TESCO: Forecasting Financial Statements - Case Study Example

TESCO – FORECASTING FINANCIAL MENT There are many business entities that operate in this world to earn revenues for their respective owners. Shareholders are the basic owners of companies whose stocks are traded at stock exchanges. Shareholders usually invest their money into an organization hoping to receive good return on their investments. These organizations are operated by their respective managements and usually the management has its own interest above that of the shareholders. Thus to give a proper financial proof of the organization’s operation they (the management) are required to produce up-to-date financial statements. These financial statements give a proper understanding to the shareholder, owners and other potential investors of a company’s financial operation performed by the management throughout the specified period of the time. Besides this, financial statements are a mandatory thing to be produced by any business existing with an aim of making profit. Under the Legal Law of any country it is a requirement for companies to make financial statement in such a manner that they correctly portray the financial condition of an organization. The basic financial statements that are prepared by any company include: Statement of Comprehensive Income Statement/ Income Statement Balance Sheet/ Statement of financial Position Cash Flow Statement Forecasting financial statements involves future prediction and estimation of many different accounts of the financial statements. The basic method used for forecasting financial statements is the Percentage of Sales method. This method involves the items of the balance sheet and the income statement to directly vary with the appropriate change estimated for the growth rate in sales. The basic problem with forecasting financial statement is that it uses lots of prediction and estimation, these estimations can never be fully accurate. Besides this, before using this technique, a big assumption is made that the company’s operations are performed efficiently and that the company has the necessary assets and liabilities for the existing situation. Besides this assumption there are many other things to consider when forecasting financial statements such as “some liability and equity accounts can be tapped by the financial manager for any external financing needed. This is called negotiated sources. It is the amount that you plug in somewhere to make the balance sheet balance. The accounts that will go up with sales are called spontaneous”. (Financial Forecasting and Pro-Forma Statements) TESCO is a well diversified company working in many different ventures; it has over the years created a great deal of value in the eyes of their customer Company Profile “Tesco operates 923 stores and employs 240,000 people, giving us access to a population of 260 million across our nine markets. Over the past five years, we have expanded from our traditional UK supermarket base into new countries, products and services, including a major non-food business, personal finance and internet shopping. The increasing scale and internationalization of our sales and purchasing operations makes a significant contribution to our efficiency and profitability, as we progress towards our long-term goal of becoming a truly international retailer” (Global Sources). FORECASTING FINANCIAL STATEMENT – TESCO FEBRUARY 2010 First Step: Calculate compound annual growth rate. Second Step: Express the Balance Sheet and Income Statement items which vary directly with Sales as percentages of Sales Calculating compound annual growth rate (Sales Revenue) = (Future Value/ Present Value)1/n – 1 Where; Future Value = Total Group Sales in 2009 Present Value = Total Group Sales in 2005 N = number of years The Compound Annual Sales Growth Rate for TESCO (5 years) = (54,327/ 33,866)1/5 – 1 Growth Rate = 9.9 or approximately 10% Percentage of Sales Calculation Description Detail (2009) Calculation Percentage Cash Cash/ Sales 3,509/ 54,327 * 100 6.5% Inventory Inventory/ Sales 2,669/ 54,327 * 100 5% Accounts Receivable Accounts Receivable/ Sales 1,798/ 54,327 * 100 3.3% Administrative Expenses Admin Exp/ Sales 1,248/ 54,327 * 100 2.3% Accounts Payable Accounts Payable/ Sales 8,522/ 54,327 * 100 15.7% COGS COGS/ Sales 50,109/ 54,327 * 100 92.2% Taxation Taxation/ Sales 788/ 54,327 * 100 1.5% Net Income Profit for the year/ Sales 2,166/ 54,327 * 100 4% Fixed Assets Non-current assets/ Sales 32,008/ 54,327 * 100 59% Note: The items chosen above in the table all affect Revenue or are affected by Revenue Assumption: Fixed assets are at full capacity and would vary with sales Preparing Partial Pro-forma Financial Statement S1= S0 (1 + g) = 54,327 (1+0.1) = 59,760 Where; S1 = the forecasted Sales level, S0 = the current Sales level, and g = the forecasted growth rate in Sales (Elizabeth, 2001) Based upon the percentage calculations above, the figures would be calculated as changes to percentage in sales. FINANCIAL ANALYSIS AND LETTER TO THE MANAGEMENT   To interpret any company’s financial statements, proper working needs to be done. There are certain Ratios that need to be calculated to analyse any company’s financial organization. TESCO’s financial analysis would also require the same thing. LIQUIDITY RATIO Liquidity Ratios evaluate a company’s ability to pay off their debts when they fall due. Basically it gives a basic picture of a running position of a company. There are two basic ratios that are calculated to ascertain a company’s liquidity position Current Ratio This ratio illustrates a company’s ability to pay off its short term obligation/ current liabilities (amount due within 12 months time) with the current assets that it holds. It is calculated as follows: Current Ratio = Current Assets ÷ Current Liabilities Acid Test Ratio/ Quick Ratio This ratio shows the company’s ability to pay off its current liabilities with the most liquid assets (assets easily convertible into cash) that it holds (Panesnath, 1982). The formula to calculate acid test ratio is: Acid Test Ratio = Current Asset less Stock/Inventory Current Liabilities The liquidity Ratios calculated for TESCO plc are as follows: Ratio Calculation 2009 Calculation 2008 2009 2008 Current Ratio 13.647/18,040 5,992/10,263 0.75 : 1 0.58 : 1 Quick Ratio 13,647 – 2,669/18,040 5,992 – 2,430/10,263 0.61 : 1 0.34 : 1 The liquidity ratios calculated above clearly predict that the company is facing some working capital issues, the feasible result for the current ratio is 2 : 1, whereas the feasible result for acid test ratio would be 1 : 1. According the ratios calculated, TESCO does not have the necessary current assets to deal with its current liabilities. GEARING RATIO Gearing is an essential element which helps in deciding upon the balance between equity and debt financing. The more highly a company is geared, the more difficult it would be for the company to raise further debt finance as high level of gearing denotes that the company is highly involved in debt financing. The higher the level of gearing, the higher would be the return required from the loan provider as he would be exposed to greater risk and the susceptibility that his money might go unpaid if the company goes bankrupt. Gearing is usually divided into two types: Financial gearing; measures the relationship between shareholders capital plus reserves and either prior charge capital or borrowings or both. The most common ways of calculating financial gearing are based on the balance sheet values of the fixed interest and equity capital. It is calculated using the formula: Financial Gearing = Prior Charge capital × 100% Equity capital (Including Reserves) Operational gearing; measures the relationship between contribution and profit before interest and tax. It is commonly calculated as such: Operational Gearing = Contribution Profit before Interest and Tax “However, Operational and Financial gearing have the common feature that an increase in either (i.e. higher fixed cost or higher debt) reduces the earnings available to shareholders and thereby increases their risk. High operational gearing also exposes lenders to the risk that, if an entity makes losses or suffers a serious fall in profits, their loans may not be fully or even partially serviced” (Capital Structure and Cost of Capital, 2006) Debt/Equity Ratio = Total Debts : Total Equity This ratio gives the proportion of the Debt and Equity acquired by any company to finance its operations Interest Cover = Profit before interest and tax Interest Interest cover is a measure of financial risk i.e. it shows a company ability to pay off its interest obligation on any borrowings that it has made with the profit that it makes in that period. According to the financial statements of TESCO, the ratios calculated would be as follows: Gearing Ratios - TESCO Ratio Calculation 2009 Calculation 2008 FY 2009 FY 2008 Financial Gearing 14,255/ 12,995 × 100% 7,174/ 11,902 × 100% 109.6% 60.3% Interest Cover 3,432/ 478 3,053/ 250 7 times 12 times Debt/ Equity Ratio 14,255/ 12,955 7,174/ 11,902 109.6% 60.3% Working Prior Charge Capital; 2009 2008 Borrowings 12,391 5,972 Derivative financial instruments and other liabilities 302 322 Post-employment benefit obligations 1,494 838 Other non-current payables 68 42 Total 14,255 7,174 Profit before interest and tax; 2009 2008 Operating profit 3,206 2,791 Share of post-tax profits of joint ventures and associates 110 75 Finance income 116 187 Total 3,432 3,053 According to the Gearing ratios calculated above, TESCO’s capital structure shows a heavy reliance upon Debt finance in the Year 2009 whilst in 2008 it has been more involved with equity financing. According to the financial gearing ratio any company having a gearing ratio of less than 100% is deemed to be a low geared company, at 100% it is said to be neutrally geared and above 100% ratio indicates a highly geared company. With reference to this information, the TESCO seems to be a low geared company in 2008 with a sudden increase in its debt making it a highly geared company in 2009. On the contrary, according to the Debt/Equity ratio, 50% is regarded as a safe limit to debt but in TESCO’s case both the year 2008 and 2009 has an increased level of debt making the company too much dependent upon debt financing. This may refrain them from acquiring any major borrowing from any institution in the future as their ratio buzzers an alarming position, besides if TESCO obtains debt finance in the future, it would have to pay a heavy amount of return to its creditor because the one giving out the loan to the company would be exposed to greater risk in the future as compared to prior years. Interest cover is a measure of financial risk i.e. it shows a company ability to pay off its interest obligation on any borrowings that it has made with the profit that it makes in that period. TESCO’s interest cover is not that low compared to the fact that the company has a good profitability rate. Despite the increase in borrowings and interest paid by the company, it has an increase of approximately 2% in profits for 2009 as compared to 2008. The overall situation for the company with reference to the capital structure does not seem much alarming but if the company pays off some of its long term obligation in the near future, it may further improve their financial position and the capital structure as well. (Annual Report, TESCO, 2009) BIBLIOGRAPHY Annual Report and Financial Statements 2009 www.tescoplc.com/annualreport09 Capital Structure and Cost of Capital, MANAGEMENT ACCOUNTING – FINANCIAL STRATEGY, 2006 Chattopadhyay, Panesnath. Solvency and Liquidity Ratios. Bombay: Commerce, 1982. Financial Forecasting and Pro-Forma Statements http://academic.uofs.edu/faculty/gramborw/tufinfor.html Financial Planning and Forecasting Financial Statements, .docstoc, Documents for Small business and Professionals,2009 http://www.docstoc.com/docs/3563682/Financial-Planning-and-Forecasting-Financial-Statements/ Global Sources, Buyer Profile, TESCO http://www.globalsources.com/PEC/PROFILES/TESCO.HTM Howard, Elizabeth. Earnings Restatement and Analysts Forecast Revisions. 2001 Read More