The Current and Quick Ratio Interpretation of the Two Companies - Essay Example

?Morrison’s Financial Analysis Reasons for using ratio analysis To analyze the company’s performance, we will be using ratio analysis – both time period analysis as well as the comparative analysis with respect to number one retail player in the UK market i.e. Tesco. The advantage of using ratio analysis is that absolute numbers do not give an exact picture of how well a company is performing with respect to its competitors as well as its own previous performance. For example when we say that the Net profit of company A is $500 million while that of company B is $ 350 million, it can be easily concluded that company A is earning better profits than company B. However these figures do not show how efficiently the company is earning these profits. How much risk each company is taking to earn these returns is not known. The future prospects of the company with respect to its performance can also not be predicted by just looking at absolute numbers. It is important to analyze each figure in relation to the others to be able to conclude about a company’s performance. Hence, though company A is earning more than B, we need to look at the sales figures on which these profits are earned. Hence, if company B is earning this on a sale of $10,000 million while company A is earning it on sale of $20,000, company A is actually earning only 2.5% on its total sales while B is earning 3.5%. Hence, B is actually earning better. Similarly, if company B has very high debt with respect to its equity, then this company is highly leveraged and much riskier than A, though the absolute debt figures of company A might look bigger than B. Thus, ratio analysis which helps to establish relationship of one financial figure with the other helps in analyzing different companies in better light. Another advantage of ratio analysis is that it helps in comparing completely different balance sheets. For example, company A might publish its results in British pounds while B might do the same in Dollars. Ratios help in directly comparing the two companies irrespective of the currency they use in their financial statements. Ratio analysis also helps in analyzing a company’s performance by looking at its various business aspects i.e. profitability, liquidity, leverage, operational efficiency (turnover ratios) as well as market valuations. Various aspects of analysis We will conduct a time series analysis (for the various ratios) for Wm Morrison Supermarkets for a period from 2008 to 2010. We will also compare it with Tesco which operates in the same industrial sector. Other than the ratio analysis we will also compare some other aspects of their business like their market penetration, and their product line etc. Choosing the right ratios The various ratios we will be using will be based on following categories Profitability ratios – (Gross Profit, Net profit and Operating ratios) These ratios help in analyzing the efficiency with which the company has used its resources to generate profits. Gross profit sees the amount of profit earned after taking out the cost of sales which includes administrative and sales expenses. Net profit looks at overall earnings after taking into account all expenses including interest and tax expenses. Operating ratio takes into account operating expenses viz-a-viz sales. Liquidity ratios – (Current ratio, Quick ratio) These ratios show how easily a company can liquidate its short term assets to honor its short term liabilities especially the suppliers and financers. Turnover/activity ratios – (Fixed assets, Current assets and inventory turnover ratios and day’s receivable holding) These ratios help in analyzing how efficiently a company converts its assets into revenues. They also tell how effectively the company has used is resources to generate sales (revenues) (Loth 2011). Leverage – (Debt-Equity) These ratios tell about the amount of risk a company has taken and eventually its share holders are facing. Valuation ratios - ROI (Return on Investment) These ratios help in measuring the returns that the company gives to its investors and hence decides its future market value. Ratio Analysis Starting with the profitability ratios we can see that the company has improved its gross, net and operating margins (Appendix – Profitability ratios). The operating ratio which measures the operating expense of the company also shows an impressive figure of 1.01% in 2010 which has reduced since 2008. This shows that the company has managed to keep its costs low even during the financial crisis period. Comparison of its 3 year average figure to that of Tesco shows that that it is much lower at 1.41% as against 1.90% (Appendix – Morrison vs Tesco). Though its net and gross profit margin ratios are much lower than Tesco’s it has better control over costs. This could be because Morrison is less diversified geographically (see company profile comparison in the later section) and hence would require lesser administrative setup. Short term liquidity position of the company doesn’t look very good. A good current ratio for the company would have been anywhere between 1.5 to 2.0 (Rameshkumar and Anbumani). However its average current ratio is 0.51 and quick ratio is 0.26 (Appendix - Morrison vs Tesco). Though Tesco is also not doing very well on these figures, it is better placed at 0.69 and 0.52. However, it would not be advisable to conclude about the illiquidity of Morrison as compared to Tesco without looking at the inventory turnover figures. On an average the inventory has turned 28.36 times in case of Morrison and 20.25 times for (Appendix - Tesco Morrison vs Tesco). Morrison held 13.67 days of inventory in 2010 (Appendix – Turnover/activity ratios). Also its account receivable days were only 3.70 in 2010 much lower than in 2009 but slightly higher than 2008 (Appendix - Turnover/activity ratios). Average accounts receivable days of Tesco are far higher at 16.30. This shows that Morrison has more cash sales as compared to Tesco and hence, the quality of its liquid assets is far better in terms of ease of conversion into cash. Thus, we can conclude that though Tesco’s current ratio position looks better than Morrison’s it is in a better position convert its current assets to cash if need be. The quick ratio of Morrison is also lower than Tesco’s. Though this also follows same pattern as current ratio and has similar weakness, it shows a very notable trend – the figures are significantly lower than (around 50% in all 3 years) the corresponding current ratio figures, while this is not the case with Tesco figure. This shows that the company’s inventories form a higher component of its current assets. Total assets turnover figures of Morrison are higher than Tesco, showing better utilization of assets. Debt to Equity ratio of Tesco is far higher than that of Morrison. Tesco carries 2.10 Pounds of debt for ever pound of equity invested while Morrison’s has only 0.78 pounds. There can be 2 conclusions from this. One is that Tesco is a bigger company as compared to Morrison and hence doesn’t have much problem in increasing its loan component. Morrison on the other hand might find it difficult to increase its loans due to lack of trust from the market. Secondly, Tesco is geographically more diversified and hence is more aggressive. However, Morrison’s are following a more conservative approach and are trying to expand within the market well known to them. Hence, they require lesser capital for expansion. In a way it is a good approach as when they feel that the time is ripe for expansion; they will have higher capability to get credit from the market while Tesco is already over leveraged. ROI (Return on Investment or Equity) is the most important figure that the investors follow. The three year figure of Morrison shows that it was lowest in 2009 but has now returned to a much higher level. However, Tesco has been able to provide better returns to the investors. In general, a ratio ranging between 15-20% is considered to a good return on equity (Loth 2011). Looking at this figure, Morrison has underperformed during the 3 year period while Tesco is performing as per expectation. However, the Debt/Equity ratio of Tesco shows that it has much higher debt in its capital structure than in Morrison’s case. This can produce a higher return even on lower net income. Company Profile comparison Morrison Supermarket is a leading retailer in UK which mainly deals in a variety of products (mostly food and health related). Its product range includes fruits, vegetables, groceries, drinks (both soft and hard), baby products, pharmacy and other health related products and pet and other household products (finance.yahoo). Tesco, along with its subsidiaries, offers products in both food and non-food segments. It not only offers products related to health, clothing, furniture, electrical equipments etc. but also offers telecom and financial and insurance services. It has stores all over the world including China, Japan and US etc. As of 2009 it had 4,308 stores. Thus the company is far bigger than Morrison in terms of its reach as well as the product portfolio. Conclusion and recommendations On the whole Morrison has improved most of its ratios over the last three years. The company has a huge opportunity of expanding into more product lines as well as geographical locations. Looking at the capital structure of the company it is well placed to increase its capital by increasing its borrowings for expansion. Its assets turnover and profit margin ratios are indicative of a good management of resources which will be helpful in the expansion process. Limitations of the analysis Ratios on their own do not always make sense unless they are compared to previous year’s figures or to another company’s data. They do not provide qualitative information about the company. For example, we have seen that the accounts receivable days of Morrison are pretty low. But how good the debtors are cannot be determined from this ratio. Our analysis has considered a three year trend which includes the financial crisis years. This is not a normal situation. Hence, five year period before 2008 could have given an idea of the company’s performance under normal circumstances. The ratios calculated are as good as the data presented by the company managers (icmrindia.org). Misrepresenting data by meddling with price, depreciation or interest figures will not show the correct picture as all ratios are purely calculated from financial statements. Companies also use various accounting policies like IFRS GAAP and UK GAAP (Morrison annual report 2009). Thus, companies representing data with different policies cannot be compared. For example, Tesco’s annual report mentions the use of new IFRS guidelines post 2008/9 while Morrison adheres to both UK GAAP and IFRS. It is also important to see the relationship of various ratios and not jump to conclusions based on one ratio. We discussed the current and quick ratio interpretation of the two companies in the analysis. Without looking at the turnover and account receivables days figures the current ant quick ratios represented a completely different picture. References Finance.yahoo, Tesco PLC, viewed on April 4, 2011 http://finance.yahoo.com/q/is?s=TSCO.L+Income+Statement&annual icmrindia.org (2010) A note on financial ratio analysis, Case studies and management resources, viewed on April 4, 2011 http://www.icmrindia.org/free%20resources/casestudies/finance16.htm Loth, R (2011) Financial ratio tutorial, The Wall Street Journal – Investopedia, viewed on April 4, 2011 http://www.investopedia.com/university/ratios/ Morrison – Annual report 2009, viewed on April 4, 2011 Rameshkumar, C and Dr. Anbumani, N (2011) An overview on financial statements and ratio analysis, viewed on April 4, 2011 http://www.fibre2fashion.com/industry-article/10/912/an-overview-on-financial-statements4.asp Tesco – Annual report 2009, viewed on April 4, 2011 monycentral.msn, Financial results – MRWSF, viewed on April 4, 2011 http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?symbol=US%3aMRWSF Appendix Morrison’s Financial data Million British Pounds 2010 2009 2008 Revenues Top of Form 15,410Bottom of Form 14,528 12,969 % revenue growth 6.07% 12.02% 4.07% Cost of rev. Top of Form 14,348Bottom of Form 13,615 12,151Bottom of Form Gross profit 1,062 913 818 Operating exp 155 242 206 Operating income 907 671 612 NIBT Top of Form 858Bottom of Form 655 612Bottom of Form Net income Top of Form 598Bottom of Form 460 554Bottom of Form current assets Top of Form 1,092Bottom of Form 1,065 906Bottom of Form total assets Top of Form 8,760Bottom of Form 8,226 7,636Bottom of Form Equity Top of Form 4,949Bottom of Form 4,520 4,378Bottom of Form Current liabilities Top of Form 2,152Bottom of Form 2,024 1,853Bottom of Form Long term assets Top of Form 7,668Bottom of Form 7,161 6,730 Long term debt 1,022 1,049 774 Inventories Top of Form 577Bottom of Form 494 442Bottom of Form Accounts receivable Top of Form 156Bottom of Form 244 124Bottom of Form Accounts payable Top of Form 1,350Bottom of Form 1,915 1,152Bottom of Form Total liabilities Top of Form 3,811Bottom of Form 3,706 3,258 Source: 2010 figures - moneycentral.msn 2009 and 2008 – Tesco annual report 2009 Profitability ratios   2010 2009 2008 Formulae Gross Profit margin 6.89% 6.28% 6.31% Gross Profit/sales Net Profit margin 3.88% 3.17% 4.27% Net Profit/sales Operating profit margin 5.89% 4.62% 4.72% Operating Profit/sales Operating ratio 1.01% 1.67% 1.59% Operating expenses/sales Liquidity ratios 2010 2009 2008 Formulae Current Ratio 0.51 0.53 0.49 Current assets/current liabilities Quick ratio 0.24 0.28 0.25 (Current assets-Inventories)/current liabilities Turnover/activity ratios 2010 2009 2008 Formulae Quick ratio 0.24 0.28 0.25 (Current assets-Inventories)/current liabilities Inventory turnover (times) 26.71 29.41 29.34 Inventory/Sales Number of days of inventory 13.67 12.41 12.44 365/Inventory Turnover Current assets turnover 14.11 13.64 14.31 Current Assets/Current Liabilities Total assets turnover 1.76 1.77 1.70 Total Assets/Sales Accounts receivable days 3.70 6.13 3.49 (Accounts receivable/Sales)*365 Leverage ratios 2010 2009 2008 Formulae Debt to Equity 0.77 0.82 0.74 Debt(Total liabilities)/Equity Valuation ratios 2010 2009 2008 Formulae ROI-return on equity 12.08 10.18 12.65 Net Income/Equity Tesco’s Financial figures Million British Pounds 2010 2009 2008 Revenues 56,910 54,327 47,298 % growth 5.59 14.86 10.92 Cost of rev. 52,303 50,109 43,668 Gross profit 4,607 4,218 3,630 Operating exp 1,150 1,012 839 Operating income 3,457 3,206 2,791 NIBT 3,176 2,954 2,803 NIAT 2,336 2,166 2,130 Net income 2,327 2,133 2,124 current assets 11,392 1,798 1,311 total assets 46,023 13,647 5,992 Equity 14,596 46,053 30,164 current liabilities 16,015.00 12,995 11,902 Inventories 2,729 18,040.00 10,263.00 total liabilities 31,427 2,669 2,430 Source: 2010 figures - finance.yahoo 2009 and 2008 – Tesco annual report 2009 Morrison Vs Tesco (3 year average)   Morrison Tesco Gross profit margin 6.51 7.86 ROI-return on equity 11.64 16.67 % increase in revenues 7.39 10.18 Cost of sales as % sales 93.49 92.14 Net profit margin 3.76% 5.96% Current ratio 0.51 0.70 Quick ratio 0.26 0.52 Inventory turnover 28.36 20.25 Current assets turnover 14.01 5.11 Total Assets turnover 1.74 1.30 Debt to Equity 0.78 2.10 Operating ratio 1.41% 1.89% Accounts receivable days 4.46 16.30 Read More