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Valuation and Analysis of Dollar General as of June 1, 2007
Ravi Patel [email protected]
Thai Tran [email protected] Jackee Otieno [email protected]
Nathan Johnson [email protected] Lauren Kirkland [email protected]
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Table of Contents
Executive Summary1
Overview of Dollar General6 Five Forces Model................................................9
Rivalry among Existing Firms................................9 Industry Growth.10
Concentration..10
Differentiation and Switching costs13
Scale Economies and Fixed/Variable Costs..13
Excess Capacity and Exit Barriers14
Threat of New Entrants..15
Economies of Scale.15
Channels of Distribution and Relationships..16
Legal Barriers17
Threat of Substitute products.17
Buyers willingness to switch17
Bargaining Power..18
Bargaining Power of the Customer...............................18
Switching Cost.18
Product Cost and Quality..19
Number of Buyers..19
Volume per Buyer..19
Bargaining Power of the Suppliers...20
Switching Cost...............................................20
Product Cost and Quality..20
3
Number of Suppliers....20
Value Chain Analysis...21
Efficient Production22
Simpler Product Design.22
Lower Input Costs....22
Low-cost Distribution...22
Minimal Brand Image Cost..23
Tight Cost Control..23
Firm Competitive Advantage Analysis....23
Efficient Production..24
Simpler Product Design.24
Lower Input Costs....24
Low-cost Distribution25
Minimal Brand Image Cost..25
Tight Cost Control..25
Conclusion...26
Accounting Analysis.......27
Key Accounting Policies.28
Degrees of accounting flexibility..30
Accounting Strategy...32
Quality of Disclosure..34 Identify Potential Red Flags...44
Undo Accounting Distortions.45
Financial Analysis.48
Trend and Cross Sectional Analysis48
Financial Ratio Analysis.49
4
Liquidity Ratios..49
Current Ratio...............................................50
Acid Test..50
Quick Asset Ratio.52
Inventory Turnover...53
Profitability Ratios...57
Gross Profit Margin....57 Operating Profit Margin...58
Net Profit Margin....59
Asset Turnover.60
Return on Assets.61
Return on Equity.62
Capital Structure Ratios..63
Debt to Equity..64
Times Interest Earned.65
Debt Service Margin.66
IGR/SGR Ratios67
Forecasting Financial Statements..70
Income Statement....70
Balance Sheet.72
Statement of Cash Flows..75
Cost of Capital Estimation.76
WACC estimation....78
Valuation analysis.79
Method of comparables80
Intrinsic Value Models.85
Discounted Dividends Model.85
Free Cash Flow.87
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Residual Income..88
Long Run Residual Income...90
Abnormal Earnings Growth...91
APPENDIX.92
6
Executive Summary
Investment Recommendation: Overvalued, Sell 6-1-07
DG----NYSE (6/1/07) $21.63 EPS Forecast 52 Week Range $12.10-$21.85 2008 2009 2010 2011 2012 Revenue (2/2/07) $9,169,822 .44 .46 .48 .50 .55 Market Capitalization $6.86 Bill Shares Outstanding 314.88 Mill Ratio comp. DG DLTR FDO 3-Month Avg. Daily Trading Volume: Trailing P/E 9.53 22.19 22.75 Institutional Ownership 66% Forward P/E 7.62 17.78 18.98 Book Value per Share $5.706 PEG .065 1.27 1.61 ROE: 20% P/B 11.8 3.87 3.95 ROA: 12% Cost of Capital Est. R2 Beta Ke Valuation Estimates: 3-Month .19 1.19 Actual Price (6/1/07): $21.63 6-Month .19 1.19 Trailing P/E $9.57 2-Year .19 1.19 Forward P/E $7.80 5-Year .19 1.19 PEG $2.92 10-Year .18 1.18 P/B $54.00 P/EBITDA $28.24 Ke 12.09% P/FCF $123.39 Kd 5.19% EV/EBITDA $3.54 WACC 10.99% Altman Z-Score Intrinsic Valuations Actual 2003 2004 2005 2006 2007 Discounted Dividend $18.40 7.48 7.88 7.74 6.43 7.33 Free Cash $29.71 Residual Income $3.22 Revised Z-Score 2007: 2.847 LR ROE $7.21 AEG $8.79
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Recommendation: Sell-Overvalued
Industry Analysis
Dollar General was founded in Scottsville, Kentucky in 1939 and was
originally called J.L. Turner and Son Wholesale, then Turners Department Store,
and then in 1955 it was converted to Dollar General and did not sell any item
over $1. Dollar General was the originator of the dollar store concept and in 1968
it became a publicly traded company. Dollar General is a Fortune 500
company and the leader in the dollar store segment, with more than 8,000
stores and $9.2 billion in fiscal 2006 sales (www.dollargeneral.com).
Dollar General is in the discount retail store industry and focuses on cost
leadership. Its direct competitors are Family Dollar Stores, Freds Inc., and Dollar
Tree. In this industry, maintaining low costs are crucial to generating profits,
since the merchandise is already being sold at a discount and there is such high
competition between companies. The competition is high due to the threat of
substitute products: the products being sold are extremely similar, if not identical
and pose no switching costs to customers.
8
Accounting Analysis
A major part of analyzing and valuing a firm is analyzing its methods of
accounting. The information needed to do this can be found in the companys
annual 10-K report. First the key accounting policies are analyzed to ensure that
they correspond with the key success factors as defined by the five forces model.
Then the degree of flexibility allowed by GAAP is determined, as well as the
actual accounting strategy used by the firm. The quality of disclosure is how
transparent the companys reports are and how believable their numbers are and
is determined though screening ratios. These ratios alert us of any red flags in
their accounting, and finally any distortions found are corrected to show the
company more accurately.
After our analysis, the only area in which Dollar General uses flexibility is
in the reporting of leases, which is allowed by GAAP, but greatly alters their
financial statements. While the footnotes were very clear in disclosing
information, the consolidation of the financial statements makes it difficult to
actually see what they are disclosing. After computing all of the revenue and
expense manipulation ratios we did not find any red flags so the only distortion
to undo was the reporting of the leases.
9
Ratio Analysis, Forecast Financials, & Cost of Capital
Estimation
Ratio analysis is done to evaluate a company and to find out how it ranks
with its competitors. There are three sets of ratios used in this part of the
analysis; liquidity ratios, profitability ratios, and capital structure ratios. All the
information needed to compute these can be found in a companys financial
statements. In our analysis of the past five years, Dollar General has performed
about average with the industry and in a few cases has out-performed the
industry. Once these ratios have been calculated they can be used to forecast
the companys future performance. By using the CAPM model, a Beta for the
company can be estimated; then using the estimated Beta, the companies
estimated cost of equity can be determined through regression analysis. Finally
the estimated cost of equity can be computed by using the WACC formula.
Valuations
The main focus for valuation models are to show whether the companies
estimated value is worth what the market implies. To derive such prices, you
must estimate the firms cost of capital and equity, the growth rate, and the
WACC and use them to determine how well the companys stock is priced. There
are five different valuation models the discounted dividends, free cash flows,
residual income, long-run residual income, and the abnormal growth earnings.
10
These models use different factors in deriving the estimated share price, in which
some are more accurate than others.
We began with the method of comparables, which uses the current
financials of Dollar General and also the financials of industry competitors. This
method includes using the P/B ratio, PEG ratio, DPS, and trailing/forecasted P/E
ratio. We believe this is a good benchmark to where firms should stand when
compared to the industry.
For our valuation models, we based our valuations using our ten
year forecasted financials. The models indicated that Dollar General is highly
overvalued compared to our intrinsic valuations. The free cash flow model
shows that Dollar General is undervalued; we believe this valuation is doubtful
based on the uncertainty of our forecasted cash flow. After using all five models,
our overall decision is that Dollar General is highly overvalued and investors
should sell.
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Overview of Dollar General
Dollar General is in the discount retail store industry selling common
household necessities, such as cleaning supplies, health and beauty aids, basic
food items, some clothing, and seasonal products. The target market of this
corporation is people who generally have lower, middle and fixed incomes.
Dollar General started out as J.L. Turner & Son, in 1939 as a wholesale business
in Scottsville, Ky. The company coined the dollar store concept in 1955 opening
retail stores which boosted the companys sales. In 1968 the company went
public and changed its name to Dollar General. Today, the corporate office is
located in Goodlettsville, TN. (www.dollargeneral.com)
Sales volume and growth are very important factors for success in the
discount retail industry. As shown below, sales for the industry has been rising
each year for the past five years with Dollar General leading the way.
Sales Volume
*All numbers in thousands.
(www.edgarscan.com)
* 2002 2003 2004 2005 2006
Dollar General $6,100,404 $6,871,992 $7,660,927 $8,582,237 $9,169,822
Dollar Tree
Stores, Inc.
$2,357,836 $2,799,872 $3,126,000 $3,393,900 $3,969,400
Family Dollar
Stores, Inc.
$1,108,637 $1,244,683 $1,380,245 $1,511,457 $1,600,264
Freds, Inc. $1,103,418 $1,302,650 $1,441,781 $1,589,342 $1,767,239
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While Dollar Generals sales have exceeded their competition by far,
their net income decreased this past year while the competitions rose. This is
mainly due to the fact that Dollar Generals general expenses rose and interest
income decreased.
Industry Net Income
*All numbers in thousands.
Dollar Generals Stock is currently selling for $21.63 and there are
314,788,000 outstanding shares giving it a market capitalization of
$6,808,864,440. While it has far more outstanding shares than its competitors,
they are selling at a lower price. In the past year Dollar Generals price per share
has remained relatively constant while its competitions prices have been rising.
(www.nyse.com).
* 2002 2003 2004 2005 2006
Dollar General $262,351 $299,002 $344,190 $350,155 $137,943
Dollar Tree
Stores, Inc.
$145,219 $177,583 $180,300 $173,900 $192,000
Family Dollar
Stores, Inc.
$57,478 $64,452 $55,355 $51,389 $54,124
Freds, Inc. $27,491 $32,795 $27,952 $27,952 $26,746
13
Average Stock Prices 2003-2007
05
101520253035
2003 2004 2005 2006 2007
Year
Pric
e
FREDFDODLTRDG
Within the past year, stock prices have been on the rise after hitting the
low of 13.42 which is the lowest it has been in two years.
http://moneycentral.msn.com
In comparison to its competitors, Dollar Generals stock is outperforming
its competitors this year after prices fell in the third quarter last year.
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THE FIVE FORCES MODEL
The five forces model is an excellent tool used to analyze the industry in
which the firm is competing in. It helps us see the type of industry the firm is
competing in, what characteristics are associated with the type of industry, and
also identify what types of things the firm can do to stay a head of the
competition. The five forces model includes: Rivalry among existing firms,
Threats of new entrants, threat of substitute products and bargaining power of
buyers and suppliers. These forces assess the degree of competition and the
marketing power of buyers and suppliers.
We will use the five forces model to evaluate the industry as a whole.
After briefly explaining each segment of the five forces model, the model will be
put to use by developing a value chain analysis. After the value chain analysis we
will use the complete information to compare Dollar General with the rest of the
industry.
Cost Leadership Industry
Rivalry among
Existing firms
Threats of
new
Entrants
Threats of
substitute
products
Bargaining
power of
buyers
Bargaining
power of
suppliers
Very High Low High Moderate Moderate
Rivalry among Existing Firms
Dollar General is in the discount retail merchandise industry, which is
highly competitive with respect to price, store location, merchandise quality, in-
stock consistency and customer service. Since the discount retail industry is a
highly concentrated industry they strive to provide merchandise at low prices,
thus it is necessary to keep prices as close to marginal cost as possible.
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Industry Growth
A company striving to make it in this industry has to come up with
innovative ways to grow. Most of the firms competing in this industry have found
a niche in small towns because of the low and low-middle class population. In
doing so, they have experienced a rapid expansion and in turn have increased
their number of stores. Another element encouraging growth is the low every
day prices characterized by the industry. As a result of the low prices they are
able to cut costs and expand in different areas, like offering a new line of
products or even increasing number of stores. Other firms in this industry have
invested in advertising, by inserting circulars in the newspapers and reaching out
to different customers who dont necessarily shop at a dollar store.
Concentration
Concentration plays a very big role in price setting. The more competitors
in an industry the lower concentrated the industry is which creates price wars.
Dollar Generals main competitors include: Family Dollar, Dollar Tree, Freds and
99 Cents Only. The industry is characterized by providing the every day low
prices and still making a profit by having a low cost structure and relatively low
assortment of products.
16
Market Percentage
2002
40%
17%
31%
7% 5%
Dollar General Dollar Tree Family Dollar Fred's 99 cents
2003
47%
1%
37%
9% 6%
Dollar General Dollar Tree Family Dollar Fred's 99 cents
17
2004
40%
16%
31%
8% 5%
Dollar GeneralDollar TreeFamily DollarFred's99 cents
2005
42%
17%
32%
8% 1%Dollar GeneralDollar TreeFamily DollarFred's99 cents
18
2006
40%
16%
31%
8% 5%Dollar GeneralDollar TreeFamily DollarFred's99 cents
Differentiation and switching costs
The discount retail industry has no differentiation cost because it is a cost
leadership competitive Industry. Switching cost would be low because our
merchandise is easily liquidated. It would take very little to get rid of the
merchandise without losing money and switching to another industry.
Scale economies and fixed/variable costs
The price of the merchandise depends on how a company handles
operational costs. Dollar General emphasizes aggressive management of its
overhead cost structure. Additionally, they seek to locate stores in
neighborhoods where rental and operating costs are relatively low. Individual
Dollar General Store leases vary in their terms, rental provisions, and expiration
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dates. Majority of the leases are low-cost and short-term ranging from three to
five years. Family Dollar leases 5719 of their stores and only owns 489; this
indicates that they have high fixed costs. The 99 cents only store own 37 stores
and lease 105 store which again shows they have high fixed costs.
The level of fixed cost plays a role in the growth of a company in this
industry. If the fixed costs are too high then expansion is going to be slow.
Family Dollar has 350 stores opened in 2006. The 99 cents only store has only
19 store opening this year. Dollar General has introduced control in fixed cost
which is supported by the 300 stores they plan to open this year, plus
remodeling 300 other stores. In such an industry, firms must generate large
inventory turnover for the fixed cost to cover variable costs.
In conclusion, if a firm wants to be successful in this industry they have to
make sure that they do not have too many fixed costs, because this slows down
growth. If they have a lot of fixed costs then they need to make sure that they
generate large inventory turnover to cover the variable costs.
Excess Capacity and Exit Barriers
Excess capacity exists if the customer demand exceeds supply. In the
discount retail industry, supply is always greater than demand because of the
amount of competition and ease of access. Same-store sales are one way to
monitor just how much sales a firm is getting. Same-store sales measure the
increase or decrease in sales for the stores that have been open for more than
one year. This helps a firm know just how well they are doing in comparison to
the industry. There are high exit barriers in the discount retail industry mainly
because it would be costly and time consuming to liquidate merchandise or break
lease agreements. For these reasons, the industry requires lower cost and
increases rivalry among existing firms.
The discount retail industry is characterized by high exit barriers mainly
due to cost of liquidation. Same-store sales are an important measure for firms
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to use so they can see just how much they are selling and how much inventory
they have left, thus avoid tying up their resources in idol inventory.
THREAT OF NEW ENTRANTS
The potential for earning high profits in an industry will attract new
entrants to an industry. Easily accessible industries force existing firms to
compete not only with the new entrant but also amongst other firms. There are
many barriers for new entrants in the discount retail industry. New entrants
must rise above large economies of scale that exist within established firms.
Also, suppliers will be difficult to find in the discount retail business mainly
because of profitability sought by suppliers. There are few legal barriers to be
faced; new firms will face some legal discretion just like in any industry. There is
the possibility for entrance of new firms but there are barriers to be faced.
Economies of Scale
When entering into a specific industry, economies of scale play a major
role. New entrants will initially suffer from a cost disadvantage in competing
with well established firms. New entrants do not have the capital and resources
to compete on such a level. Dollar General and Family Dollar Stores are the two
largest firms in this industry and have the upper-hand on suppliers and
distribution access to their stores. This advantage poses high economies of scale
allowing most of the firms in the industry to offer low prices for their customers.
The diagram below shows the level of assets possessed by the existing
firms in the industry. Thus new entrants would have to acquire the minimum
capital needed to enter the industry.
21
Total Assets
0
500,000
1,000,000
1,500,000
2,000,000
2,500,000
3,000,000
3,500,000
2005 2006 2007
Dollar GeneralDollar TreeFamily DollarFred's Inc99 Cents Only
Channels of Distribution and Relationships
It is imperative for a firm to have a proficient channel of distribution and
keep good relations with the supplier in order to be cost efficient. The discount
retail industry is cost driven therefore making it essential for the company to be
efficient. It is difficult for new entrants to distribute their goods from suppliers
without the right system. Dollar General has nine distribution centers (also used
as warehouse space) of which they lease three but own the other six and has
their own trucking system to deliver goods to their stores. Family Dollar has nine
distributing centers, but they do not have enough trucks to distribute their
merchandise. 86% of their merchandise was distributed by external carriers in
2006. In order for Family Dollar to manage this, they have a good relationship
with their carriers that lead to discounts. The 99 Cents Only lease trucks and also
transport by rail.
22
Legal Barriers
There are no direct legal barriers in the discount retail industry. Legal
barriers exist when importing goods from other countries therefore making it
costly in terms of trained personnel in international trade policies. Dollar General
directly imports 14% of their goods and Dollar Tree imports 35%-40% of their
goods. Companies need to be aware of certain items such as; import laws,
currency exchange, and foreign business operations.
New entrants have a tough hurdle to overcome when it comes to legal
barriers. With most of their products supplied by companies abroad, it would be
costly and difficult for a new entrant to compete to get the same supplier or
even try to lobby for the same prices.
THREAT OF SUBSTITUTE PRODUCTS
The discount retail industry is a highly competitive industry with five direct
competitors and certain other relative competitors like Wal-mart and Target.
Customers are therefore very price sensitive. Threat of substitute products is low
in the discount retail industry because the products offered are generally the
same across the board. In the discount retail industry most of the firms have the
same suppliers therefore the products are the same.
Buyers willingness to switch
The discount retail industry is very price conscious, therefore most the
players in the industry compete in those terms. Also, since the products in the
industry are the same, customers are drawn to picking the firm with the lowest
price, therefore the customers switching cost is very high.
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Bargaining Power
In the Following sections, bargaining power will be discussed relative to
the buyers and suppliers of the market. The industry will be examined as a low-
cost, highly competitive market. The five factor model guidelines will be used in
assessing the industry. Topics that will be discussed include switching cost,
product cost and quality, number of buyers, and volume per buyer.
Information will be given on how a company should compete in order to
be effective in a highly competitive industry. The guidelines and information will
help value the companies in the industry. The next two sections will give an idea
of what the industry requires of buyers and sellers.
Bargaining power of the Customer
In such a highly competitive market, the customers have a rather large
bargaining power over the companies in the industry. It is easy for customers to
switch from store to store depending on the relative prices of each. The
switching cost is merely the price of gas to drive or time to walk from one store
to the next. The customers of the discount retail industry have a some what
higher volume per purchase because the stores are catered to be a one stop
shop for the lower/ lower middle class customer. For this reason, firms in this
particular retail market have incentive to keep prices as low as possible because
of the bargaining power of the customer.
Switching Cost
Switching cost of the customer is a large reason why the customer has
bargaining power. A customer can easily switch from one low price store to
another depending on how cheap the stores products are. The price sensitivity of
the buyer is relatively high because they have limited financial means. Each of
the companies in the industry carry the same line of products, and the customers
will look for the best prices among each. For the reasons above, it is highly
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important where a store is located. Most companies will situate a store in or very
near low-income neighborhoods.
Product Cost and Quality
The particular industry does not focus as much on the product quality as it
does on the price of the product. The companies in this industry will carry
substitute products that are lower quality rather then name brand items in more
expensive stores. The industry has to focus on the cost rather then quality
because the customers demand the cheapest product possible.
Number of Buyers
The number of buyers in the industry is the lower middle and lower
income consumers in the industry area. The discount retail industry is affected
by every customer. The number of customers and amount bought determines
the profitability of the company. In essence, the customer has more bargaining
power because the stores survival depends on the number of customers. It is
very important for companies to keep prices low to remain attractive.
Volume per Buyer
The volume of products bought by a customer in the discount retail
industry can vary from a few items to several. Most of the customers of this
industry use the stores as a one stop shop. Once again, each customer matters.
After evaluating each segment of bargaining power of the buyer, we
concluded that the bargaining power of the customers for the discount retail
industry is relatively high.
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Bargaining Power of the Suppliers
In contrast to the bargaining power of the customer, the bargaining
power of the suppliers is relatively low. The low switching costs, number of
companies, and the number of substitute suppliers are factors that give very low
bargaining power to the suppliers. The companies in the discount retail industry
are very price sensitive because it caters to the low-income customer. The
suppliers of products have to sell at the right price because companies are trying
to keep the lowest cost possible.
Switching Cost
The switching cost is relatively low among suppliers. It is important for a
company in this industry to minimize cost as much as possible. The large number
of suppliers that are available makes it easy for companies to switch to suppliers
that have the lower costs. Suppliers have to compete with one another to supply
to the companies in the industry. Their bargaining power is very low because the
stores dictate who they will choose and it will always be the lowest cost supplier.
Product Cost and Quality
Suppliers have to focus on minimizing costs. Product quality is not at the
forefront t because companies are not shopping for quality products, but they
are looking for low cost products. The suppliers have no choice but to focus on
cutting costs.
Number of Suppliers
The number of suppliers in the discount retail industry is very large. The
large number of supplier decreases the bargaining power of the supplier because
of the number of alternatives for the customers. Each supplier has no choice, but
to compete with each other and whoever is able to achieve the lowest price gets
the deal.
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Volume per Supplier
The volume of purchases by the companies is moderate. The suppliers
need to keep cost low in order for companies to consider them as a supplier. If
the supplier cant supply the products at the right price set by the companies the
company will look for other producers. The volume at which the companies will
purchase at is more incentive for suppliers to keep cost low.
In conclusion, the suppliers in the industry need to maintain low costs
because of the bargaining power in the hands of the company. The number of
suppliers available and the ease of switching from one to the other affect how
much bargaining power each supplier is able to have; therefore, the bargaining
power of suppliers is low.
Lastly, the five forces model is a tool used to value an industry and see
how attractive it is. The model is divided into two categories, the degree of
actual and potential competition, which talks about how the firms in the industry
compete with each other and the strategies used in the industry in order to stay
competitive. The second part is the bargaining power in the input and output
markets, which talks about the bargaining power of suppliers and buyers. It
focuses on the things they do in order to stay ahead of the competition.
Value Chain Analysis
The value chain analysis discusses important strategies that a company
needs to utilize in order to be a cost leader in the industry. The following
paragraphs will go through each strategy and analyze effective ways a company
can pursue in order to keep costs low.
The following analysis will present information on how a discount retail
company should compete in a highly competitive industry. After the value chain
analysis is complete we will use the information to evaluate Dollar Generals
performance in the discount retail industry.
27
Dollar General resides in a highly competitive discount retail industry.
Each company competes to provide basic commodities and service at a low price.
In order to be successful, each competitor has adopted the business strategy of
cost leadership. By implementing this strategy successfully, companies will be
able to earn profits and gain greater market share.
Efficient production
In order for a company to be a cost leader in the discount retail industry,
the company has to be efficient and strive to have low operational costs.
Improving Technology helps to cut cost and increase efficiency with systems like
inventory management tools and supply chain systems (Dollar General 10k).
Another way to be efficient is by maximizing trailer loads in order to cut down on
the number of trips to be made and increase efficiency (family Dollar 10k)
Simpler Product Design
Since this is a discount retail industry, quality is not as an important factor
therefore a company can sacrifice on using high quality raw materials and go for
the generic products that cost much less. The companies need to use low cost
products many of which rely on the supplier they choose. Efficient companies are
able to get semi-decent quality products at a very low price.
Lower Input costs
A company in the discount retail industry needs to keep input cost at a
minimum. Companies can reduce the amount of input costs by managing leases,
buildings, and warehouse in an efficient manner.
Low-cost distribution
Lower cost distribution is also very imperative in cutting costs. If a
company has to hire a transporting company, warehouse space and labor that go
along with it, they incur unnecessary costs. This factor alone makes it very
28
difficult for new entrants to survive in the industry. The company needs to
minimize these cost by using efficient, low-price means of distribution.
Minimal Brand Image cost
Companies in the discount retail industry need to have very little expenses
in brand images. A company that spent money to keep its image up would be
using unnecessary cost. In order for a company to be a cost leader, it must
minimize its unnecessary expenses.
Tight cost control
The discount retail industry mainly deals with the same types of products
therefore making it important for a company to strive to be a price leader. Since
the industry deals in discounted products you can only lower the price so much,
thus the company has to focus of having lower operational cost in order to be
able to have the everyday low prices. Having long relationships with suppliers, is
a good way of cutting cost because it enables a company to have a steady
supply of merchandise at a discount. This not only makes it hard for new
entrants, but it also cuts costs.
Firm Competitive Advantage Analysis
In this section, we will discuss how Dollar General has performed using
the value chain analysis in the previous section. Each section of the value chain
presented above will be presented relative to our company. We will discuss how
the company has performed historically, currently, and how they are projected to
perform in the future.
The competitive advantage analysis is important because it shows how
well Dollar General is utilizing cost leadership in a very competitive industry. Each
Section below will discuss important information that will help value the company
relative to other companies in the industry.
29
Efficient production
Dollar General has done a decent job to utilize the cost leadership
strategies. It has focused on efficient low cost production and distribution. They
have their own warehouse and trucks to supply stores to minimize transportation
costs. Dollar General will only use suppliers that can maintain a low cost on
products and delivery. They have diversified their supplier chain to minimize
costs which is due to 14% coming from Proctor & Gamble, 16% from imports,
and the maintaining from different suppliers. They have located every store in
cities that are 20,000 or less populated to cater to their target market.
Currently, Dollar General is trying to improve the efficiency of its stores.
They are closing a few stores in less productive areas and spending money to
remodel, advertise and develop a more efficient means of distribution. They
hope to improve the quality of existing stores to maintain there slightly higher
position in the industry.
Simpler product design
As a leader in the industry, Dollar General provides basic commodities at a
low price. A sacrifice in the quality must be made to achieve these low prices.
As a result, products that are offered do not carry a brand image and has no
research and development costs. This is a key to be competitive in the industry
and Dollar General will continue to provide simple product designs throughout
the year to accommodate the demand for low cost merchandise
Lower Input Costs
Dollar general historically has minimized input cost spending very little on
capital improvement costs. They have tried to minimize the cost of owning
buildings by leasing out most of their buildings. They have had a system that has
focused on minimizing input-costs.
30
Currently, Dollar general has spent more money trying to remodel worn
down buildings and increase sales space. They have also invested a lot of money
into improving their distribution system to increase efficiency. They have also
incurred costs to shut down non-producing stores.
Dollar General hopes that these improvements will increase sales and
lower costs in the future. We believe that these expenses will have a negative
effect on the companys value currently, but could improve the companys value
in the future.
Low-cost Distribution
Dollar General owns six of there nine distribution centers across the U.S.
and have their own trucking service. This helps minimize the cost of contracting
to other trucking companies. The distribution centers, being located in central
hub areas, cut costs of transportation to Dollar General stores. 99 Cents Only
lease to trucking companies which adds to cost. We believe because they are
cutting distribution costs, they have the upper-hand against the competitors in
the industry.
Minimal Brand Image Cost
Dollar General owns several trademarks pertaining to their company and
subsidiaries. Brand image is not a high cost for Dollar General; they invest when
needed in their image to protect their identity in the industry.
Tight Cost Control
As a leader in the discount retail industry, Dollar General has to
continually focus on improving their tight cost controls. This will help sustain low
prices that drive the success of the stores. Recent improvements in the point of
sale system allow the store to accept gift cards which will bring in a new source
of revenue. An additional upgrade of software applications was added to
monitor inventory in each store. This allows management to efficiently manage
31
their in store stocks and improve turnover. These investments made will help
Dollar General operate their stores more efficiently and will in turn reduce their
operating costs.
Conclusion
In our analysis, we have concluded that Dollar General is doing a decent
job in utilizing cost leadership strategies. They are striving to be the cost leader
in their industry. They have taken on many projects to improve quality,
efficiency, and production that could help lower overall costs in the future. The
company has also spent only what it needs on brand imaging keeping costs low.
Dollar General owns most of there distribution centers and trucks minimizing
contracting fees.
We believe that Dollar General recent costs to improve their stores and
improve production may decrease the value of the firm in the short-run
compared to competitors; however, the improvements to the stores quality and
efficiency could improve the company overall in the future. Other then the recent
costs to improve current stores, Dollar general is utilizing effective cost
leadership strategies.
32
Accounting analysis
Within a companys financial reports lies crucial information to determine
the valuation of its performance. An accounting analysis is used to assess the
financial disclosures and conclude if its accounting practices support the
structure of the industry in which the company resides in. This examination is
important because the financial reports released have managerial estimates and
judgments that affect the outcome. The first step is to identify the key
accounting policies of the company. Next, the analyst has to assess the degree
of potential accounting flexibility, or how able the company is to manipulate
numbers and still follow the rules outlined by GAAP. An evaluation of the actual
accounting strategy is performed next to decide how conservatively or
aggressively the flexibility is used to manipulate financial reports. The next step
is to review the quality of information disclosed in the statements. From the
evaluation, there could be some red flags that signal discrepancies in the
reported information. The figures need further investigation to determine its
validity. The last step in the analysis involves undoing the accounting
distortions. The following is the assessment of Dollar Generals accounting
practices.
33
Key Accounting Policies
Dollar Generals main Key Success Factors focuses on cost leadership. Dollar
General uses slightly aggressive accounting policies and is only partially clear in
stating how they record transactions in their footnotes; however the only balance
sheets they give are consolidated so you cannot actually see the individual
events being recorded.
Dollar General record vendors rebates as a reduction of merchandise
purchases costs and are recognized in the statement of operations at the time
the goods are sold (Dollar General 10-K). This reduces their overall costs and
allocates the extra cash to the correct account.
Dollar General does not have any Goodwill recorded, which can be used to
inflate a companys value since it is an intangible asset. Dollar General records
store opening costs as expenses as they occur (Dollar General 10-K p56) rather
than capitalizing them. This is the appropriate and honest way to account for
these costs.
Another way Dollar General maintains their cost leadership is through the
reporting of building leases. In terms of the types of leases Dollar General has,
they have both operating and capital leases. Dollar General leases the majority
of its stores on a short term of 3-5 years. These leases include multiple
renewing options for the managers to decide on a basis of performance and
sales. In addition, there are store that are built-to-suit where the leases range
from 7-10 years. Among all the stores that Dollar General leases, half are
operating on a contingent rent based on sales. If a store is performing well, the
34
likelihood of it renewing its lease is high. This conditional rent expense is
recognized when sales goals are met or probable. For the remaining stores, rent
expense is recognized on a straight line basis over the term of the lease. Also, if
it is stated in the lease that rent will increase annually at a fixed rate, rent
expense is recognized on a straight line basis while the increased amount will be
recorded as deferred rent. Another accounting strategy that Dollar General uses
to its benefit is to record tenant allowances as deferred incentive rent. This in
turn can be amortized to reduce rent expense over the term of the lease.
Industry Inventory 2002-2006
$0
$200,000,000
$400,000,000
$600,000,000
$800,000,000
$1,000,000,000
$1,200,000,000
$1,400,000,000
$1,600,000,000
2002 2003 2004 2005 2006
Dollar GeneralFamily Dollar, Inc.Dollar Tree, Inc.Fred's, Inc.
35
Degrees of accounting flexibility
Managers at Dollar General may have latitude with their reporting
methods within their financial statements, but they must comply with industry
standards of GAAP. This set of regulations is the framework for which all
companies must use in the preparation of financial statements. Accounting
manipulation within the guidelines of GAAP may produce or conceal important
information that would work in favor the company. Dollar General uses this
flexibility in reporting their key accounting policies of leases and vendor rebates.
As previously stated, Dollar General accounts for its leases under both
capital and operating. The accounting flexibility in balancing between these two
methods allows them to determine how much is disclosed on their financial
statements from operations. The benefit of operating leases is that it allows
Dollar General to report its lease expenses as an operating expense leaving it off
the balance sheet. This in turns reduces the liability of the company. Conversely,
the amounts that are reported under capital leases are recognized immediately
on the balance sheet. The following table shows how the leases are currently
reported for Dollar General. They are discounted at an effective interest rate of
6.7%.
36
Future Minimum Payments of leases
*In thousands Capital Leases * Operating Leases * 2007 7,658 304,567 2008 5,440 254,087 2009 2,082 206,369 2010 599 169,454 2011 599 139,841 Thereafter 7,036 415,263 Total minimum payments 23,414 1,489,581 Discount rate 6.7%
(Dollar General 2006 10-K)
It is evident that the majority of Dollar Generals leasing costs are
operating rather than capital leases. The large amount of operating leases is
crucial to the stores success in the discount retail industry. A stores ability to
bring in revenues and earn profits is the key to remain in business. The
flexibility in the terms of the lease allows managers to assess the profits earned
for a store and to determine if they can afford to remain in business. The ability
of Dollar General to spend a large amount of money on operating leases allows
them to keep that same amount off the balance sheet as a liability. This reduces
the amount of debt reported on the balance sheet working in favor of the
company.
Another method of accounting flexibility shown by Dollar General is the
way vendor rebates are handled on the financial statements. Vendor rebates
received are accounted for as a reduction in the purchase cost of the
merchandise. This is recognized in the statement of operations at time the
37
commodities are sold. Cash considerations from the vendor may in turn offset
some general, selling and administrative (GS&A) expenses related to the sale of
the merchandise. Depending on the amount of rebates Dollar General realizes, it
reduces operating expenses showing greater income. This rebate is limited and
will only offset the costs associated with the GS&A expenses incurred of the
merchandise. Consequently, this is an incentive for Dollar General to claim as
many vendor rebates as they can. However, while the footnotes are very clear
on how they do this the actual numbers are not given on the balance sheet;
therefore, it is unclear just how much this affects their financials.
Accounting Strategy
Dollar General uses slightly aggressive methods when reporting their
financials. Dollar General disclosed quiet a bit of information in their footnotes,
but supporting data was hard to interpret. We feel that their slightly aggressive
accounting policies made it difficult to go through their financial statements.
Dollar General has both operating and capital leases. The majority of
capital leases have terms between 3 to 5 years with renewable options. There
are built-to-suit arrangements with landlords that have terms of 7 to 10 year and
multiple renewal options on some of the leases. Operating leases are treated as
rent expense rather than being liabilities therefore it does not give a true picture
of total liabilities on the balance sheet. Improvements of leased properties are
38
amortized over the shorter of the life of the applicable lease term or the
estimated useful life of the asset (Dollar General 10k) Dollar Tree and 99 Cents
Only also have similar accounting strategies, concluding that this could be an
industry trend.
The recording of depreciation, benefit, and goodwill are a few of the
minor things Dollar General has done to stay a head of the competition in a cost
leadership industry. Dollar General depreciates property, plant, and equipment
using the straight-line method. A benefit to using the straight-line method is at
the end of the life term of the asset the company pays the salvage value of the
asset opposed to the fair value, decreasing the expenses related to these assets
and further helping the bottom line. Employee benefit plans are expensed on a
year to year basis rather than being liabilities to the firm. Dollar General does
not have any goodwill on the books which we consider a very conservative
accounting strategy. This indicates that they do not inflate their numbers for
investors.
Since Dollar General is in a low concentrated industry, they strive to
provide merchandise at everyday low prices thus it is necessary to keep prices as
close to marginal cost as possible. Dollar General has achieved this by
categorizing their products into four distinct areas; highly consumable, home
products, seasonal, and basic clothing. This has made it easy for management to
track where most sales come from and improve where they need to, as shown
below in the graph.
39
Product Sales
0.00%10.00%20.00%30.00%40.00%50.00%60.00%70.00%
2006 2005 2004
HighlyconsumableHome products
Seasonal
Basic Clothing
Quality of Disclosure
Qualitative
The quality of disclosure is very important to investors and analysts. The
10K is usually the best source of information when looking at a companys well
being. However not many companys do a good job in disclosing a lot of
important information in their 10K.
Dollar General does a good job in disclosing a lot of important information
in their 10K. They not only focus on showing only the elements in which they
excel in but also areas that they are not doing too well in. For example The gross
40
profit rate declined in 2006 from 28.7% to 25.8%. They farther go on to explain
the reason for the decline which resulted due to significant increase in
markdowns activity as a percentage of sales, and store closing initiatives. The
only downfall is that they do not disclose how they will go about correcting the
problem; we thought that would be critical information for investors to know,
otherwise they may think that gross profit will continue to fall.
Dollar Generals 10K is loaded with good information. They go into detail
talking about the company performance measures, the results of operations. This
managers overview helps an investor know exactly how the firm is doing without
doing too much research.
The footnotes on the financial statements are informative and explain
what on the financial statements. For example it states how the capital leases
and operating leases are handled and what percentage they cover. In February
2006 the gross amount of property and equipment recorded was 85.1million and
150.2 million as of February 2007. This gives a true picture of the fixed assets
that Dollar General has.
Quantitative
41
The measure of the quantitative quality of disclosure involves two sets of
ratios, revenue diagnostics and expense diagnostics. We will use the data from
the ratios in our valuation of the firm. The data we collect from this section will
indicate how well Dollar General has reported their financial information and
potentially identify any red flags.
Sales Manipulation Diagnostics
We calculated five core sales manipulation or revenue diagnostics. We
found these by dividing a companys net sales by the following denominators:
cash from sales, net accounts receivable, unearned revenues, warranty liabilities,
and inventory. When analyzing a company, the ratios are calculated over time
and compared to those of the competitors in the same industry. The ratios
indicate how well the company is reporting their revenues.
42
Net Sales/Cash from Sales
0
0.2
0.4
0.6
0.8
1
1.2
Dollar General 1 1 1 1 1
Dollar Tree 1 1 1 1 1
Family Dollar 1 1 1 1 1
Fred's Inc. 1 1 1 1 1
2002 2003 2004 2005 2006
Net sales/Cash from sales
The discount retail industry is cash to sales basis industry. A cash to sale
industry is one in which every sale is accompanied by payment, therefore
deferred payments do not exist. Thus, the ratio of net sales/ cash from sales is 1
all across the board.
Net sales/Net accounts receivable
Since the discount retail industry is cash to sale industry they do not have
any account receivables, thus the ratio does not affect the industry.
43
Net sales/Unearned revenues
Unearned revenue is when a company offers a service or product and
does not receive immediate payment until later. The discount retail industry does
not have credit sales because everything is on a cash to sale basis, therefore this
ratio does not apply to the industry.
Net sales/Warranty liabilities
Warranty is when a company guarantees their products of by offering to
replace or repair the product if something goes wrong within a specified amount
of time. So a company that has warranty liabilities would have high sales but low
revenues. The discount retail industry does not offer warranties on their products
so again this ratio does not apply to the industry.
Net Sales/Inventory
0
2
4
6
8
Dollar General 5.43 5.94 5.57 5.82 6.4
Dollar Tree 5.37 5.33 5.08 5.89 6.56
Family Dollar 5.43 5.56 5.39 4.42 6.16
Fred's Inc. 5.7 5.43 5.24 5.23 5.79
2002 2003 2004 2005 2006
44
Net Sales/Inventory
The net sales/ inventory ratio is important because it tells us the amount
of inventory we have in relation to our sales. It asks the question; do reported
sales and inventory match each other in a believable way? If this number starts
increasing rapidly and/or unexplained it raises a red flag because it would imply
that while sales are growing, inventory is decreasing. If it is increasing like this,
the company must be recording things wrong, or perhaps channel stuffing. We
have found the industry as a whole to be pretty consistent the past five years
and have not found any potential red flags for Dollar General.
Core Expense Manipulation Diagnostics
There are six core expense manipulation diagnostics. These ratios are
found in a variety of ways, but they all relate to a companys expenses and are
also used to identify potential red flags.
45
Asset Turnover (sales/assets)
0
1
2
3
4
Dollar General 2.61 2.62 2.7 2.88 3.02
Dollar Tree 1.81 1.86 1.74 1.89 2.12
Family Dollar 2.37 2.39 2.37 2.42 2.53
Fred's Inc. 3.19 3.14 3.1 3.19 3.43
2002 2003 2004 2005 2006
Asset Turnover Net Sales/Total Assets
The asset turnover tells us how much sales our assets can generate. If
this number begins declining, it implies that sales are decreasing while assets are
increasing, we must wonder if the company has the appropriate amount of
assets to generate the desired sales. Through off-balance sheet accounting,
reporting operating leases, as opposed to capital leases, a company can show
fewer assets on the balance sheet and in turn have a higher asset turnover ratio.
Overall the industry is quite consistent and Dollar General has remained
consistent with the industry standards and show no potential red flags.
46
CFFO/OI
-1.00
0.00
1.00
2.00
3.00
Dollar General 0.93 1.01 0.70 0.98 1.63
Dollar Tree 2.77 0.83 0.94 1.28 1.33
Family Dollar 0.23 -0.33 -0.11 0.44 0.52
Fred's Inc. 1.02 0.72 0.54 1.21 0.86
2002 2003 2004 2005 2006
Changes in CFFO/OI
This ratio is found by dividing the cash flow from operations by the
operating income and tells us whether or not the income is being supported by
the cash flows. If this number is dropping without explanation it raises a red flag
because cash flows cannot be increasing while income decreases. In this
situation, expenses may not be recorded or revenues may be overstated. With
the exception of Dollar Tree in 2002, the industry has remained quite consistent.
Seeing that Dollar General has remained consistent with the trends and has not
fluctuated too much over the past five years there are no potential red flags to
investigate.
47
CFFO/NOA
-1
-0.5
0
0.5
1
Dollar General 0.42 0.54 0.36 0.47 0.33
Dollar Tree -0.5 0.38 0.4 0.54 0.58
Family Dollar 0.59 0.36 0.41 0.29 0.42
Fred's Inc. 0.34 0.49 0.28 0.15 0.35
2002 2003 2004 2005 2006
Changes in CFFO/NOA
This ratio is found by dividing the changes in a companys cash flow from
operations from the previous year by its net operating assets. If this ratio is
dropping without explanation it raises a red flag because in order for this to
happen the assets are most likely being overstated to increase a companys
value. Overall the industry has remained steady with the exception of Freds
Inc., who had a negative cash flow in 2002, but has since recovered. The only
concern we have is that Dollar Generals ratio slightly dropped in 2004 and 2006.
However, this drop can be explained by an increase in net operating assets due
to recent renovations and added equipment, such as freezers. Overall, there are
no potential red flags in this area.
48
Accruals/ Changes in Sales-
This ratio is found by taking the total accruals for the year and dividing
them by the difference in the sales of the current year and the previous year.
Total accruals are found by subtracting the net cash flow from operations from
the net income. This measure is a way to measure the returns the company is
getting form operating assets.
Pension Expense/ SG&A
Dollar General has a defined contribution plan in place. The defined
contribution plan leaves the liability on the hands of the employee and the
obligation of the employer is merely a small percent of the plan. They do not
need to recognize any Pension Expense through out the year only when it is
incurred. No ratios needed to be calculated.
Other Employment Expenses/ SG&A
Other employment expense includes medical insurance and other certain
benefit programs. Due to the nature of the discount retail Industry Companys
offer little to no benefit packages. Most employees are privately insured. No
Ratios need to be calculated.
49
Identifying Potential Red Flags
The quantitative characteristics of a firms accounting disclosure can be
analyzed to signal distortions in the accounting. In this section, we will analyze
the discount retail industry and compare Dollar General with the rest of the
industry. The main purpose of this section is to find potential deviations from the
norm that could potentially distort the companies accounting records. We will be
assessing several ratios and evaluating the amount of disclosure Dollar General
has presented.
Identifying potential distortions in the accounting is important because a
clearer view of the company can be presented once the distortions are fixed. The
following ratios will help compare and signal any deviations Dollar General may
have compared with the rest of the company.
* The fact that Freds Inc. fiscal year ends in August while every other
company year ends in March or May was taken into consideration in the
comparability in our analysis.
50
Undoing Accounting Distortions
Accounting distortions occur when a company unknowingly or knowingly
reports numbers that are misleading. This allows the managers to influence the
outcome of the financial statements to show better performance. The simplistic
nature of the discount retail industry enables Dollar General to report their
financials rather straight forward without accounting alterations to show better
value. This industry is driven by high volume sales of low cost items. Revenues
and profitability determine if store operating leases will be renewed to cut loses.
After analyzing Dollar Generals financial statements and determining the level of
sales and expense manipulation, we did find a potential red flag from the
CFFO/NOA ratio.
Dollar Generals expense diagnostics raise a red flag with their accounting
reporting. The cash flow from operations to net operating asset ratio shows us
the proportion of the operation cash flows from the property, plant, and
equipment owned. In comparison to its competitors, the ratio is on average
except for 2005 when the ratio dropped for Dollar General. The increase in the
net operating assets is a result from the growth of the company in the past
years. Dollar General has been acquiring new assets to expand their
departments to meet the demand of the discount retail industry. This
information was disclosed on the Dollar General 10-K allowing us to match the
increase in assets.
51
Dollar General has used accounting flexibility to record a large portion of
their leases as operating leases. In the next table we have converted the current
operating lease payments into capital leases to show the differences of
approximately $1.2 billion in avoided liabilities.
Operating Lease Conversion
Capital Leases Operating leases PV Factor PV
2007 $7,658.00 1 $304,567.00 0.937 $285,442.36
2008 $5,440.00 2 $254,087.00 0.878 $223,179.14
2009 $2,082.00 3 $206,369.00 0.823 $169,883.50
2010 $599.00 4 $169,454.00 0.772 $130,735.69
2011 $599.00 5 $139,841.00 0.723 $101,114.26
2012 $1,407.20 6 $83,052.60 0.678 $56,281.64
2013 $1,407.20 7 $83,052.60 0.635 $52,747.55
2014 $1,407.20 8 $83,052.60 0.595 $49,435.38
2015 $1,407.20 9 $83,052.60 0.558 $46,331.19
2016 $1,407.20 10 $83,052.60 0.523 $43,421.92
Reported
Capital
Leases $23,414.00*
Total
Operating
Leases $1,489,581.00*
Total Capital
Lease $1,158,572.63*
*In Thousands
Along with the avoided liabilities, the reporting of operating leases leads
to understated expenses. This next table shows the interest expense and
depreciation expense being avoided over the next ten years, using the 6.7% rate
found in Dollar Generals 10-K.
52
Discount
Rate 0.067 Term 10
Payment Interest Principle
Straight Line
Depreciation
1,158,573
2007 1,073,522 162,675 77,624 85,050 $115,857
2008 982,774 162,675 71,926 90,749 $115,857
2009 885,945 162,675 65,846 96,829 $115,857
2010 782,629 162,675 59,358 103,316 $115,857
2011 672,390 162,675 52,436 110,238 $115,857
2012 554,766 162,675 45,050 117,624 $115,857
2013 429,260 162,675 37,169 125,505 $115,857
2014 295,346 162,675 28,760 133,914 $115,857
2015 152,460 162,675 19,788 142,886 $115,857
2016 0 162,675 10,215 152,460 $115,857
*All Numbers in thousands.
**The affects of the capitalization of these leases on the balance sheet can be seen in the
appendix.
53
Financial Analysis
At this part of the valuation, it is important to tie together all the previous
analysis. This gives a true sense of how the company is operating in the
industry and where it is heading in the future. First we identified the business
strategy and the five success factors. This tells us how the company plans to
thrive in the discount retail industry. From the accounting analysis, we will be
able to determine from past financial statements how the company will fund
future growth. To properly forecast the future of Dollar General and assess their
development, it is essential to calculate the liquidity, profitability, and capital
structure ratios. Liquidity ratios refer to the amount of cash or equivalence on
hand for operations. Profitability ratios determine the amount of profits based
on operations. Capital structure ratios determine the cost of debt it takes to
operate the business. These ratios will help determine how well the company is
performing from a business strategy perspective to its competitors.
Trend & Cross Sectional Analysis
The analyses of a firms financial statements tell about its liquidity,
profitability, and capital structure. Know these things when analyzing a firm is
important in order to evaluate the firm and its performance. The liquidity ratios
tell us how much of the firms assets is cash or cash-equivalents and in turn tell
how timely they will be able to meet their current obligations. The profitability
ratios tell how profitable a firm is based on its efficiency and rate of return.
Finally, the capital structure ratios tell how the firm is financed and how much of
their income is being used to pay interest versus how much is being used to pay
the principal.
54
Financial Ratio Analysis
Several ratios can be performed to evaluate the financial position of a
firm. Each ratio illustrates a different aspect of the companys well being for
example how quick assets can be converted in to cash to cover liabilities. The
ratios can also tell how efficient the company is in the industry. Each ratio will be
computed to reflect a 5 year trend of each company. Three main areas that will
be focused on in the following section are liquidity ratios, profitability ratios, and
capital structure ratios.
These ratios will be used to asses Dollar Generals position in the discount
retail industry. Each ratio will dissect the financial statements of Dollar General
and their competitors. From these ratios, the value of the past performance can
be determined as well as trends that can help in forecasting the future trends of
the company.
Liquidity Ratios
Liquidity ratios apply to the amount of cash equivalent assets on hand for
a firm and the ability to convert these into funds for future liabilities. The
liquidity ratio will be broken down into two different types of ratios. The first two
line items are current and acid test coverage ratios which display a companys
ability to cover debt with current assets. The next three ratios are operating
efficiency ratios which consist of inventory turnover, receivable turnover, and
working capital turnover. The operating efficiency ratios are based on the cause
and effect using financial data from both the income statement and the balance
sheet.
The first sets of ratios we have analyzed are the liquidity ratios and of
these the first to discuss is the current ratio. The current ratio is found by
dividing a firms current assets by its current liabilities. Current assets are almost
all assets besides land, buildings, equipment, and intangibles; and current
liabilities are any liabilities that will be due in the next year. This number tells us
55
how many dollars of assets we have for every one dollar of liability. The higher
the number this ratio is, the more liquid a firm is, or the greater ability it has to
pay off its upcoming obligations. However if this number is too high above the
industry standard the firm is most likely not using all their assets efficiently. The
lower this number is the more debt the firm has in comparison to its assets, and
therefore less able to pay them off. Dollar Generals current ratio over the past
five years has remained just below the industry average. Although, when looking
at the chart you can see that Dollar Tree has had a much higher ratio than the
other firms, and in turn has brought the industry average up. Dollar Generals
ratio being lower than the industrys is nothing to be alarmed about, especially
since they have constantly had more than one dollar of assets to every one dollar
of liabilities.
Current Ratio over the past five years
Below is the cross sectional analysis showing the trends of Dollar General
over the past five years in comparison with the trends of its direct competitors
and the industry as a whole. Dollar General started out with the lowest current
ratio, but more recently has been just below the industry standard. While Family
Dollar started out with a higher ratio than Dollar General, their ratio has been
declining and they currently have the lowest ratio in the industry. Freds and
Dollar Tree have ratios that remained higher than the industry in the past five
years. This could mean they are inefficiently using their assets. Overall Dollar
General has the best ratio because it is closest to the industry standard without
2002 2003 2004 2005 2006
Dollar General 1.37 1.99 2.22 2.1 1.89
Family Dollar 1.99 1.94 1.72 1.51 1.44
Dollar Tree 2.88 2.73 3.29 3.19 2.5
Freds 3.27 2.55 2.55 2.76 2.58
56
being too high. The trend with each competitor in the industry appears to be
heading towards convergence within the next couple of years.
Current Ratio
0
0.5
1
1.5
2
2.5
3
3.5
2002 2003 2004 2005 2006
Dollar GeneralFamily DollarDollar TreeFredsIndustry. Average
The second liquidity ratio is the quick asset ratio or acid test. This shows
how much cash or cash-equivalents there are for every dollar of liability and is
found by dividing the quick assets by the current liabilities. Quick assets are cash
and any assets that can be easily converted to cash if need be. Dollar Generals
quick asset ratio has been pretty low for the past five years with the exception of
2004 where it peaked. This is similar to the current ratio in that too high a
number can equate to inefficient use of assets. Recently Dollar General has
remained below the industry average, but has still followed the industrys trends.
Acid Test for the past five years
2002 2003 2004 2005 2006
Dollar General 0.23 0.18 0.54 0.33 0.22
Family Dollar 0.41 0.35 0.21 0.16 0.22
Dollar Tree 1.13 0.64 1.08 1.15 0.8
Freds 0.26 0.09 0.04 0.046 .023
57
Below is the cross sectional analysis of Dollar Generals quick ratio as well
as its direct competitors and the industrys as a whole. With the exception of
Freds, the industry has remained within the range of a dollar over the past five
years ($0.16-$1.15). Freds most likely has far too many assets in comparison to
the industry, which shows signs of inefficiency. Dollar Tree, Dollar General, and
Freds have all followed the industry trend the past five years, while Family Dollar
has done just the opposite. Since Freds has such a higher ratio it has brought
the industry ratio up; therefore there is no need to be alarmed over Dollar
General being slightly lower than the industry.
Quick Asset Ratio
0
0.2
0.4
0.6
0.8
1
1.2
1.4
2002 2003 2004 2005 2006
Dollar GeneralFamily DollarDollar TreeFredsIndustry Average
Although the next two ratios -inventory turnover and working capital
turnover- are classified as liquidity ratios, they tell more about a firms operating
efficiency than its actual liquidity. The first of these to analyze is the Inventory
Turnover. This ratio measures how frequently the inventory in a companys
warehouse is used and replenished. The higher the number is the better because
it indicates higher sales. This number is found by dividing the cost of goods sold
58
by the inventory and it tells us how many times per year the inventory is
replenished. Dollar General, being the industry leader, has consistently had one
of the highest inventory turnovers in the industry.
Inventory Turnover for the past 5 years
2002 2003 2004 2005 2006
Dollar General 3.37 3.9 4.19 3.92 4.15
Family Dollar 0.64 0.6 0.59 0.06 0.08
Dollar Tree 0.26 3.4 3.27 3.85 4.32
Freds 4.04 4.13 3.9 3.76 3.76
Industry Avg. 2.077 3.01 2.98 2.89 3.078
The cross sectional analysis below shows the industry and its trends over
the past five years. Family Dollar is well below the industry standard, showing
that they are not selling efficiently enough to keep up with the industry. Dollar
Tree experienced a tremendous amount of growth from 2002-2003 and has
since been able to remain above the industry average; however if Family Dollar
wasnt so low, bringing the average down, Dollar Tree would probably be just
below the industry average up until the past year or so. Freds has one of the
higher turnovers of the industry showing very efficient sales, with a slight decline
just recently. Dollar Generals ratio was rising until 2004 with a decline in 2005
and now is almost back on track.
Dollar General has followed the industry trend more than any of other
firms and has remained above the industry every year. Operating efficiency has
been consistent with inventory turnover averaging four times a year. This shows
that their inventory is fairly liquid with three month intervals out of the year.
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Inventory Turnover
00.5
11.5
22.5
33.5
44.5
5
2002 2003 2004 2005 2006
Dollar GeneralFamily DollarDollar TreeFredsIndustry average
The other liquidity ratio that measures operating efficiency is the Working
Capital Turnover. This number is found by dividing a companys sales by its
working capital, working capital being the companys current assets less its
current liabilities. Working capital measures how many sales dollars every one
dollar of working capital can generate. The higher this number is the better,
because it indicates higher sales. Dollar General has set the industry standard
for working capital turnover and has had the highest turnover every year for the
past five years with the exception of 2004. Since 2004, Dollar General has had a
steadily rising turnover.
Working Capital Turnover
Below is the cross sectional analysis of Dollar Generals working capital
turnover as well as its direct competitors and the industry as a whole. As you can
2002 2003 2004 2005 2006
Dollar General 12.6 9.25 7.56 8.46 10.35
Family Dollar 0.24 0.25 0.3 0.27 0.08
Dollar Tree 0.32 6.12 4.63 5.24 6.89
Freds 6.58 7.97 7.87 7.08 7.43
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see Dollar General leads the industry and has had the highest turnover every
year for the past five years, with the exception of 2004, where they were just
barley behind Freds. Since 2003 Dollar General has been setting the trends for
the industry. Family Dollar has a very low turnover relative to the other
companies, while Freds and Dollar Tree are just a little behind Dollar General.
Working Capital Turnover
0
2
4
6
8
10
12
14
2002 2003 2004 2005 2006
Dollar GeneralFamily DollarDollar TreeFredsIndustry average
The nature of the discount retail industry does not entail the need for
accounts receivables. The industry is dependent on the volume of purchases
because basic commodities are sold at low prices. As a result, the average
customer purchase was $9.36 in 2006. (Dollar General 10-K) Therefore the
accounts receivable turnover ratio will not be calculated for Dollar General. If
the receivables turnover ratio were to be calculated, it would be performed by
taking total sales and dividing it by accounts receivable. This would be a
valuable tool for determining the corporations cash to cash cycle. This is the
measure of how long it would take to free up cash from accounts receivables and
inventory. The faster the cycle is the more amounts of cash is available for
operations and reducing debt. The only part of this cycle that Dollar General can
monitor is the day supply of inventory. In essence, the cash to cash cycle for the
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industry is just the day supply of inventory. This is first half of the cash to cash
cycle. This is calculated by taking the number of days in the year and dividing it
by the inventory turnover ratio. The smaller the ratio is the better it is for the
firm. It states how many days inventory stays in storage instead of being sold
on the floor. Below is a chart showing the day supply of inventory for Dollar
General and the industry. They have been leading the industry with Freds and
have remained below the industry average. This is favorable because it shows
that inventory is generating revenue instead of sitting in storage.
Day Supply of Inventory
0
1000
2000
3000
4000
5000
6000
7000
2002 2003 2004 2005 2006
Dollar General
Family Dollar
Dollar Tree
Freds
Industry Average
Liquidity overview
Over the past five years Dollar General has followed the industry liquidity
trends quite consistently and has set the trends in inventory and working capital
turnover. Dollar General is quite liquid in comparison to the industry which
means they are able to quickly convert their cash to assets if necessary to meet
current and upcoming obligations. Dollar General has shown great ability to
generate sales over the past five years and is the leader in its industry.
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Profitability Ratios
The basis of profitability ratios is to determine the rate at which a
company can turn a profit off of operations. Four main factors determining
profits are operating efficiency, asset productivity, rate of return on assets, and
rate of return on equity. The overall goal of any company is to make sales at the
lowest cost feasible to achieve profits. This operating efficiency is measured by
the gross profit, operating profit, and net profit margin. Asset productivity is the
efficiency rates a company can turnover investments of assets into revenue.
This is calculated by the ratio of return on assets. Lastly, the rate of return on
equity measures the effectiveness a company can produce earnings growth from
investments.
Gross Profit Margin
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
0.4
2002 2003 2004 2005 2006
Dollar GeneralFamily DollarDollar TreeFredsIndustry average
The gross profit margin ratio measures the gross profits of the company
to the amount of sales. We can determine how well a company has minimized
cost of good sold. According to the graph, Dollar General has maintained about a
25 to 30% ranges on it gross profit margin for the past five years. Freds Inc has
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remained about the same as Dollar General, but Dollar Tree has minimized more
cost of good sold and created more profit. Dollar Tree has done average on its
profit margin, but as Dollar Trees ratios prove, Dollar General can improve on its
efficiency whether it is improving inventory costs or finding cheaper suppliers.
Operating Profit Margin
-0.06
-0.04
-0.02
0
0.02
0.04
0.06
0.08
0.1
0.12
2002 2003 2004 2005 2006
Dollar GeneralFamily Dollar Dollar TreeFredsIndustry average
Operating profit ratio measures the same thing the gross profit ratio
measures, but it includes selling and administrating expenses. Once again, Dollar
General has maintained an average percentage of the past five years of around 7
%. Compared to Freds Inc, Dollar General has done well to keep costs at a
minimum. As before, Dollar Tree has maintained greater efficiency of the past
five years on average, but we should expect this because their gross profit
margin was higher. Once again we did not include Family Dollar in our valuation
of Dollar General though we did consider that Family Dollar did have a higher
operating profit ratio in 2006. We have concluded from the above data that
Dollar General is only doing average to the rest of the market. The trend of the
overall industry seems to be converging on Dollar Generals position, but we
believe that Dollar General can improve its position in the industry by getting rid
of excess cost.
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Net Profit Margin
-0.08
-0.06
-0.04
-0.02
0
0.02
0.04
0.06
0.08
2002 2003 2004 2005 2006
Dollar General
Dollar Tree
Family Dollar
Freds
Industryaverage
The net profit margin considers the overall effect of expenses compared
to sales and other income. We see that Dollar General has flat lined over the
past five years. They have no trends of growing or shrinking and have
maintained about a 4% net profit. The slightly higher margin for Dollar General is
because of an interest income. Dollar Generals competitors Family Dollar and
Dollar Tree have done a slightly better job over the past five years except for
2006 where Family Dollar has incurred more costs. Freds Inc. has done the
worst in the industry with a ratio of only 2% in the past two years. Dollar
General has a good job of maintaining a near average ratio margin, but
competitors are doing better which means Dollar General is not as efficient as
they could be.
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Asset Turnover
0
0.5
1
1.5
2
2.5
3
3.5
2002 2003 2004 2005 2006
Dollar General
Dollar Tree
Family Dollar
Freds
Industryaverage
The asset turnover ratios were used earlier as an expense diagnostic. We
have now used average assets instead of total assets. The asset turnover ratios
show that for every dollar of assets the company has a certain number of sales
will be made. In the past five years, Dollar General has improved their revenue
profitability. In 2002, they were getting two dollars worth of sales for every
asset. They have steadily increased this number over the past five years and in
2006 they are up to about 3.2-3.3 dollars per asset. Compared to the
competitors only Freds Inc has done a better job of asset turnover then Dollar
General. Freds inc. high asset turnover can be explained by size. They have far
less inventory and are a much smaller company then the other three companies.
Family Dollar has maintained a 2.5 asset turnover which is only slightly up from
past years. Dollar Tree has been lagging behind at 2.2 asset turnovers which
have been slightly better then past years. We can conclude from this information
that Dollar General is doing a good job of using assets to support sales volume.
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Return on Assets
-0.02
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0.16
2002 2003 2004 2005 2006
Dollar General
Dollar Tree
Family Dollar
Freds
Industryaverage
The return on asset is the overall measure of profitability. It uses the net
income and the average total assets which include parts of other ratios mainly
net profit margin and asset turnover ratio. By dividing net income by assets we
can determine the return on the assets. We hope to see a greater percentage
from year to year. As the graph displays, Dollar General over the past five years
has increased its ROA except for the last year. It is now at a 12 % ROA down
from 13% the year before, but the company has improved its ROA from 2002
where it was at a 9% ROA. Dollar General has done relatively well against its
competitors. Dollar Tree has maintained a 10 % ROA in the past three years
while Family Dollar and Freds Inc are down to 5% ROA. We can conclude from
this information that Dollar General is doing overall better on its profitability from
asset productivity and operating efficiency compared to the other companies in
the industry. However, the recent decline, which is slightly unfavorable, in ROA
may be signaling a downward trend which could bring it further down to the
industry average.
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Return on Equity
-0.05
0
0.05
0.1
0.15
0.2
0.25
2002 2003 2004 2005 2006
Dollar General
Dollar Tree
Family Dollar
Freds
Industryaverage
The Return on equity is the net income of the company divided by the
past years owners equity. The ROE measures the amount of the owners interest
in total assets (class notes). We expect to this ratio much larger then the ROA
because equity is only a p
