Financial accounting - Essay Example

?Financial accounting Contents Financial accounting Contents 2 Introduction 4 Objectives of the Project 4 Scope of the Project 5 Part A 5 Background of Sainsbury & Tesco 5 Comparative Price Movements 6 6 Comparative Ratio Analysis 7 Profitability Analysis 8 Management Efficiency Analysis 9 Liquidity Analysis 11 Investment Analysis 12 Part B 14 Findings 14 Recent Developments 15 Recommendations 16 Part C 16 About IASB & FASB 16 Transitional Reliefs 17 Conclusion 18 References 19 Appendices 23 Introduction This project is divided into three parts. The first part includes the comparative analysis of the two UK-based companies- J Sainsbury Plc and Tesco Plc, based on the financial statements and other relevant information provided in the companies’ 2011 annual reports. This includes the ratio analysis and share price movements along with the FTSE 100 movements for the past four weeks. The second part includes the findings based on the financial analysis from the first part and the recommendations which follow from the findings as to which company has potential for better long-term investment. The third part of the project has the brief history of International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) and a list of transitional reliefs granted by the two boards for the retrospective application of a new revenue standard to ensure the comparability of revenues across all reporting periods. Objectives of the Project The objectives of this project are: To make a comparative analysis of Sainsbury and Tesco with the help of ratio analysis, share movements and related industry news To recommend which company would be better for long-term investment. To give a brief history of IASB and FASB and state the four transitional reliefs provided by the boards to the proposed common revenue recognition standard for comparability across reporting periods. Scope of the Project This project covers the financial analysis of two companies- Sainsbury and Tesco with the help of share price movements and their annual reports. The share price movements are studied by taking the companies’ historical prices of the past four weeks and charting them in comparison to the relevant index. The analysis of the two companies is done by means of ratio analysis, by calculating the companies’ profitability, management efficiency, liquidity and price multiples. The analysis and interpretation is also helped by studying the business news related to the retailers’ industry. The four transitional reliefs related to the revenue recognition standard the IASB and FASB have granted in June 2011, are discussed. Part A Background of Sainsbury & Tesco John James Sainsbury and his wife founded Sainsbury in 1869 with only one retail store in London. Since then it has grown the largest retailer in UK with 934 stores consisting 377 convenience stores and 557 supermarkets. It has a joint ownership in Sainsbury Bank along with Lloyds Banking Group. The company also has 2 property joint ventures with The British Land Company Plc and Land Securities Group Plc. In the year 2010/11 Sainsbury grew by average growth rate of 8.5% in terms of space. It was the first retailer to open a bank in UK and the bank provides loans, credit cards, insurances and savings (J Sainsbury Plc, 2011). Sainsbury operates in 5 strategic areas driven 5 key values: Great food, general and merchandise clothing, complementary services and channels, new business development, and creating property value and growing space (J Sainsbury Plc-a, 2011). Tesco was founded by Jack Cohen in 1919 in London. The company has a vision to be highly valued by the community, customers, staff and shareholders and to become a modern innovative and growth company applying skills globally (Tesco Plc, 2011). The company has a seven part strategy to expand its business with sustainable long-term growth: Grow the core business in UK, be an outstanding online and store international retailer, become strong in other businesses besides food, grow retail services in all markets in which it is operating, responsibilities to communities, creator of brands valued highly, and build a team to create more value (Tesco Plc-a, 2011). Tesco currently operates in 14 markets across North America, Europe and Asia (Tesco Plc-b, 2011). Comparative Price Movements Chart 1: Price comparison of Tesco Plc, J Sainsbury Plc & FTSE 100 Index from 10/10/2011-9/11/2011 Source: (MSN Money, 2011) The beta of Sainsbury is 0.72 (Thomson Reuters, 2011). The beta of Tesco is 0.76 (Thomson Reuters-a, 2011). If we compare the betas of the two companies with that of the FTSE 100 index, it can be seen that both the shares defensive shares. A defensive share is a share whose beta is less than 1 and whose movements are less volatile than the index movement. The beta of a share measures the co-movement of that share with the index. Beta of 0.72 for Sainsbury and 0.76 for Tesco mean that with every 1% up or down movement in FTSE 100, Sainsbury will move only 0.72% up or down and Tesco will move up or down 0.76% correspondingly. This entails for low risk profiles of the two shares. Chart 1 shows the price movements of the two shares with that of the index for the past 4 weeks and it is found that Tesco is the least volatile shares followed by Sainsbury and then FTSE 100. Comparative Ratio Analysis For the ratio analysis, the financial ratios are calculated from the financial statements of Sainsbury and Tesco which are provided under ‘Appendices’ at the end of the project. Profitability Analysis Chart 2: Profitability Ratios Source Industry Data: (Thomson Reuters-b, 2011) The profitability analysis of Sainsbury and Tesco is done by comparing Return on Capital Employed (ROCE), Gross Profit Margin, Net Profit Margin, Return on Equity (ROE) and Return on Assets (ROA). The profitability ratios depict the firm’s use of assets and control of expenses to generate profits. ROCE shows the percentage of returns earned by the firm from its assets and liabilities. The ROCE for Tesco is higher than Sainsbury because Tesco has higher operating profit as compared to Sainsbury. The margin ratios show the efficiency of the firm in controlling its costs. The gross profit margin of Tesco is higher than the Sainsbury because the proportion of cost of sales to the revenues is lower for Tesco. The Net Profit Margin is different from gross profit margin because it considers other operating and non-operating costs as well. The net profit margin for Tesco is also higher than Sainsbury. Similarly the return on equity and return on assets which are the ratios of net profit to equity and total assets respectively, are also higher for Tesco than Sainsbury. Compared to the industry except the gross profit margin, both the companies are more profitable. This might be due to high operating costs in retail industry where these two companies have managed their operations better than the industry. Management Efficiency Analysis Chart 3: Activity Ratios The management efficiency is compared with the help of operating cycle (OC) and cash conversion cycle (CCC) comparison. The OC gives the number of days the firm takes to convert the purchases into cash receipts. The CCC is the time period between the cash disbursement and collection. The Chart 3 shows that Sainsbury has managed its inventory better than Tesco because Sainsbury has low inventory conversion period which means that the Sainsbury takes an average 14 days to convert its new inventory into finished goods and then sales whereas Tesco takes 19 days. The negative CCC means that the firm collects from customers before it pays the suppliers. Short or negative CCC is considered good but it is not sustainable because it indicates that the firm might be delaying payments due to high operating costs and competition over price-cutting as happened with the retail industry in early 2011. Therfore we can say that CCC for Sainsbury appears to be more sustainable than theTesco’s. Chart 4: Asset Turnover Ratio Source Industry Data: (Thomson Reuters-b, 2011) Asset turnover ratio describes the company’s efficiency in the use of total assets in earning revenues. The higher the ratio better is the asset management. Sainsbury’s asset turnover ratio is higher than Tesco and Industry because Sainsbury has earned ?1.85 of revenue from ?1 of its asset and Tesco has earned only ?1.29. Liquidity Analysis Chart 5: Liquidity Ratios The liquidity analysis includes the analysis of liquidity ratios mainly current ratio which is the ratio of current assets and current liabilities, quick ratio and operating cash flow to long-term debt ratio. The liquidity ratios measure the ability of the firm to repay its short-term liabilities with cash and highly liquid assets. Operating cash flow-debt ratio shows the company’s ability to repay long-term debt from the operating cash it has generated. Generally the current ratio of 1 or more is considered good. As we can see that both the firms have their liquidity ratios below 1. However, Tesco looks more liquid than Sainsbury because it has more liquid assets as a percentage of current liabilities in comparison to Sainsbury. Moreover it has generated more operating cash flow to service its long-term debt than Sainsbury. Investment Analysis Chart 6: Investment Analysis The Earnings per Share is the net profit earned per share outstanding in the market. EPS for Sainsbury is slightly higher than Tesco. Slainsbury gave an interim dividend of 4.3 pence per share paid in January and final dividend of 10.8 pence per share in July 2011 whereas Tesco paid an interim dividend of 4.37 pence per share and final dividend of 10.09 pence per share. The dividends per share are much the same for the two companies which means that both the companies want to keep their investors happy. So there is no competition between Sainsbury and Tesco in terms of dividends. Chart 7: Price Multiples (J Sainsbury Plc Data Source: MSN Money-a, 2011; Tesco Plc & Industry Data Source: MSN Money-b, 2011) The price multiples provide the value of investment in the company’s shares. These are important indicators for choosing shares for long-term investment. The P/E is calculated by dividing the share’s current price with the EPS. P/B ratio is the ratio of current price and book value of equity. P/CF is the ratio of current price to operating cash flow and P/S is the ratio of current price to sales. From Chart 7, it is clear that Sainsbury has a lower valuation as compared to Tesco and industry on the basis of all the four price multiples. Table 1 shows Tesco has the largest market capitalization in the industry and Sainsbury stands at number three with market capitalization equal to two-third of Tesco’s. Table 1: Industry Comparison Source: (Yahoo Finance UK, 2011) Part B Findings The findings from Section-A are summarised as follows: The betas of both the shares are low with less volatility in the Tesco’s share. However Sainsbury follow the index closely. The overall profitability of Tesco is better than Sainsbury and industry as well. This may be due to the fact that Tesco’s Sales grew at 8.1% whereas Sainsbury grew at 4.9%. In terms of management efficiency Sainsbury has managed its inventory, receivables and total assets better than Tesco. In terms of liquidity Tesco appears more liquid than Sainsbury. Both are dividend paying companies and have paid comparable dividends in the last fiscal year. Although low in profitability, the EPS of Sainsbury is better than Tesco. Sainsbury has a lower valuation in terms of price multiples as compared to Tesco and industry. Recent Developments The profit margins in grocery retail industry are very low and economies of scale play a major role. Moreover the Government’s plan to increase taxes is expected to diminish the profit margins for the retails industry. This is the reason the top retailers are looking out for non-food industries in order to diversify the business. Sainsbury has recently acquired one of its main clients Global Media Vault Ltd which operates in online digital entertainment business. GMV was earlier operating with Sainsbury (Thomson Reuters-c, 2011). RBS insurance and Sainsbury were in talks to set a 5 year venture where the RBS will sell car insurance under Sainsbury’s brand name (Thomson Reuters-d, 2011). Tesco announced the sale of Japanese business and to buy Polish Zabka Chain in order to boost its position in central and Eastern Europe (Thomson Reuters-e, 2011). It also signed agreement to setup a joint venture to run shopping malls in China in February 2011 (Thomson Reuters-f, 2011). A survey by a UK analyst predicted that the Tesco will grow at CAGR of 7.5% from year 2010 to 2015 as compared to a low predicted growth for Wal-Mart (Bloomberg, 2011). The year 2011 saw price wars in between retailers in February and March on everyday groceries in the fears of losing business due to rise in taxes and austerity cuts by UK Government (The Wall Street Journal, 2011). Recommendations Those investors who opt for long-term investments look for fundamentally strong shares and low valuation. The long-term investment time horizon is usually for more than 5 years. Simply by studying the shares’ movement for four weeks does not provide the idea of the shares’ price trends. Therefore the decision to invest for long period cannot be based on the findings from shares movements. However it can be said that the shares are defensive shares and thus less risky. Based on the findings from the financial analysis of Sainsbury and Tesco’ annual reports and their recent business activities, both the shares are meant for low-risk investors. Based on the ratio analysis, Sainsbury is a better share as it is undervalued and has greater operational efficiency which is a core requirement to stay profitable in the industry. For those investors who are willing to invest in high P/E with high profitability and better liquidity position can invest in Tesco. Both these shares are defensive shares and are not recommended for investors with appetite for high risk and requirement of high returns. Part C About IASB & FASB The IASB is an independent body of the IFRS Foundation and is responsible for development and publication of the financial reporting standards i.e. IFRSs. The standard-setting body works in association with the investors, analysts, accountants, accounting standard setters, regulators, and business leaders around the world in fulfilling the standard-setting duties. IASB’s meetings are held in webcast and public. IASB’s standard setting duties are published as discussion papers and exposure draft for public comments. IASB has an interpretative body, the IFRS interpretations committee which has 14 voting members appointed by Trustees (IFRS Foundation, 2011). The FASB was established in 1973 as an independent organization for establishing financial accounting standards that govern the preparation of financial reports by private sector entities in US. The standards issued by FASB are recognized as authoritative by SEC and AICPA. FASB’s mission is to establish and improve financial accounting and reporting standards for the interests of the investors. FASB has 7 full-time members appointed by Foundation’s Board of Trustees. In its standard setting process, it objectively considers all the stakeholders views. The standard setting process is subject to oversight by FAF’s (Financial Accounting Foundation) Board of trustees (Financial Accounting Standards Board, n.d.). Transitional Reliefs The IASB and FASB met on 14 June 2011 in London to affirm their decision on the exposure draft on ‘Revenue from Contracts with Customers’ and discussed the proposed standard’s effect on telecommunications and other firms, transition requirements and necessity to re-expose the proposed standard. The boards require the firms to apply the proposed standard on retrospective basis. In order to relieve the firms from the burden of applying the new standard in the first year the boards have provided the following transition reliefs: 1. The firm need not restate the contracts that begin and end in the same reporting period. 2. The firm is permitted to use its own perception and observation to estimate the variable consideration in comparative reporting periods. 3. The firm can perform the onerous test at effective date if it has not recognized the onerous contract liability in the previous comparative reporting period. 4. The firm need not disclose the maturity analyses for prior periods The firm should apply the transitional relief consistently to all transactions in all the comparative periods. The boards also decided that if any firm employs any of the four reliefs it should disclose the following: 1. The reliefs employed by the firm. 2. If possible, a qualitative assessment of the probable effect of applying those reliefs The disclosures were supported by 5 members of FASB and 8 members of IASB (IFRS Foundation-a, 2011). Conclusion This project presented the financial analysis of the two UK-based companies J Sainsbury Plc and Tesco Plc. Tesco is the largest retailer in UK based on the market capitalization whereas Sainsbury is UK’s third largest retailer. Based on the findings of the analysis Sainsbury is a better option for long term investment because its share is undervalued as evident from low P/E and has greater operational efficiency. The operational efficiency is a very important indicator of a retail firm. As both the shares are less risky, therefore the investment recommendation will be suitable for investors who have low risk profile. References Bloomberg. (2011). Tesco growth to outpace rivals – BusinessWeek. [Online]. Available at: http://www.businessweek.com/ap/financialnews/D9LEKU180.htm. [Accessed on November 10, 2011]. Financial Accounting Standards Board. (No date). FASB Facts About FASB. [Online]. Available at: http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176154526495. [Accessed on November 10, 2011]. IFRS Foundation. (2011). About the IFRS Foundation and the IASB. [Online]. Available at: http://www.ifrs.org/The+organisation/IASCF+and+IASB.htm. [Accessed on November 09, 2011]. IFRS Foundation-a. (2011). IASB / FASB June 2011. [Online]. Available at: http://www.ifrs.org/Current+Projects/IASB+Projects/Revenue+Recognition/Meeting+Summaries+and+Observer+Notes/IASB+June+2011.htm. 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Appendices Appendix 1: Group Income Statement of J Sainsbury Plc for the Year ending 19 March 2011 Source: (J Sainsbury Plc-b, 2011, p.50) Appendix 2: Balance Sheet of J Sainsbury Plc as on 19 March 2011 Source: (J Sainsbury Plc-b, 2011, p.52) Appendix 3: Cash flow Statement of J Sainsbury Plc for the Year ending 19 March 2011 Source: (J Sainsbury Plc-b, 2011, p.53) Appendix 4: Group Income Statement of Tesco Plc for the Year ending 26 February 2011 Source: (Tesco Plc-c, 2011, p.94) Appendix 5: Group Balance Sheet of Tesco Plc as on 26 February 2011 Source: (Tesco Plc-c, 2011, p.96) Appendix 6: Cash flow Statement of Tesco Plc for the Year ending 26 February 2011 Source: (Tesco Plc-c, 2011, p.98) Read More