Financial Analysis of Tesco Supermarket - Research Paper Example

Running Head: TESCO PLC AND J. SAINSBURY PLC: A FINANCIAL PERFORMANCE COMPARISON Tesco Plc and J. Sainsbury: A Financial Performance Comparison in APA Style by Student's Name Introduction to Financial Accounting University Table of Contents I. Executive Summary 3 II. Introduction 4 III. Company Background and Comparison 4 A. Tesco Plc 4 B. J. Sainsbury Plc 6 IV. Methods, Analysis, and Findings 7 A. Financial Ratios 8 B. Analysis and Findings 10 V. Conclusion and Recommendation 13 VI. Appendices 14 VII. References 18 I. EXECUTIVE SUMMARY This report looks at the financial status of Tesco Plc. In order to get a more accurate and adequate insight of its performance, it becomes important to benchmark it with a competitor that faces the same opportunities, challenges, threats, and risk. Thus, this report will compare the financial strategy and ratios of Tesco Plc with its rival J. Sainsbury Plc. This report will start by giving a brief background of the two organizations in terms of their financial approaches. The analysis and benchmarking of their financial ratios will follow. This paper concludes with a recommendation for Tesco Plc to improve its liquidity. For a potential investor, the stock of Tesco Plc is strongly recommended as better investment than its rival because it provides higher gains in the long-run. II. INTRODUCTION The performance of a business organization is quantitatively reflected in its financial statements. Ascertaining the financial health of a company has become important to different decision makers like managers, stockholders, potential investors and creditors. As such, it becomes important to evaluate the financial situation of any business organization to identify their relative strengths and weaknesses. In order to accomplish this task, this report will utilize financial ratio analysis. III. COMPANY BACKGROUND AND COMPARISON To complement the financial analysis, this section will be devoted in the discussion of the similarities and differences in the strategies and approaches utilized by Tesco Plc and J. Sainsbury. A. Tesco Plc From its humble beginning as a one-man business in 1919, Tesco is now highly regarded for its size and strength in the global retailing industry. Tesco is engaged in international grocery and general merchandising retail chain. It is named as the largest retailer in Britain in terms of global sales and domestic market share. During 2006, it is estimated that in every 8 spent is UK retail sales, 1 is spent on Tesco indicating its strong foothold of the market (Tesco Plc 2007). The success of Tesco is based on a fourfold long term growth strategy: "to grow the core UK business; to become a successful international retailer; to be as strong in food as in non-food; and to develop retailing services such as Tesco personal finance, Telecoms; and Tesco.com" (Tesco Plc). With this, Tesco has established presence in international markets such as Ireland, Hungary, Poland, Czech Republic, Slovakia, Turkey, Thailand, South Korea, Taiwan, Malaysia, Japan, and China and has complemented its core business with retailer service business such as online shopping, personal finance, and telecoms. In order to comply with regulatory requirements, Tesco has adopted the International Financial Reporting Standards (IFRS) in preparing its financial statements in the fiscal year 2005 (from UK GAAP). The adoption of IFRS is expected to lower the reported turnover and net income and increase debt. As with any other business organization, the company also recognizes the presence of risks and uncertainties in its operations. Financially, Tesco is facing challenges in "the availability of fund to meet business needs, the risk of default by counter-parties to financial transactions, and fluctuations in interest and foreign exchange rates" (Tesco Plc 2007). In order to ensure fund availability, Tesco employs policy which includes smoothing the debt maturity profile, arranging funding ahead of requirements and maintaining sufficient undrawn committed bank facilities, and strengthening credit rating. It should be noted that Tesco acquires an A1 credit rating from Moody and A+ from Standard and Poor (Tesco Plc 2007). Meanwhile, interest rate management is through forward rate agreements, interest rate swaps, caps and collars. As a player in the foreign market, Tesco is also exposed to the risk of foreign exchange rate fluctuations which it manage through the hedging of major investments in its subsidiaries via foreign exchange transactions in matching currencies. In order to attract and retain shareholders, Tesco strives to maximize shareholder value by paying adequate dividends and increasing earnings per share. It is reported that the company's largest shareholder is FMR Corporation which holds approximately 5.02% of its total stocks. In order to motivate its employees in enhancing financial success, Tesco offers a number of scheme including employee-profit sharing scheme, savings-related option scheme, partnership share plan. The company also strives to maintain its strategic partnership with suppliers by its on-time payment. It should be noted that Tesco does not report any trade payable on its balance sheets (Tesco Plc 2007). B. J. Sainsbury Plc Before 1995, J. Sainsbury Plc is regarded as the market leader in the United Kingdom retailing industry. The more intense competition in the market together with the management failures of its CEO David Sainsbury and his successors facilitated the overtaking of Tesco. To make things worse, J. Sainsbury is pushed into the third rank by ASDA during 2003. Taylor Nelson Sofres reports a 15.7% domestic market share for J. Sainsbury (J. Sainsbury Plc 2007). J. Sainsbury Plc's business operations include its supermarkets, online stores, convenience stores, and Sainsbury Bank. The company's main strategy is the provision of "great products at low prices." J. Sainsbury is also strongly committed in improving and developing its product ranges and the provision of excellent shopping experience to customers (J. Sainsbury Plc 2007). Compared to Tesco Plc which operates on a global basis, J. Sainsbury focuses only on serving the UK market. The fiscal year 2005, is a part of the company's recovery plan where the main focus is in increasing total sales by providing the needs of customers and balancing their needs of quality and healthy products. The company boasts of its new labeling program which recognizes the customers want of being informed of the nutritional content of what they are buying. The company plans to lead in this area by further providing healthier alternatives. As part of the recovery plan, the company launches its "Try something new" program which encourages customers to experience the improvements they have made (J. Sainsbury Plc 2007). Just like Tesco, J. Sainsbury also adopted the IFRS during its preparation of 2006 financial statements. However, it also discloses that the adoption did not change any of its accounts. The company also sees to it that its suppliers are paid on time leading to zero trade payables. J. Sainsbury has been having a hard time financing its resources through equity because of the decline in its stock price. The company continues its effort through the payment of dividends and enhancement of earnings per share. During 2006, the AXA SA and Brands Investment Partners are reported to have the largest shares of stocks having 13% and 11% of stocks, respectively (J. Sainsbury Plc 2007). IV. METHODS, ANALYSIS, AND FINDINGS Financial ratio analysis is a very essential tool in assessing the financial health of a business entity. It enables a financial analyst to spot trends in a business and to compare it with the performance of similar business enterprises within the same industry. This tool is currently utilized by business managers, investors, creditors, suppliers, and other decision makers in order to determine the financial performance and well being of a business organisation (Horngren 2000). Financial ratios are grouped into five categories, each showing a different aspect of a company's financial operations. These are profitability ratios, financial leverage ratios, liquidity/solvency ratios, efficiency ratios, and investor ratios. A. Financial Ratios In order to compare the financial performance of Tesco and J. Sainsbury, this report utilizes their annual reports for the five year period 2001-2005. It should be noted that as the two business organizations have shifted from UK GAAP to IFRS during 2006, their positions in that particular year are not comparable with the previous accounting periods. To facilitate the accurate computation, the balance sheet, income statement, and cash flow are encoded in a Microsoft Excel spreadsheet. The calculations are also conducted by the aforementioned software. The ratios utilized are classified according to the following aspects. In order to understand the analysis, this section will provide the theoretical frameworks and concepts utilized. Profitability ratios measure the ability of the company to generate income from its investments less the costs incurred. The computed gross profit margin is the ratio of gross profit to sales measures as a percentage of sales. Net profit margin, on the other hand, is the ratio of net income to sales. Return on capital employed (ROCE) is a variant of return on investment. The return on capital employed assesses the rate of return on the investments of common stockholders and long term creditors in the company (Analyzing Company Reports 2005). Another ratio is the turnover ratio which shows to what the extent the company uses its assets to produce revenue. Logically, higher profitability ratios indicate a healthier financial condition. Financial leverage ratios provide an indication of the long-term solvency of the firm. They indicate the extent of non-owner claims on the firm's profits as well as the firm's operating capability to meet its obligation. Gearing is the long-term debt to equity ratio which assesses the balance between liabilities and equity in the firm's long term resource structure. Another is the interest coverage ratio which measures the extent to which earnings cover the interest obligation of the company (Thomson 2002, p. C-6). Liquidity or solvency ratios are used as measures of the company's ability to finance its short-term obligations by its cash and near cash items. Included in these ratios are current, acid test or quick, and cash ratios. Current ratio expresses the "working capital' relationship of current assets available to meet the company's current obligations. Quick ratio is an indicator of the extent to which a company can pay current liabilities without relying on the sale of inventory and without relying on the receipts of the accounts receivables (Horngren 2000, p.153). On the other hand, cash ratio indicates percentage of current liabilities that can be immediately paid off by cash. Higher ratios indicate more liquidity. Activity ratios are operating efficiency measures, which determine the ability of a company to maximise its output given a certain level of resources. These ratios significantly gauge the asset, investment, and cost management performance of the business entity. Ratios under this category are average debtor's turnover, stocks turnover, and creditor's turnover. Investor ratios are financial ratios especially designed to covey to investors the asses the profitability of the company's stock as an investment. Earnings per share shows the return to common stock shareholder for each share owned (Fraser and Ormiston 2004). As stockholders gain from the company's distribution of dividends, annual dividend pay-outs are also considered. Return on equity measures the ability of a business organization to maximize shareholder value. According to the Du Pont technique, this measure is the ultimate indicator of the company's financial health. B. Analysis and Findings The computed financial ratios shown in the appendices shows the financial situation of Tesco Plc and J. Sainsbury from the fiscal year 2001-2005 in the categories considered. Profitability All the ratios computed in this category strongly indicates the higher profitability of Tesco Plc's operation relative to its rival J. Sainsbury Plc. Over the five year period of 2001-2005, Tesco records an average ROCE of 0.207 impressively higher than J. Sainsbury's 0.095. It should also be noted that Tesco's ROCE improved by 1.8% while that of its competitor slumped by 11.7% during 2005 and 2004. Tesco also leads in terms of asset turnover, generating revenue which is almost four times its total assets. J. Sainsbury is not far behind at 3.456. It should be noted that Tesco's asset turnover has been in a decline since 2002 while the financial recovery program of J. Sainsbury seems to be improving the turnover generated by its assets. During the five year profit, gross profit margin of Tesco averages at 0.077 while J. Sainsbury's averages 0.036. This high discrepancy in the ratios indicates Tesco's higher bargaining power with its suppliers. For J. Sainsbury, this can reveal the retailer's effort in charging lower prices by charging minimal premiums. Tesco is also superior in terms of net profit margin by being able to turn 4% of sales into profit. J. Sainsbury lags behind with 0.4% indicating its less efficiency in managing its costs (Appendix 1). Financial Leverage In terms of capital structure, both of the companies show increasing preference for debt financing indicated by the growing gearing ratio. During 2006, Tesco shows a capital structure of 33:67 in favor of equity which is riskier than the 28:72 reported in 2001. J. Sainsbury, facing the difficulty of attracting equity investments, also relies in the higher debt financing. The capital structure of the company in 2006 is almost the same with Tesco at 32:68 in favor of debt. However, this is a larger shift from the 18:82 in 2001 which warrants the quick ballooning of debt (Appendix 2). Both of the company's debt financing entails the periodic payment of interest. Tesco Plc appears to have no problem with this because of its high interest coverage ratio. The company's earnings before tax and interest can cover its twelve times of interest liability in 2006. This is a large improvement from the 8.750 average during 2004-2005. J. Sainsbury used to report excellent capacity in paying its interest expense. However, this is eroded in 2005 when interest coverage ratio slumped at 1.163 from the averaged 8.762 during the previous years (Appendix 2). Liquidity In general, both companies show low level of liquidity indicated by the less than one computed current, quick, and cash ratios. Tesco's current ratio in 2005 is 0.569 while quick and cash ratios are 0.354 and 0.132, respectively. J. Sainsbury reports better liquidity with average current ratio of 0.843 which is almost double that of its competitor. In 2005, the company's current asset can pay off 91.8% of its immediate liabilities. Deducting the company's stocks, liquid assets can cover 79.9% while cash can adequately finance 14.3% of its current obligations in 2005. Aside from this higher liquidity, J. Sainsbury's liquidity is in an increasing trend (Appendix 3). Activity Overall, Tesco Plc shows more efficient management of its day to day transactions compared to its competitor. During the five years considered, Tesco's do not report accounts receivable because all sales are collected by the time they are generated. Trades payable are within an average period of 31 days while stocks are moved from the warehouse and are turned into sales in a period of 15 days. J. Sainsbury reveals less efficiency with a collection period of 6.172 days and trade payment period of 39.785 days. Even though the company is able to move its inventory faster in 2005 relative to Tesco, it still averages longer at almost 17 days (Appendix 4). Investor Ratios With the failure of J. Sainsbury, it had made an aggressive effort in attracting investors through the issuance of higher dividends. Thus, in terms of dividend yield, the company has a far higher average than Tesco. J. Sainsbury manages to pay an annual average dividend of 13.646p far from the 6.236p of Tesco. Even though J. Sainsbury reports negative earnings per share in 2007, 2001-2005 average is still higher than Tesco. The former reports an average EPS of 15.4p while the latter records 11.29p. Overall, Tesco maximizes shareholder value with a high ROE of 0.143 indicating that each 1 invested in it generates 14.3p (Appendix 5). V. CONCLUSION AND RECOMMENDATION The financial ratio analysis conducted above shows the financial positions of two large retailers in the UK market. Tesco Plc shows superior profitability, efficiency, financial leverage, and return to investor. However, it lags behind J. Sainsbury in terms of liquidity. Thus, the overall recommendation for Tesco is to improve its liquidity by allocating more liquid assets. The company can do this by allocating more cash in its fund to cushion the possibility of having all its current liabilities becoming due. For a potential investor contemplating in investing his fund in either of the two companies, this report strongly recommends Tesco Plc as it generates higher gains for its investors in the long run. It should be noted that even though J. Sainsbury allocates high dividends for its investors, this is only in the short run. Without being able to recover financially, the company cannot adequately provide gains for investors. VI. APPENDICES Appendix 1-A. Profitability Ratios of Tesco Plc Appendix 1-B. Profitability Ratios of J. Sainsbury Plc Appendix 2-A. Financial Leverage Ratios of Tesco Plc Appendix 2-B. Financial Leverage Ratios of J. Sainsbury Plc Appendix 3-A. Liquidity Rations of Tesco Plc Appendix 3-B. Liquidity Ratios of J. Sainsbury Plc Appendix 4-A. Activity Ratios of Tesco Plc Appendix 4-B. Activity Ratios of J. Sainsbury Plc Appendix 5-A. Investor Rations of Tesco Plc Appendix 5- B. Investor Ratios of J. Sainsbury Plc VII. REFERENCES Brealey and Myers 2005, Principles of corporate finance, McGraw-Hill, 8th Edition. Fraser, L. & Ormiston A 2004, Understanding Financial Statements, Pearson-Prentice Hall: Upper Saddle New Jersey Horngren , C. et. al..2000, Accounting.4th ed. New Jersey: Prentice Hall J. Sainsbury Plc, 2007, Retrieved 19 March 2007, from http://jsainsbury.co.uk Keown, A.J., Martin, J.D., Petty, J.W., and Scott Jr., D.F, 2005, Financial Management principles and applications, Pearson/Prentice Hall International Edition, 10th Edition. Tesco Plc, 2007, Retrieved 19 March 2007, from http://www.tescocorporate.com Thompson, A. & Strickland , J 2002,Strategic Management.3rd ed. New York McGraw- Hill Read More