Key Factors in a Companys Success - Essay Example

2. Performance Any analysis of this nature must necessarily start from an overall picture of each company’s performance to “Analysis doesn’t start with ratios – it starts with understanding” (McKenzie, 2003: 190). Before one can begin to understand why the two companies have had the results they’ve had, it is first necessary to understand where they’ve been. To best do this, it is necessary to track their progress throughout the past few years. 2.1 Turnover, cost and profit Key factors in a company’s success remain securely connected to the organization’s turnover rate, sales numbers, overall expenditures and resulting profits. Turnover rate refers to the price of the units times the number of units that have been sold. There are several factors that can affect a company’s turnover rate. These can include changes in the volume of units produced, changes in the prices per unit or some kind of combination of each of these factors. Other factors that can have an impact on the turnover rate include non-company controlled factors such as exchange rate movement for exporting companies (Holmes & Sugdem, 1997). However, these types of factors cannot be taken into account in an analysis of the two companies concerned here because of the depth of analysis necessary to adequately address these issues requires a great deal more information from the companies themselves, which is not available at this time. The information provided in the Annual Reports of each company is actually quite poor, making it difficult to provide even an estimate of which of these factors played a more significant role in turnover. Despite this, some estimation can be obtained by comparing the profit margins by looking at turnover as compared to cost of sales. It can be seen in the appendices that while TESCO’s turnover rate continued to grow throughout the entire period we are concerned with, Sainsbury’s turnover rates slowed and stabilized, holding at a relatively constant rate for the past five years. In terms of sales, both companies showed relatively equal sales numbers for 1999, but then diverged. While TESCO’s sales doubled following 1999, Sainsbury’s sales remained relatively flat. Not surprisingly, these results are reflected in the profits reported by each company. TESCO’s continuously growing turnover led to progressively increasing profits, reaching an almost 100 per cent gain during the period. At the same time, Sainsbury continuously reported losing profits, actually entering the negative range in the period between 1996 and 2004. These profit losses actually reached as low as £12 million British in 2001. While it can be seen that Sainsbury had a higher sales cost than TESCO, these differences were too great to be explained solely by this difference. Another possible factor for Sainsbury’s unfavorable results could be attributed to other factors such as solvency. 2.2 Solvency Solvency refers to whether or not a company is able to pay out its debt. In determining this, it’s equally important to determine how the company manages debt, short-term liabilities and long-term obligations. There are three main considerations in looking at solvency. These include immediate solvency which is also often referred to as liquidity), short-term solvency and medium- or long-term solvency. This indicates the structure of the companies’ overall capital. 2.2.1 Immediate solvency and short-term solvency The ability of a company to meet obligations on time is what is meant by liquidity or immediate solvency. Related to this issue is the concept of short-term solvency, which generally refers to a slightly longer period, generally not longer than a year, in which the company would have the time necessary to sell stock as a means of meeting any obligations it might have that cannot be covered immediately. Holmes and Sugdem (1997) suggest the best way of analyzing this factor is by calculating the quick ratio. These ratios can be calculated in the following way: In calculating these figures, it is possible to see that the Quick Ratio of TESCO is actually much lower than that returned for Sainsbury for the entire period, a condition echoed in the calculations performed for the Current Ratio. Within these calculations, it can be seen that TESCO’s Quick Ratio and Current Ratios remained stable throughout the period, increasing at a stable rate beginning in 1996. Sainsbury’s numbers, however, proved to be wildly erratic from year to year, especially within the Quick Ratio. A common factor shared by both companies is that they both returned ratios lower than 1, indicating that they each possess more assets than current liabilities. According to Atrill and Mclanely’s (2001) classic theory, this indicates that both companies are in some degree of danger. They suggest a healthy number is closer to a 1.5 range. This is tempered by the idea that different companies interpret these ratios differently based upon the type of business being conducted. Since each company is predominantly a retail enterprise, it is understandable that their current liabilities outweigh their short-term assets. Retail business frequently do not carry much in the way of stock, carry a good deal of credit via credit cards and make several purchases from suppliers based on credit (McKenzie, 2003). 2.2.2 Long-term solvency The recommended means of analyzing long-term solvency is to start from the net worth valuation, which can be obtained by determining the difference between total assets and total liabilities (McKenzie, 2003). On the surface, this seems a very simple means of determining whether or not a company will be able to meet any long-term obligations, even if it means selling all of its assets, including fixed assets. Yet this process becomes more complicated when such factors as asset re-evaluation and movement in the exchange rate are taken into consideration. These factors can offset the net worth value of the company and confuse any calculations made. In terms of the two companies analyzed here, both show positive net worth and stable growth. However, TESCO managed to surpass Sainsbury’s growth in 2004 and maintain this advantage. 2.3 Gearing Gearing is a measurement of the company’s total amount of debt expressed as a percentage of all the capital employed by the company. While there is no hard and fast answer regarding how much debt is optimal, gearing is necessary to determine which of these companies holds the larger degree of debt. This will also indicate to some extent how this debt will affect overall performance. Gearing is often defined as a debt to equity ratio displaying the borrower’s (shareholder’s) funds and the percentage of funds used corresponding to the amounts borrowed. The most useful ways to do this are recommended by Holmes and Sugdem (1997) and Foster (1986) in the following equations: When these equations are calculated using current liabilities, no obvious leader between the two companies emerges, although TESCO emerges as the leader in the ‘traditional ratio’ (McKenzie, 2003). In trying to determine what the ratios actually mean, there have been several suggestions. Some researchers (Brealey and Myers, 2003) indicate that there isn’t a clear optimal percentage of how much a company should borrow, making it difficult for companies to determine not only the level, but how this fluctuates depending upon the specific environment and what can be afforded. Because of this uncertainty, it is impossible to tell simply from these gearing ratios which of the two companies are in a better position. However, it is possible to see that Sainsbury tends to rely principally upon its own capital in order to build its business while TESCO has been borrowing extensively to do the same, nearly doubling the borrowed amount during the past three years. 2.4 Interest cover When it comes to determining whether or not a company can afford their current level of borrowing, it is helpful to use the interest cover ratio. Calculating this ratio can indicate how many times the company’s profit levels can cover any interest on the funds borrowed. To determine this, the equation is as follows: In processing this calculation, there appears to be some sort of link between this ratio calculation and the gearing ratio as the Sainsbury figures coincide with each other for these two calculations. When the company had a higher gearing ratio, the interest cover ratio also increased, but it is difficult to make this connection simply based upon these figures. Sainsbury was not able to show reliable, stable growth in profit during the study period. Before any connection can be made, this correlation would need to be observed in more than one case. 2.5 Profitability Perhaps the most important part of this analysis is profitability. It’s importance is based partially on the fact that most investors will look first at profitability, comparing it with other companies to determine which companies they wish to invest in. This figure also indicates the level of ‘shareholder value’, which McKenzie (2003) indicates is the major determinant of share price movements. As might be deduced through common reasoning, larger added values equate to bigger benefits to the company and its shareholders. The profitability measurement indicates the various factors that affect each company’s profits as well as how profitable each business is. In determining profitability, it is necessary to assess the returns on funds actually invested in the business or its development. Profitability is typically measured in terms of a ratio of profit before interest and tax (PBIT) and capital employed, but this is not the only definition used. For this reason, it is necessary to use more than one approach so as to provide a more balanced result. For the purposes of this study, three popular ratios will be used as it is felt a look at these three will provide sufficient data regarding the companies’ profitability to give an accurate picture. The primary ratio employed is the income-to-turnover (ITT) ratio. This calculation demonstrates the amount of net income was earned from each pound of revenue. In the following equation, net income refers to the level of profit retained once all tax and interest have been deducted. The level of common shareholders equity can be found through the Net income to Shareholders (ISF) ratio: The final ratio used in this analysis was the net income to total assets (ITA) ratio, which illustrates how much profitability has been gained through the assets of the companies analyzed. Performing these calculations, it can be seen that TESCO performs better on every ratio. Throughout the analysis, it is seen that TESCO continues to show itself much more stable than the erratic figures returned for Sainsbury. This instability on the part of Sainsbury is most evident in 2001, the year the company began it’s restructuring (J Sainsbury’s Annual Reports 2002, 2003, 2004). While the restructuring had some effect, the final report year (2004) again showed a significant decrease in profitability. 2.6 The investor’s perspective 2.6.1 Investment Ratios Another important ratio investors are commonly interested in is the earning per share ratio (EPS). Because most investors seek companies with a growing EPS, this figure is an essential element for every listed company. Fortunately, it is a relatively simple ratio to determine. To calculate, one must divide the profit attributable to ordinary shareholders by the number of ordinary shares issued. Like many of the other figures, though, the EPS can take on additional nuances as companies have begun to report basic EPS as well as diluted EPS numbers. While basic EPS refers to the calculation already described, outstanding share options are included in the denominator of the diluted EPS. For this analysis, the diluted EPS was used. While the numbers indicate Sainsbury earns more than TESCO, this is due to the fact that Sainsbury has fewer shares issued than TESCO. Despite this, Sainsbury’s EPS ratio fell in 2004 which reduces the attractiveness of the company to investors in the market. By contrast, TESCO continues to increase its EPS each year. To determine how much each company pays to their shareholders in the form of dividends, the total dividend is divided by the number of shares issued and becomes another important aspect of investor interest. Again, Sainsbury shows higher dividends per share, but TESCO again demonstrates better performance. Through this calculation, it is shown that TESCO continues to spend more money for dividends and continues to increase this amount each year by at least 10 per cent, allowing shareholders of this company’s stock to have a higher overall return on their investment than those who have invested in Sainsbury. With knowledge of the dividend per share, several other indicator ratios can also be calculated that would assist investors in determining which company to choose. These include dividend yield, dividend cover and payout ratio. To determine how many times the dividends can be paid out from the profit available, dividend cover is used in the same way as the interest cover ratio was used earlier. Because TESCO continues to pay the same portion of its profit to shareholders each year, its profits continue to rise year by year, maintaining a steady balance. However, Sainsbury continues to pay out most of their profit in dividends, providing them with fewer resources for reinvestment. However, they are trapped in this situation as decreasing dividends at this point in time would prove disastrous to the company’s market share price. Read More