debt level. The other three industries also utilize a relatively high proportion of debt. However, these industries are not regulated and their markets are more competitive and volatile. Consequently, their use of debt carries more risk. At the lower end of debt financing are software firms whose profits and cash flows can be very uncertain; and pharmaceutical firms whose persistently high profits and cash flows reduce the need for debt financing. Home Depot's totalliabilities-to-equity ratio is 1.12 in 2011 ($21,236 million/$18,889 mil- lion), a marked drop from 1.5 in 2008-see graphic below. Home Depot's ratio is much lower than the average for retailing firms 0.5) and just slightly above 1.0, the average for publicly traded companies. Home Depot Solvency Ratios 1.7 1.5 1.3 1.1 0.9 0.7 0.5 0.3 V'" -.'.;':--"-; "'j-/k";"; /1''**/''--' "'j-/'<O;:-- ..... :-.., ~ 0.1 2008 2009 2010 2011 Total debt-to-equity A drawback of the liabilities-to-equity ratio is that it does not distinguish between operating creditors (such as accounts payable) and debt obligations. We can refine our analysis with a solvency ratio such as follows: Long-term debt including current portion + Short-term debt Total debt-to-equity = S k toe holders' equity
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Module 4 I Credit Risk Analysis and Interpretation 4-18 solvency ratio assumes that current operating liabilities will be repaid from current assets e-called self-liquidating) such that lenders should focus on the relative proportions of debt and -_'.(Variations of this ratio include only long-term debt in the numerator and/or total capital in ominator; these solvency ratios differ in their exact definitions but all assess the company's structure and measure the relative debt load.) Home Depot's 2011 ratio was 0.52 [($1,042 million + $8,707 million)/$18,889 million] about same as in 2010 but markedly lower than in 2008 when the ratio was 0.76-see graphic above. Depot has less debt than in prior years and, consequently, both solvency ratios are stronger. Juring 2011, Home Depot repurchased $2.6 billion of common stock. The effect of this o decrease solvency but only by a fraction because Home Depot also repaid debt dur- e year. At the end of 2010, S&P addressed Home Depot's stock buybacks, saying, "The y's intermediate financial risk profile is somewhat weak for the 'BBB+' rating, and ludes our expectation that leverage will increase due potentially to future debt-financed repurchase activity. As of Aug. 1,2010, we estimate the company could add about $3 bil- ebt to repurchase shares and remain below 2.5x leverage. We currently believe such debt- S:::!::K:ed share repurchases would only occur when the company believes the environment has . ed." In sum, Home Depot's ratio analysis reveals a profitable company that effectively debt to increase returns to shareholders, a company with strengthening coverage and cash ratios, and improved liquidity and solvency. 4: Perform prospective analysis ~ .aluate the creditworthiness of a prospective borrower, creditors must forecast the bor- 's cash flows to estimate its ability to repay its obligations. To effectively look forward, - t must look back. That is, the forecasting process begins by adjusting current and prior .financial statements so that they accurately reflect the company's financial condition and
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