Profitability Analysis Sainsbury PLC versus Tesco PLC - Essay Example

?Profitability Analysis – Sainsbury PLC v/s Tesco PLC Introduction The preparation and developments of financial ments are carried out in order to provide a true picture of the company regarding its financial performance and position. What company achieved, what company lost and what company maintained in financial aspects, all are presented under financial statements of a company. However, the financial statements of a company provide the absolute figures (amounts in currency units). These amounts of financial statements can be used for comparison in respect of the past performance of the company. But what if an analyst wants to compare the financial performance and position of a company with other competitor or with the industry? For this reason, the actual presentation of financial statements with the absolute figures becomes meaningless as it does not provide a rational basis for comparing with the competitor or with the industry. The industry and competitor might have several differences due to which it is not practically justified that the analysis between the two should be made. For instance, if a company has revenues of $5 million and one of its competitors has the revenues of $500,000 then on the basis of these absolute figures, there is no comparison between the two companies. However, if the growth in revenue of the former company is, let’s say 6% and the latter company has growth in revenues of around 8%, then there is a rationale of analyzing both the companies as the same footing for comparison is available now. In short, in the absence of reasonable commonalities between the financial aspects of the two companies, the comparison of the two companies turns out to be meaningless. The best way to make a comparison in financial aspect between the two companies is to undertake financial ratio analysis. This analysis provides a common platform for the companies so that their performance can be compared on reasonable basis. Issues like absolute figures, size of the firms, differences in the operating activities and other issues are relaxed when financial statements are analyzed on the basis of ratios. The technique of ratio analysis works on the basis of common figures that are comparable. These comparable figures are computed as a percentage of some figures. For instance, what is the percentage of net profits with respect to sales, with respect to total asset, with respect to equity, and so on? But if stand alone figure of net profit is taken into account, then due to difference in size of the company, its value, its nature of operations, its capital structure and other elements, that net profit figure would not reflect a true picture. Structure of Article This article is developed in such a manner that the profitability analysis of two UK companies, Sainsbury PLC and Tesco PLC, has been conducted on the basis of ratio analysis. As far as the size of the two companies is considered, Tesco PLC is bigger than Sainsbury PLC. So what exactly be the measure which should be used in order to bring both of these firms to a common platform is the ratio analysis. The introductory part of the analysis briefly highlights the description of both the companies regarding their industry, history, products, branches etc. Next part focuses comprehensively upon the importance, meaning and interpretation of each of the profitability ratio. Third part of this report conducts an analysis on the basis of earlier explained ratios. Those ratios are divided into two categories such that first part of the analysis emphasizes upon the performance of each individual company on the basis of its past performance in the form of trend analysis. Second part of the analysis makes a profitability comparison between the two firms on the basis of their own important heads of accounts. At the end of this report the calculation of the ratio analysis is presented in the appendix. Tesco Tesco is one of the largest retailers. It operates more than 2,300 convenience stores and supermarkets. The total number of employees working for Tesco is 326,000 people. The core business of Tesco is in Britain. In Britain, Tesco is ranked as the largest food retailer operating around 1,900 stores all over Britain. Apart from this, Tesco also operates in other parts of Continental Europe which includes Poland, Ireland, Hungary, Czech Republic, Turkey and Slovakia. Apart from Europe, the company also operates in some parts of Asia including South Korea, Japan, Taiwan, Malaysia, Thailand etc. Despite of these tangible stores, the company also possesses online shopping system. Through Tesco.com, it delivers food products to its customers and therefore is considered as largest online shopping store. Apart from food related products and services, Tesco also offers financial services. These financial services account for 4.6 million account of customers. These financial services are mainly divided between car insurance policies and credit cards. Due to its 100 unit Tesco Express Chain, the company is considered as largest seller of gasoline in U.K. Market Share Tesco has strived a lot to gain its market share. It opened stores all over the Britain and in Europe and Asia as well. Due to such expansion, the market share of Tesco reached 30% in 2011. Principal Competitors Tesco now faces serious competition from some major food retailers in U.K which include Dunnes Stores, ASDA and Sainsbury. Principal Subsidiaries Some major subsidiaries of Tesco include; Tesco Insurance Ltd, Tesco Capital Ltd, Tesco Stores Hong Kong Ltd, Tesco Property Holdings Ltd, Tesco Stores Limited, Tesco.com, Global TH (Hungary), Tesco Personal Finance, Savia S.A (Poland), GroceryWorks Holdings Inc. (35%). Sainsbury Sainsbury was established in 1869 by Mary Ann Sainsbury and John James. Sainsbury is one of the largest food retailers in Britain. The principle of founders of Sainsbury was to provide their customers with excellent service, high quality products and attention to details. There are nearly 440 stores of Sainsbury in Britain. These stores consist of largest stock of products including a maximum of 23,000 products. Sainsbury possesses nearly 170 supermarkets in United States under the name of Shaw and Star Markets. Sainsbury was leading the food retail of market until competitors snatched a substantial chunk of market share from Sainsbury yet Sainsbury has been very strong in gaining back its previous market position and therefore in 2012, According to The Telegraph, Sainsbury is now gaining back the market share which it had list a long time ago.(Wallop, 2012) Market Share A substantial chunk of market share of Sainsbury has been snatched by Tesco, dropping it at number 3 among all the food retailers. Having such intense competition, Sainsbury stands at 3 having market share of 16%. Major Competitors Sainsbury used to be the largest and leading food retailer in U.K but the entrance of Tesco and ASDA dropped Sainsbury at number 3. The principal competitors of Sainsbury include; ASDA Group Limited, The Stop & Shop Companies Inc., Safeway Plc., Hannaford Bros Co. and Tesco Plc. Principal Subsidiaries Principal subsidiaries Shaw’s Supermarkets Inc., Sainsbury’s Supermarkets Ltd., Sainsbury’s Bank Plc. (55%), J Sainsbury Developments Ltd. Ratio Analysis Under the techniques of ratio analysis, a company’s financial performance is evaluated in terms of different areas such as, its profitability that it generated, the efficiency level that it managed, the riskiness of the company, liquidity and cash position of the company, the utilization of its assets, working capital management of the company, stock performance of the company. The above mentioned areas are can be categorized into one set of ratio analysis. However, the other set of ratio analysis deals with the trend analysis. Trend analysis also named as vertical analysis, is conducted in such a manner that the past performance of the company is compared with the current performance of the company. This suggests that how much a company has performed in terms of growth. Under the following heads, both sets trend analysis as well as traditional profitability ratio analysis are discussed. 1. Trend Analysis As mentioned earlier, a trend analysis of a company is made in order to assess the historical performance of the company with the respect to the existing performance so that a better predictability measure can be made for future estimations. Commonly, trend analysis is developed into two forms such that either the performance of the company is analyzed on year on year basis so that per year growth of that company in that particular area can be highlighted. The other way of monitoring the performance of the company is to make one period as the base period and then the performance of each subsequent year is compared with the performance of that base year. For instance, year on year trend analysis can be made in such a manner that a company makes profits of $1million in 2007, its profits are increased (decreased) in the following pattern like $1.1 million, $0.9 million, $1.3 million and $1.15 in 2008, 2009, 2010 and 2011 respectively. The year on year growth in terms of profits of the company would be 10%, -18%, 44% and -11.5% for the years 2008 till 2010 respectively. But if we consider 2007 as a base year and the performance of the company is analyzed with respect to 2007, then it can be said that the company made a growth of 10%, -10%, 30% and 15% for each year from 2008 to 2011 with respect to 2007. In short, the base year trend analysis cumulatively identifies a complete growth in the concerned periods however year on year growth reflects that growth of the company on continuous basis. 2. Cross-Sectional Ratio Analysis The cross sectional ratio analysis is another important tool for conducting financial analysis such that under this technique, a comparison of one company with its competitor or industry can be made on the basis of some common triggers. The performance of the company can be evaluated under different manners such that the growth rates obtained from trend analysis can also be used for comparison under cross sectional analysis. Moreover, the traditional ratios like net profit margin, operating profit margin, return on assets etc are can also be computed. Since the main objective of this report is to analyze the profitability of the two companies, therefore, the entire focus will be put on the concerned profitability ratios of both the companies. Five profitability ratios are highlighted to cover the profitability analysis of the company, which are Net Profit Margin, Operating Profit Margin, Return on Total Assets, Return on Fixed Assets and Return on Common Equity. The description of each of the above mentioned ratio is explained below: a) Net Profit Margin Net Profit Margin is considered as the most primary and basic profitability ratio. This ratio is quite famous because it highlights the level of the profitability in an instant manner and the user of the financial statement assesses the performance of the company without any hassle. The Net Profit Margin can be outlined under the following formula: Net Profit Margin = Net Income / Total Revenues x 100 If the formula is observed closely it can be inferred that the Net Profit Margin is actually the ratio of net income with respect to the total revenues under percentage terms. For instance, if a company earns 7% Net Profit Margin, it means that the company has earned 7% of the total sales as its net income. If total sales were $100 million, then the amount of net income constitutes to $7 million. In a summarized way, this ratio is considered as the highly important ratio in terms of profitability analysis as it describes how much a company earns as a percentage of its sales. b) Operating Profit Margin On technical aspects, Operating Profit Margin ratio is considered as the most appropriate ratio such this ratio highlights as the percentage of sales that constitute to operating profit of the company. The operating profit is actually that profit that the company earns from its normal business operations. It is the profit that is generally utilized by the company to make distribution to debt providers and the tax collection authorities as payments to both of these stakeholders do not constitute under the normal business operations of the business. The appropriate formula for operating profit margin is outlines as under: Operating Profit Margin = Operating Profit / Total Revenues x 100 Where, Operating Profit = Earnings before Interest and Taxes (EBIT) For instance, a company generates the revenues of around $100 million and the operating profits are $35 million, then the company’s Operating Profit Margin would be 35% which shows that the company has managed to earn 35% of its total revenues as its operating profits which can be further used to make distributions to debt holders and the relevant taxation authorities. c) Return on Total Assets From the balance sheet point of view, this ratio is quite considerable as it describes as how much a company is earning by utilizing all the resources of the company. These resources are termed as total assets. Since the company deploys different kinds of resources in its operations to earn revenues and profits, therefore it is vital to know as to how much a company earns from those resources. The main objective of this ratio is to analyze the power of assets to generate revenues and thus, profits. The following formula highlights Return on Total Assets: Return on Total Assets = Net Income / Total Assets x 100 From the above formula, it is clearly evident that it depicts the percentage of total assets which are used to generate net income. For instance, if a company earns $1 million as its net income and possesses the total assets of around $25 million, then the Return on Assets of the company would amount to 4%. d) Return on Fixed Assets This ratio is also considered as a technical ratio to judge the profitability of the company such that the net income of the company is compared with the fixed assets deployed by the company in the form of property, plant and equipment. Obviously, a company purchases and makes huge investments in its property plant and equipment in order to generate more profits. The following formula denotes to, Return on Fixed Assets. Return on Fixed Assets = Net Income / Total Fixed Assets x 100 The above mentioned formula depicts that what percentage of Total Fixed Assets is being converted into the net income of the company. In other words, how much net income being generated by the company by deploying specific amount on fixed assets in business operations, is elaborated by this ratio. e) Return on Equity From investors’ point of view, this ratio is extremely significant as it describes how much net income is produced by injecting a specific amount in the equity. Shareholders and other equity investors carefully analyze the both the size of net profits as well as the amount of equity being used as a funding source in financing the assets of the company. The following formula highlights return on equity of a company. Return on Equity = Net Income / Total Shareholder’s Equity x 100 From the above mentioned formula, it can be noticed that the profits are compared with the amount equity injected in the company. So if the company aims to provide a decent picture of its financial performance and position, it has to make this ratio especially attractive to the investors. Trend Analysis – Sainsbury PLC v/s Tesco PLC The following trend analysis has been conducted for both Sainsbury PLC and Tesco PLC such that the trend analysis has been conducted for the last five years from 2007 till 2011. There are two bases which have been used for this particular trend analysis which are 1) Base year basis, and 2) Year on year basis. The following table highlights the growth patterns for Sainsbury PLC Sainsbury PLC 2011 2010 2009 2008 2007     Revenues 21,102.0 19,964.0 18,911.0 17,837.0 17,151.0 Growth - Base Year Basis 23.04% 16.40% 10.26% 4.00%   Growth -Year on Year Basis 5.70% 5.57% 6.02% 4.00%       Operating Income 591.0 684.0 549.0 532.0 526.0 Growth - Base Year Basis 12.36% 30.04% 4.37% 1.14%   Growth - Year on Year Basis -13.60% 24.59% 3.20% 1.14%       Net Income 640.0 585.0 289.0 329.0 325.0 Growth - Base Year Basis 96.92% 80.00% -11.08% 1.23%   Growth - Year on Year Basis 9.40% 102.42% -12.16% 1.23%   The above table highlights some key facts regarding the profitability of Sainsbury PLC under the three broader terms which are revenues, operating income and finally net income. If revenue streams of Sainsbury are taken into consideration, it can be noted that the company is maintaining stable growth rate in between 4% and 6% over last five years. Since 2007 the company has increased its revenues by around 23% without any fluctuation, it is the sign of company’s stable sales growth. If the operating income of the company is considered, here there is a fluctuation that can be observed in the last year of the analysis where company’s profits slipped into negative zone. Overall the performance of the company in generating the operating profits has been reasonably good as it added to around 12% in five years with respect to 2007. Net Income of the company has turned out to be the best profitability indicator for Sainsbury as the company managed to grow almost 100% in the five year horizon. However, this growth also experienced fluctuation in 2009 because of the recessionary period, but it bounced back very strongly next year and made a record growth of around 102% in 2010. The growth rate came back to its normal average in 2011 with year on year growth of 9.4%. The following table highlights the trend analysis of the performance of Tesco PLC for last five years: Tesco PLC 2011 2010 2009 2008 2007     Revenues 60,931.0 56,910.0 53,898.0 47,298.0 42,641.0 Growth - Base Year Basis 42.89% 33.46% 26.40% 10.92%   Growth - Year on Year Basis 7.07% 5.59% 13.95% 10.92%       Operating Income 3,486.0 2,757.0 2,562.0 2,603.0 2,142.0 Growth - Base Year Basis 62.75% 28.71% 19.61% 21.52%   Growth - Year on Year Basis 26.44% 7.61% -1.58% 21.52%       Net Income 2,655.0 2,327.0 2,133.0 2,124.0 1,874.0 Growth - Base Year Basis 41.68% 24.17% 13.82% 13.34%   Growth - Year on Year Basis 14.10% 9.10% 0.42% 13.34%   As per the above findings of Tesco PLC, it can be observed that the company’s financial performance remains quite satisfactory as the company achieved a consistent growth pattern in terms of its profitability patterns. The company accomplishes a growth rate between 5% and 14% in the five years period. There were slight fluctuations in the performance of the company after 2009 yet the company performed satisfactorily. Overall the company added 42% in its overall revenues with respect to 2007 which is a very healthy increase. Substantial increase can also be found in respect of operating income of the company as the company made good growths especially in 2008 and 2011. However, in the middle periods, the performance in this regard remained on a tumbling side. Massive increase of around 62% in the overall operating profits from 2007 is a very promising sign for the company. So far as the net profits of the company are concerned, it can be noted that the company managed to keep a healthy growth rate of almost double figures for the whole five years except 2009. This shows the stability of the financial performance of the company. Tesco also managed to increase around 41% in its net income with respect to the base year of 2007. Cross-Sectional Profitability Ratio Analysis Profitability ratios for Sainsbury PLC and Tesco PLC have been analyzed below for the last five years. Five ratios for assessing the profitability of both the companies have been selected which are net profit margin, operating profit margin, return on assets, return on fixed assets and lastly return on equity. Sainsbury PLC   2011 2010 2009 2008 2007 Profitability Ratios       Net Profit Margin 3.03% 2.93% 1.53% 1.84% 1.89% Operating Profit Margin 2.80% 3.43% 2.90% 2.98% 3.07% Return on Assets 5.61% 5.39% 2.88% 3.25% 3.39% Return of Fixed Assets 7.29% 7.13% 3.70% 4.43% 4.53% Return on Equity 11.80% 11.78% 6.60% 6.67% 7.46%               Tesco PLC   2011 2010 2009 2008 2007 Profitability Ratios       Net Profit Margin 4.36% 4.09% 3.96% 4.49% 4.39% Operating Profit Margin 5.72% 4.09% 4.75% 5.50% 5.02% Return on Assets 5.63% 5.06% 4.69% 7.07% 7.56% Return of Fixed Assets 10.88% 9.61% 9.21% 10.73% 11.04% Return on Equity 16.06% 15.94% 16.60% 17.98% 17.84%               a) Net Profit Margin From the above table it can be observed that net profit margin of Tesco PLC has an edge over Sainsbury PLC in almost every year. Sainsbury experienced very slow growth in terms of its net profit margin within the range 1% to 3%. However a consistent pattern of 4% growth in every year can be observed for Tesco’s net profit margins. b) Operating Profit Margin The operating profit margins of Sainsbury have remained consistent mostly at 3% every year which is a good sign of stability. In contrast to that if the performance of operating profits is considered for Tesco, a substantial increase can be observed as the company managed to earn operating profits of around 5% every year. c) Return on Assets Return on Assets for Sainsbury have remained a bit volatile especially in the beginning years. However, in last 2 years they have been around 5%. Conversely, the performance of Tesco in this respect remained a bit sluggish such that in the initial 2 years, it maintained a good growth rate of around 7% since then it is struggling in making good return percentage from its total assets. d) Return on Fixed Assets The fixed assets of Sainsbury have remained quite efficient in making returns of around 7% in the last 2 years overcoming the early volatile performance. On the other hand, Tesco’s performance has remained incredibly well such that it earned almost more than 10% out of its total fixed assets every year. e) Return on Equity Return on Equity has remained very well throughout the five years for both the companies. The ROE for Sainsbury has increased from 6% to some 11% which is a very bright sign for the investors. On the other hand, Tesco remained successful in generating handsome return on equity of around 16% to 17% every year throughout five year horizon. Appendix 1 Sainsbury Formula   2011   2010   2009   2008   2007   Profitability Ratios       Net Profit Margin Profit After Tax 640 3.03% 585 2.93% 289 1.53% 329 1.84% 325 1.89%   Sales 21,102 19,964 18,911 17,837 17,151       Operating Profit Margin Operating Profit 591 2.80% 684 3.43% 549 2.90% 532 2.98% 526 3.07%   Sales 21,102 19,964 18,911 17,837 17,151       Return on Assets Profit After Tax 640 5.61% 585 5.39% 289 2.88% 329 3.25% 325 3.39%   Total Assets 11,399 10,855 10,033 10,115 9,576       Return of Fixed Assets Profit After Tax 640 7.29% 585 7.13% 289 3.70% 329 4.43% 325 4.53%   Total Fixed Assets 8,784 8,203 7,821 7,424 7,176       Return on Equity Profit After Tax 640 11.80% 585 11.78% 289 6.60% 329 6.67% 325 7.46%   Shareholders' Equity 5,424 4,966 4,376 4,935 4,359                             Appendix 2 Tesco PLC Formula   2011   2010   2009   2008   2007   Profitability Ratios       Net Profit Margin Profit After Tax 2,655.0 4.36% 2,327.0 4.09% 2,133.0 3.96% 2,124.0 4.49% 1,874.0 4.39%   Sales 60,931.0 56,910.0 53,898.0 47,298.0 42,641.0       Operating Profit Margin Operating Profit 3,486.0 5.72% 2,327.0 4.09% 2,562.0 4.75% 2,603.0 5.50% 2,142.0 5.02%   Sales 60,931.0 56,910.0 53,898.0 47,298.0 42,641.0       Return on Assets Profit After Tax 2,655.0 5.63% 2,327.0 5.06% 2,133.0 4.69% 2,124.0 7.07% 1,874.0 7.56%   Total Assets 47,158.0 45,985.0 45,515.0 30,060.0 24,775.0       Return of Fixed Assets Profit After Tax 2,655.0 10.88% 2,327.0 9.61% 2,133.0 9.21% 2,124.0 10.73% 1,874.0 11.04%   Total Fixed Assets 24,398.0 24,203.0 23,152.0 19,787.0 16,976.0       Return on Equity Profit After Tax 2,655.0 16.06% 2,327.0 15.94% 2,133.0 16.60% 2,124.0 17.98% 1,874.0 17.84%   Shareholders' Equity 16,535.0 14,596.0 12,849.0 11,815.0 10,506.0                             Works Cited Brigham, Eugene F. and Ehrhardt, Michael C., 2008. 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