Financial Analysis of Tesco - Assignment Example

Financial Analysis of Tesco of Introduction This paper seeks to answer given questions about Tesco plc. in relation to the latter’s financial statements from its 2013 Annual Report. From the combined questions, this paper will essentially evaluate the company’s ratios on profitability, asset management efficiency, liquidity, solvency and others. The paper will conclude on what can possibly be done to improve the situation of the company, based on the evaluation of the ratios for the years 2013 and 2012 relation to the wealth maximization objectives of the company (Brigham & Ehrhardt, 2010; Brigham and Houston, 2009, Helfert, 2011). 2. Questions and Their Anwers 2.1 Question 1: What is (are) the principal activity(ies) of this business? The principal activity of the company is retailing. Retailing essentially involves buying and selling goods particularly on groceries and other home products. The company operates many stores not only in the UK but internationally as such it faces the risks of dealing with international currency transactions (Tesco plc, 2014). 2.2 Question 2: Comment on the outcome of the auditor’s report for Tesco Plc. Briefly discuss the importance the auditor’s report with respect to financial information. The auditor’s report of Tesco Plc for the financial statements in 2013 is an unqualified one. It means that it contained no qualification as to possible material misstatements in the contents of the company’s balance sheets and that the preparation of the financial statements follow the requirements of the international financial reporting standards (IFRS) as adopted by the European Union and requirements of the Companies Act of 2006 and Article 4 of the IAS regulation (Tesco plc, 2014, p. 71). Corporations are monitored in terms of corporate governance and financial reporting regulation is one way of doing the same (Clarke, and Chanlat, 2009). Having rendered an unqualified opinion, the credibility of the financial statements are enhanced for decision making purposes. 2.3 Question 3: Compute the ratios as required. Table A below, using prescribed template is the summary of the result of computation of required ratios on profitability (return on equity, gross margin and net profit margin), liquidity(current ratio), asset management (Inventory turnover period and Trade payables’ turnover period, and other ratios (gearing and price-earnings ratio for the years 2013 and 2012: Table A – Summary of computation ( Tesco plc, 2014; Reuters, 2014; Higgins, 2007, Helfert, 2001) 2.4 Question 4. Calculate the yearly percentage change in the following items (sales, operating profit) stating, in each case, whether the change is a rise or fall. a. Sales increased by 1.42%. The change is a rise b. Operating profit decreased by 47.68%. The change is a rise. c. Share price (pence) decreased by 0.60%. The change is a fall. 2.5 Question 5: Comment and reflect upon the ratios and percentage changes in items computed in your answers to questions 3 and 4. To comment on the computed financial ratios and the yearly percentages of Tesco is to explain the changes on what happened to the company’s profitability, liquidity, solvency and investment ratios. 2.5.1 Profitability and efficiency ratios. Profitability of Tesco declined from 2012 to 2013. From the companys ROE of 15.79% in 2012, it declined abruptly to 0.75% in 2013. The result of having a very minimal level of profitability is casting a suspicion as to possible resiliency of the company to generate value from each amount of expenses used in its operation since companies are expected to be profitable. Profitability implied having enough excess of revenues over expenses (Keiso, et al, 2007). This is also apparent in the gross margin which decreased by 4.46% from 2.52% to 2.41% as against industry average of 10%. See Table A above in relation to Table B below. Table B – Summary of Changes in the relevant accounts (Tesco plc, 2014). From the gross margin decline, the result could be further analysed in what happened to the net profit margin. Generally, if gross margin decreases, net profit margin is bound to decrease. The same was confirmed in the case of Tesco from 2012 to 2013. While total revenues increased only by 1.42%, the fact of lower gross margin provides evidence of lesser control on direct costs. This less efficiency was further aggravated by higher decrease in net profit margin compared with the change in gross margin. Connecting the analysis of gross margin, and net profit margin with the return on equity (ROE) could give more meaning to how the company performed compared with its competitors in the industry. This will be done in the Dupont analysis in another section. TESCOs two-year average return on equity (ROE) of below 9% % indicated an inferior superior performance about of its past performance compared to industry average of 19%. The ROE of below 1% in the 2013 implies that for every £100, the investors profit about less than £1. See Figures A and B below. Figure A – Comparative ROE Figure B. – Comparative gross margin and net profit margin 2.5.2 Asset management Inventory turnover period slightly deteriorated from 22.44 to 22.50 days. This means that the company became less slightly efficient in 2013. Generally, the lower the inventory turnover period , the better it is for the company (Johnson et al, 20003). But it increased in the case of Tesco, so it became more sluggish to make sale in 2013 despite the increase in revenues. However the inventory turnover period is still better than industry average of 50 days. See Table A above. Payable turnover period decreased but this is would appear less favourable to the company since it became faster for the company to make payment of liabilities as cash outflows got out easier . A decline in efficiency is therefore notable that management may be made to explain or account. 2.5.3 Liquidity Tesco appears to have managed its liquidity almost within the previous years level with a very slight improvement of 2.31% increase in its current ratio for 2013. Its current ratio registered at .642 in 2012 and this increased only to 0.657. Both of these ratios however are lower than industry average of 1.7. Evidently, Tesco is less liquid than average competitors, and it is even below the level of 1.0. See Table A above. However, given that that the retail industry involves daily cash inflow, the present level of liquidity although below 1.0 is still acceptable. 2.5.4 Gearing or Financial Leverage Tesco must build shareholder value by resorting to borrowings and equity combined in the context of optimum capital structure (Arnold, 2004; Banerjee, 1987). Thus a balance between level of equity and debt is needed. This power to borrow cannot be excessive to mean poor utilization of its debts as it may happen that a company would be paying finance charges if the extra funds remain idle (Higgins, 2007). Based on the foregoing discussion Tesco registered gearing of 31.94 and 31.43 for the years 2013 and 2012 respectively as against industry average of 4. See Table A above along with Figure C below This means that Tesco’s gearing ratio makes it almost nine times riskier than the industry average. Figure C. – Comparative gearing 2.5.5 Investment ratio. Surprisingly, price earnings ratio increased from 8.54x in 2013 to 19.31xin 2013 as against industry average of 9.0x. This is despite the decrease in profitability and increased in gearing ratio. 2.6 Question 6 .Using the DuPont analysis technique, evaluate and comment on any changes in profitability (ROE) from 2012 to 2013. To apply the Dupont analysis there is need to know the breakdown of the companys profitability ratios particularly the return on equity. ROE is actually broken down into asset turnover, net profit margin and equity multiplier. The formula for asset turnover is revenues divided total assets, while that of profit margin is net income divided by total revenues. The formula for equity multiplier is total assets divided total equity. It can be observed that the higher the equity multiplier, the higher would be resulting return on assets. Among the three ratios, only net profit margin decreased while asset turnover and equity multiplier increased. The slight improvement in asset turnover is contrasted by the slight increase in inventory turnover period from 22.44 days to 22.50 days. Hence efficient cannot be conclusively evident. Even the payment period became faster from 70.07 days to 36.47 days; although still lower than industry average of 20 days. This means that if there is high equity multiplier, there would be more debts than equity to finance the activity of company but this would mean higher risk by the company. The implication would be that the higher ROE was caused by effective or strategic financing by the company. In other words it was able to take advantage of higher leverage by increased borrowing and benefiting from the tax shield as a result of the deductibility of interest expense in the computation of the net income of the company. Since this decrease in the profit margin registered at a high of more than 95%, the same must have caused the huge decline in ROE from 15.79% to 0.75%. 3. Conclusion and Recommendation The investors responded favourably with higher price-earnings ratio as against average competitors because Tesco has fulfilled its promise to its stakeholders despite decline in profitability and risk position of the company. The slight improvement in liquidity and the maintenance of low gross margin allowed Tesco to satisfy its business model of making what matters better with its customers as shown in Appendix A. This paper recommends then maintaining such good relationship with customers with low gross margin but operating efficiency must be improved such as reducing its operating expenses to be able to increase its net profit margin. This would ensure a more stable increase in its profitability and shareholder value. References: Arnold, G. (2004). The Financial Times Guide To Investing: The Definitive Companion to Investment and the Financial Markets. London: FT Prentice Hall. Banerjee, B (1987). Financial Policy and Management Accounting. PHI Learning Pvt. Ltd., p. 955 Brigham, E. & M. Ehrhardt (2010). Financial Management: Theory and Practice. Cengage Learning, p. 530 Brigham, E. and Houston, J. (2009). Fundamentals of Financial Management, London: Thomson South-Western, pp. 14-439 Clarke, T. and Chanlat, J. (2009).European Corporate Governance: Readings and Perspectives. Routledge Helfert, E. (2001). Financial Analysis: Tools and techniques: a guide for managers. McGraw-Hill Professional Helfert, E. (2011). Techniques of Financial Analysis: A Mode. McGraw-Hill Education (India) Pvt Limited Higgins (2007) Analysis for Financial Management, Eighth Edition. The McGraw-Hill Companies Johnson, et al (2003). Financial Accounting. Tata McGraw-Hill Kieso, et al (2007). Intermediate Accounting. John Wiley and Sons Reuters (2014). Price Per Share of Tesco on December 31, 2012 and 2013. Retrieved 28 April 2014 < http://www.reuters.com/finance/stocks/chart?symbol=TSCO.L > Tesco plc (2014). Annual Report for 2013. Retrieved 27 April 2014 < http://files.the-group.net/library/tesco/annualreport2013/pdfs/tesco_annual_report_2013.pdf> Appendix A- Tesco’s Business Model (Tesco plc, 2014) Read More