Financial Issues of John Lewis Partnership - Case Study Example

Financial Analysis of John Lewis Partnership Introduction The focus company selected for the purpose of financial analysis is John Lewis Partnership. The basic reason for selection of John Lewis Partnership is that it is ‘one of the UK’s top ten retail businesses with 29 John Lewis department stores and 220 Waitrose supermarkets. It is also the country’s largest employee cooperative, with 69000 employees.’(Annual Report 2009, page 1)i It has also an online catalogue business. The founder John Spedan Lewis carefully has created a governance system that is a combination of commercial acumen and corporate conscious. In this write up a financial assessment has been carried out of the performance of John Lewis over the years. This assessment or evaluation has been carried out under the categories of profitability, liquidity, efficiency in the field of inventory and assets turnover, credit period efficiencies, gearing of capital structure and an assessment from the point of view of investors. Overall an effort has been made to assess the financial performance of John Lewis in an effective manner. Background The first John Lewis departmental store was opened in 1864 at Oxford Street by the father of John Spedan Lewis. During 1914 following a conflict with his father, Spedan withdrew from Oxford Street shop. But after reconciliation in 1920 his father offered him a control of two stores and Spedan introduced a profit sharing scheme with his staff council. Such radical ideas are the basis of success of John Lewis Partnership that was formed after 21 years wherein Spedan signed an irrevocable trust settlement and the John Lewis Partnership became the property of the employees of the company. The employees, who are the partners of John Lewis Partnership ‘worked hard to offer customers everything they need under a roof; the best fashions, furnishings, and household goods of all kinds at competitive prices. In October 2009 the first new format John Lewis at home was launched in Poole, Doore. A third of shop focuses exclusively on the home, electrical and home technology assortment.’ii The strategy of John Lewis Partnership is threefold: First partners should gain satisfaction of secured and fulfilling employment by being members of the organization; second the partnership should create confidence and locality values t recruit loyal customers; and attain sufficient profitability to allow development and distribution of profits among partners (employees). Table of absolutes and Ratio Analysis Absolute Figures Ratio Analysis The ratios computed above are used to analyze the financial performance of John Lewis Partnership on fronts of profitability, liquidity, efficiency, and also on account of effects of capital gearing represented by its capital structure as under: Profitability Financial performance can best be judged through achievement on the profitability front. The ratios that are commonly used to assess this performance are Net Profit Margin Ratio, Return on investments, and Return on equities. ‘The net profit margin measures the percentage of each sales dollar remaining after all costs and expenses, including interest, taxes, and preferred stock dividend, have been deducted. The higher the margin, the better it is.’(Lawrence J. Gitman, page 67)iii Net profit is generally cited as measure of the success of an entity. Net profit margin of John Lewis has improved in 2009 as compared to 2008. During 2009 the net profit margin was 3.73% as compared to 2.15% in 2008. The basic reason for such improvement is the increasing revenue and operating income over the period. Earning before interest and taxation (EBIT) has improved from £198.7m in 2008 to £281.6m in 2009. This is certainly a commendable performance during this troubled period when economies are suffering from credit crunch. Return on investments is also called return on assets. Return on assets ratio ‘measures the effectiveness of management in employing the resources available to it.’ (Scott Hamilton, page 40)iv This ratio reflects the efficiency of the management in achieving the objectives of the entity. Though exploitation of assets is the main function of management in order to earn profits, the effectiveness of such exploitation is reflected from return on assets. The management of John Lewis has exploited its assets in a very effective manner. That is why return on assets has improved in 2009 when compared with 2008. The return on assets was 3.42% in 2008 and that increased to 5.78% in 2009. This increasing ratio is an indicator of effective and improved exploitation of assets by the management of John Lewis. These performances in economically troubled periods bring an encouragement to all involved. The third profitability ratio used to analyze the financial profitability is return on equity. ‘Return on equity (ROE) tells how efficiently a company used its investment of stockholders’ equity to produce profits. As with other profitability measures, higher is better and increasing is better.’ (Ellie William and Ellie William Clinton, page 229)v In 2008 John Lewis earned a return on equity to the tune of 7.73% and that increased to 13.55% in 2009. This is certainly a remarkable performance. Above ratios indicate that John Lewis is showing not only stability but also a rising trend in earning the profitability. This increasing trend of profitability is good indicator of the progress of the company. Liquidity Liquidity indicates the short term solvency of the company. ‘Liquidity refers to the solvency of the firm’s overall financial position- the ease with which it can pay its bill.’(Lawrence J. Gitman, page 58)vi. The ratios used to analyze liquidity of John Lewis are current ratio and quick ratio. Current Ratio reflects the liquidity position of the company. It refers to a state to describe whether the entity is in a position to meet its short term obligations when those become due. Current ratio of 2:1 is considered optimum for any type of firm. From that point of view John Lewis is facing liquidity crunch as its ratio is just 0.82:1 in 2009 and 0.74:1 in 2008. John Lewis may be finding it difficult to meet its current obligations when those become due. This current ratio reflects very delicate liquid position of the company. John Lewis has to manage its working capital more effectively in order to improve its liquidity. Quick Ratio is similar to current ratio except that in its calculations only those assets are considered that are quickly convertible into cash. That is why inventories are not considered for its calculations. Quick ratio eliminates the effects of slow moving current assets in assessing the liquidity performance of an entity. Quick ratio of 1:1 is considered best for all type of firms. The position of John Lewis is not at all comfortable as its quick ratio is just 0.41:1 in 2009 and 0.37: 1 only in 2007. It indicates that John Lewis is not meeting its current obligation when those become due. It is true that the John Lewis has increasing profitability trend, but this profitability could further be increased if the John Lewis was having a comfortable liquid position. Certain amount of profitability is being used to meet the cost of funds required to ease the liquidity of the company. In other words tight liquidity is costing some profitability that could have been saved by the company by efficient management of the working capital. Efficiency Efficiency in operations is aptly reflected from inventory and asset turnovers. As a matter of fact inventories often utilize a sizeable proportion of current assets. Inadequate inventory affects the turnover and that in turn affect the overall operation of the entity. ‘The inventory turnover ratio measures the average rate of speed inventory move through and out of the company.’(Leopold A. Bernstein and John J Wild, page 135)vii One can say inventory turnover measures the activity or liquidity of the inventory. The inventory turnover in case of John Lewis was 31 days in both 2008 and 2009. Static number of days of inventory turnover over a period indicates the stable efficiency in dealing the inventory by John Lewis. A slow inventory turnover put a pressure on company liquidity and also makes inventory as obsolete and undesirable. In case of John Lewis the inventory turnover is static indicating the stability in the rotation of sales. Assets of an entity are the base to attain its desired objectivity by exploiting assets in efficient and effective manner. That is why Asset Turnover of an entity provides a good indication of efficiency in utilizing the assets at the disposal of entity. ‘An asset turnover ratio measures the extent to which total assets are used to generate sales and provides a gauge on the effectiveness in utilizing a company’s assets. Generally, the higher the asset turnover ratio is, the smaller is the investment required to generate the same amount of sales and thus the more profitable is the firm. A low asset turnover indicates that a firm either has excess assets on hand or is not using assets efficiently.’(A Rashed Abdel- Khalik, page 282)viii John Lewis’s asset turnover is encouraging to provide an impetus to increase the sales. During 2008 its asset turnover was 1.59 times and in 2009 1.55 times, and in 2009. The assets turnover ratio is almost stable during the two years. Most entities would be satisfied in maintaining at least the same ratio as in previous year, and John Lewis is doing exactly that. Assets turnover ratio shows the relationship between assets and the sales. During 2008 John Lewis achieved a sale of £6052.2m with total assets of £3812m. Whereas in 2009 total assets increased to £4040.4m and that is an increase of 5.99% of assets over previous period; whereas the sales increased to £6267.2 which is an increase of 3.55%. Though the increase in turnover is comparatively less than increase in assets but increase in assets has laid capital base to increase the turnover in the coming periods. That speaks volume of dedication of management to increase operational efficiency even when circumstances are not in favor of attaining such efficiency. Average collection period is also a test of operational efficiency. Though most sales of John Lewis are counter sales, yet some sales are required to be collected later than the date of sales. The importance of average collection period can be gauged from the fact that ‘it is useful for working capital budgeting and cash flow forecasting purposes to have some idea of approximate receivable balance at the end of a reporting period. This ratio yields information that is used to determine how much cash will be invested in accounts receivable at that time, which is crucial for such activities as fund raising, investment activities and payment planning.’ (Steven M Bragg, page 80)ix Average collection period of John Lewis was 13 days during 2008 and that reduced by 5 days during 2009 indicates efficiency in collecting the receivable. Average payment period is the average payment time allowed by accounts payable to settle their accounts. This period is also important in evaluating the financial performance of an entity. Longer payment periods to trade creditors add strength to working capital management, and that is why average payment period is a very important aspect of working capital management. In order to attain qualitative efficiency into the operations of the business, payment period plays a crucial role, especially in retail business of John Lewis. John Lewis enjoyed an average payment period of 75 days during 2008 and this period came down to 61 days during 2009. John Lewis did not dealt efficiently with its accounts payable and the average payment period dropped to 61 days during 2009. This would have exerted some pressure on the working capital of John Lewis, which was already suffering from liquidity problems. The decrease in average payment period has leveled the efficiency attained by John Lewis in lowering the average payment period. Capital Gearing Capital gearing reflects the type of finance arranged by an entity to finance its assets. When debt capital is used in excess of equity capital, the entity is said to be highly geared or leveraged. On the other hand when debt capital employed to finance assets is less than equity capital, the capital structure is called low geared structure. This structure of capital is important from point of view of the general performance of company. This is because debt capital entails fixed charge to the income of the company and accordingly it decreases the profits to be reemployed into the business of the company. The capital gearing of a company can be assessed from its debt ratio. Higher debt ratio indicates high gearing capital structure and vice versa. In case of John Lewis the debt ratio calculated in the annexure shows 55.83% in 2008 and 57.36% in 2009. As debt ratio in both years is more than 50%, it suggests a high geared capital structure of the company. Though such a high capital structure makes a cut into profits to be reemployed into the company, it also leaves lesser amount of profitability for equity holders as they are residual owners of the assets of the company. Accordingly during period of high profits, the equity holders of John Lewis will be benefited as residual owners and during periods of low profits the equity holders will get less amount of profitability after meeting fixed liability of debt capital. The major disturbing issue with high geared capital structure is the fixed charge of debts to the profits of the entity. That is why normal or average capital structure proves most beneficial for any type of business. Impact of current events since last balance sheet As per interim report for period ending August 2009 of John Lewis Partnership the revenue has increased to £3009.2m as compared to £2940.5m during interim period ending 1 August 2008and so also its gross profit; but its operating profits have declined from 130.2m(4.42%) in interim period 2008 to 126.2m (4.07%) in interim period 2009. The decline is marginal indicating that recession days are almost over. This also speaks effective management of resources eliminating the counter effects of recession period. Current ratio has also improved during this period to 1.04:1 as compared to 0.82:1 during the full financial period ending January 2009. That shows that John Lewis is trying to come out of liquidity problems, though it has yet to go a long way as current ratio is not yet satisfactorily. The company is still highly geared putting its pressure on is profitability. Overall the performance is improving and John Lewis will soon be out of recession effects brining back its liquidity to a normal position. Predictions for the future (Conclusions) Interim results for period ending 1 August 2009 are encouraging and indicate a encouraging returns for the partners. Even though John Lewis is suffering from liquidity problems, its profitability performance is providing very encouraging signs for future earnings. John Lewis is efficiently using its inventory and other assets for obtaining increasing revenue year after year. Even though the company is highly geared but it is allowing shareholders to trade in equity. Investors are appreciating the performance in a difficult economic period when John Lewis has attain an increased profitability even though increase in capital investment is because of increase in debt liabilities. The overall performance of John Lewis is certainly commendable. Appendix Income Statement and Balance Sheets for years ending on 31 January 2009 and 31 January 2008 can be viewed at http://www.johnlewispartnership.co.uk/Display.aspx?&MasterId=b794db7d-4648-44e4-a931-81228f1340fa&NavigationId=576 Interim Income Statement and Balance Sheet as at 1 August 2009 can be viewed at http://content.yudu.com/A1g69a/JLPinterim09/resources/15.htm References Read More