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Analysis of the financial statements of tesco

This report is an interpretation and analysis of the financial statements of Tesco in relation to its performance and position in the retail sector. The main aim is to secure an ideal short term investment for Bob in relation to; high dividends, prospects of high dividend growth, high profit growth in the past, prospect of high profit growth in the past and short term investment. The report gives a brief history of the company, its management structure and remuneration, industry analysis, company trend, its financial ratios and finally a summary and recommendation encouraging Bob to invest in the company.

Tesco was originated in the markets of London’s East End, where in 1914, war veteran Jack Cohen began to sell groceries. The brand name of Tesco first appeared on tea packs in 1920s. Tesco was an amalgamation of T. E Stockwell, a partner in the firm of tea suppliers, and the first two letters of Cohen. The first Tesco store was founded in 1929 in Burnt Oak, Edgeware. Following the success of self service stores in US, Mr. Cohen opened the first self-service store in St. Albans in 1948. Gradually the business expanded and in 1960 it became a familiar household name selling household goods and clothes. This has expanded to include consumer electronics, oil and financial services.

Management structure and remuneration

The Tesco board is headed by David Reid who has served on the board since 1985; he became the chairman in 2004. The management team is led by Sir Terry Leahy who joined Tesco in 1979; he was appointed to the board in 1992 and became the CEO in 1997. Laurie Mcwllee is the group finance director. He joined Tesco in 2000 and was appointed to the board in 2009; he is currently a member of the 100 Group of Finance Directors.(annual report 2009)

Directors’ remuneration is performance-related and delivered in shares to align the interests of shareholders and executive directors (2009 annual report). The performance is reported quarterly to Tesco’s Board.

Industry analysis

Tesco PLC is the largest retail company in the UK, both by global sales and domestic market share, and the fourth largest in World. Its Total Share Return (TSR) is compared against the FTSE 100 and other international retailers such as Sainsbury, Morrison, Carrefour, Safeway Inc, Ahold, Walmart and Targe. TSR is the notional return from a share or index based on share price movements or declared dividends. The remuneration Committee’s consideration of the growth performance in respect of the 2008/9 award shows that Executive Directors have been awarded 90% of the potential maximum for cash element and 90% of the potential maximum for deferred shares element of that part of their annual bonus measured with reference to Total Shareholder Revenue (TSR), Earnings Per Share (EPS) and Corporate objectives.

Graph as shown in Tesco annual report 2009, TSR for Tesco between March 2004 and February 2009. P.53.

The graph illustrates the Group’s TSR performance for the last 5 years, in relation to FTSE 100 companies. This is to establish a broad-based comparator group of retail and non-retail companies of similar scale to Tesco.

Company trend

Tesco is invested in growing its business in all of its markets. However, more emphasis has been placed in overseeing their overseas expansion. The company’s entrance into the US and its increasing presence in Asia and the rest of Europe are major indicators of the trend the company wishes to follow. The overall number of stores has increase from 2334 in 2005 to 4332 in 2009.

Growth prospect of the company:

In order to give a full analysis of the growth of Tesco, the following key performance indicators will be considered; the sales growth, profit, earnings, number of stores and presence in the new market.

Years

2009

2008

2007

2006

2005

Sales turnover

54327

47298

42641

39454

33866

Profit

2166

2130

1899

1576

1347

Earnings

2161

2124

1892

1570

1344

Number of stores

4332

3751

3263

2672

2334

Tesco has witnessed a consistent growth over the past 5yrs with sales growth moving from 12.4% in 2005 to 15.1% in 2009, the number of Tesco stores also has grown from 2334 in 2005 to the current 4332. The company has also increased its presence in other markets across Europe and Asia with the aim of growing in business.

It has also witnessed a growth in profit and earnings per share over the last 5yrs with the managements focus growing in Asia and the rest of Europe as well as increasing the company’s market share. The growth potential of Tesco in terms of profit and earnings are quite good.

General company performance:

In assessing the company’s performance, this report would make use of the ratio analysis for a period of five years in providing an analysis of the financial health of the company. The ratios used are as follows: The performance, Efficiency, Liquidity, Gearing and Investments of the company.

Performance. Here we employ profitability ratios to give us an insight of how well a company is generating wealth for the shareholders/owners. The following ratios were considered under profitability: Return on capital employed (ROCE), Operating profit ratio, Gross profit ratio and Return on shareholders’ funds (ROSF).

Return on capital employed (ROCE): this is the key profitability ratio in measuring business performance; it states a relationship net profit generated and the average long term capital invested in the business during the period. This is vital in assessing the effectiveness with which the funds have been deployed. (Mc Laney &Atrill 2005).

ROCE is calculated as;

Year

2009

2008

2007

2006

2005

ROCE

22.73%

23.55%

25.10%

23.67%

21.89%

The ROCE for TESCO over the five years shows it increases between 2005 and 2007 and a slight decline in profitability between 2008 and 2009. The decline in profitability could be attributed to external economic factor i.e. the global financial crisis of 2008-2009.

Return on Shareholder Funds (ROSF): this is a measure of profit for a certain period which is available to the owners or shareholders stake in a business. A high ROSF percentage indicates that d company is profitable and has more profitability for shareholders. It is a narrower assessment of profitability than the return of capital employed and allows us to take a deeper look which gives us an insight into d profitability of d company. It is calculated as:

Year

2009

2008

2007

2006

2005

ROSF

16.67%

17.90%

17.96%

16.69%

15.57%

The ROSF shows a decline for 2009 when compared to its performance in the previous years that is 2008, 2007, and 2006. However, it achieved its best performance in 2007 and the 2009 figure did not drop back to its lowest in 2005. The steady increase in gearing and a decline in interest cover ratio had the effect of a slight increase in ROSF. Also, the business must have been able to borrow at a lower rate of interest to boost the returns of shareholders.

Operating profit margin: this shows how efficient the company is in converting revenue to net profit. It is used to make valid comparisons with foreign companies or companies with a different capital structure. It is calculated as;

Year

2009

2008

2007

2006

2005

Operating profit margin

5.90%

5.90%

6.21%

5.78%

5.76%

This ratio allows us to compare the profits made from sales with the sales revenue that is for every pound made from sales. In 2005, 5.76 pence was set aside for profit and so for the other years. It shows that the ability of the company to make more profit from sales indicates an increasing trend up to 2007 and a decline in 2008 but stabilized in 2009 which could be linked to the global financial meltdown.

Gross profit margin: this measures the ability of the company to sell goods more than the cost of production. (Collins & Mckeith 2010) It is therefore a measure of profitability of trading activities before other expenses are taken into account.

Gross Profit Ratio =

Year

2009

2008

2007

2006

2005

Gross profit margin

7.76%

7.67%

8.12%

7.67%

7.78%

Graph

The gross profit margin shows a slight fluctuation year in year out with the gross profit margin for 2009 indicating that gross profit is higher relative to sales revenue in 2009 than it was 2008 which is also relatively lower than 2007. This is due to a change in pricing policy and production efficiency; however the 2009 figure is lower compared to 2007 and this can be attributed to the impact of inflation on cost.

Comments on Profitability

The operating margin held steady at 5.90% for 2009 and 2008 while it declined when compared to 2007 figure by 0.31. The gross profit margin also held steady around 7.7% for 2009 and 2008 while it shows a decline by 0.45% when compared with 2007. Since the decline in gross profit is higher than is obtained for operating profit margin, this shows a fall in profitability for the years’ 2008 and 2009. This could be attributed to external adverse economic factors of 2008/09 affecting sales level.

Efficiency Ratios allows us to measure how various resources available to a business are utilized. The following ratios were employed in estimating the efficiency of Tesco; asset turnover and inventory turnover. We calculated two asset turnovers:

Asset turnover:

AND

Years

2009

2008

2007

2006

2005

Asset turnover

1.94

2.38

2.56

2.62

2.34

Asset turnover 2

1.70

1.98

2.11

2.12

2.00

The first one is a measure of revenue in terms of net assets. This allows us to measure how much is generated in terms of every pound of net assets.

The second is the measure of revenue in terms of fixed asset which allows us to see how well the fixed assets available to the company are utilised.

The asset turnover of Tesco dropped in 2009, 2008 compared to all other years. This could be related to a drop in cost of sales as a result of the economy breakdown.

Inventory turnover: this measure the average stock turnover period for company. It measures the number of days it takes Tesco to sell an item of stock.

Formula:

Year

2009

2008

2007

2006

2005

Inventory stock

19.44days

20.31days

17.89days

14.67days

15.30days

On the average, the stock turnover takes 19.44 days in 2009. This is an improvement on the 2008 turnover rate of 20.31 days but still a far cry from the 2006 turnover rate of 14.67 days, it can therefore be said that stock turnover for Tesco’s has fluctuated over the years due to timing of orders and dispatch. However the 2009 rate shows signs of promise when compared absolutely against the 2008.

Sales revenue per employee ratio:

Year

2009

2008

2007

2006

2005

Sales revenue per employee

115957.47

106496.57

103231.73

107149.94

100866.72

Sales revenue to employee measures how well employees are utilised in a company. It is a measure of productivity of the work force.

Productivity has consistently grown except for 2007 where there was a decline in productivity. However, productivity picked up in 2008/2009

Liquidity ratios: It measures the ability of a firm to meet its short term financial obligations. The following ratios are used: acid test (quick ratio) and current ratios.

Current ratio: it is a measure of a company’s short term liquidity position. It compares current assets with current liabilities. Where the current ratio is greater than unity, it means current asset is greater than current liabilities. The ideal current ratio for a firm depends on the industry it operates and its own time series range for previous years. (Elliot & Elliot, 2008).

The formula for calculating this is:

Year

2009

2008

2007

2006

2005

Current ratio

0.76

0.58

0.51

0.50

0.57

In the case of Tesco, the current ratio is within the company range. However to better understand the current ratio; it would be appraised in conjunction with the acid test.

Acid test (Quick ratio): this is similar to current ratio. It indicates d ability of a firm to repay immediately its short term financial obligations using cash or near cash. It excludes the value of inventory.

Year

2009

2008

2007

2006

2005

Quick ratio

0.61

0.35

0.27

0.30

0.34

The acid test of Tesco is within its normal range as a retail company. It however sells inventory very quickly for cash.

Gearing ratios: Financial gearing occurs when a business is financed by part borrowing instead of finance provided by the owners. The level of gearing that is the level in which a company is financed by sources that require a fixed return is important in assessing risk (McLaney & Atrill). The following two ratios are considered: gearing and interest cover. The gearing structure of a company refers to the amount of borrowing to the amount of shareholder’s fund and a company with high gearing is predominantly financed by debt and that which is low is financed by shareholder’s equity.

Gearing: it measures d proportion of capital employed which is accounted for by long term fixed interest debt. The gearing structure of a company.

Year

2009

2008

2007

2006

2005

Gearing

48.81%

33.41%

28.17%

28.39%

34.52%

The gearing for Tesco shows a decline between 2006/2007 that is a reduction in the debt component of its finances and a substantial increase in 2008/2009. As a result it has generated a proportionate increase in ROSF. However, it is still below the safe limit of 50%.

Interest cover: measures the amount of profit available to cover interest payment.

Year

2009

2008

2007

2006

2005

Interest cover

5.70

6.81

7.04

6.26

5.58

The interest cover shows that profit can cover interest payable 5 times over in 2009 and 7times in 2007. This is in conjunction with the accounting standard that a company’s interest cover should exceed 3 times and so Tesco’s interest costs are within limits.

Shareholder Investment ratios: these are ratios designed to help investors assess the returns on their investment.

Earnings per share: relates the earnings generated by a business and available to shareholders for a period to the number of shares in issue of the same period. Earnings per share are a measure of share performance and it allows us to access the investment potential or a company’s share over time.

Year

2009

2008

2007

2006

2005

EPS(pence)

27.50

26.95

23.61

20.07

17.44

The earnings per share for Tesco have shown a steady rise over the years and this show that Tesco has a viable investment potential of its business shares.

Price earnings ratio (P/E): it is a measure of market confidence in the share of a company. However market price also takes into account anticipated change in earnings arising from d assessment with macro event (Elliot & Elliot, 2008- 674). The P/E ratio measures the confidence of the market in the future earning power of the business. Consequently, the higher the P/E ratio, the more investors are willing to pay in relation to the earning stream of the business. (McLaney & Atrill-236)

This ratio is calculated as follows:

Year

2009

2008

2007

2006

2005

P/E ratio

12.07

14.84

18.30

16.52

16.75

The price for Tesco ordinary share has historically been volatile which could cause a loss of part of the investment. The market price of Tesco like the price of other retail companies is volatile. In addition, the stock market has experienced extreme price and volume fluctuations. However, investors are willing to pay in 12.07p in 2009 for every penny of earnings as opposed to 2008 where they were willing to pay 14.84 and 18.30 in 2007 for every one penny of earnings.

Dividend per share: is the total allocated dividend payment divided by the number of shares in issue.

Year

2009

2008

2007

2006

2005

Dividend per share(pence)

0.11

0.10

0.06

0.06

0.06

Dividend cover: indicates the cushion that exists to meet dividend payment in d future. It shows how many times a company can keep paying dividend with poor earnings if earnings were to deteriorate.

Year

2009

2008

2007

2006

2005

Dividend cover

2.44

2.68

4.07

3.57

3.01

It suggests that should there be poor earnings Tesco will be able to cover dividend payment twice over by 2009 figure and they would be able to cover it approximately 3 times in 2008 and 4times over in 2007. This shows that the dividend cover for Tesco has reduced over the years since 2007.

Dividend yield: it measure the annual return received by way of a dividend as a percentage of the current price. This helps investors to access the cash return on their investment in the business. It must however be noted that it is not a measure of the total return to the shareholder since a growth of value in a share is not taking into account (Collins & Mckeith-642)

Year

2009

2008

2007

2006

2005

Dividend yield

2.99%

2.07%

0.90%

1.26%

1.26%

It has consistently increased over the years from 1.26 to 2.99 and a drop in 2007.

Dividend Policy

Tesco makes annual dividend payment to its shareholders. The company has a dividend cover estimated as 2 times, that is the company could cover at least 2 more dividend payment even if earnings performed badly.

The dividend yield stands at 2.99% for 2009 which shows that the company returns on the average of 3% on shares through dividends, (this is outside of the return on investment due to share growth). On the average the company pays a dividend of 11 pence per share.

Recommendation

Tesco PLC is a UK based supermarket chain, the largest in Britain both by global sales and domestic market share and the fourth largest retailer in the world. The company has an above average total shareholder return when compared with the FTSE 100. It has a strong management team led by Sir Terry Leahy, who has been with the company for over thirty years. The management directors are aligned with shareholder’s objectives through the remuneration policy employed by the company. It has a strong growth potential as a result of its expanding presence in US, Asia and the rest of Europe.

The key performance indicators for profitability in terms of efficiency, gearing and liquidity show good performance on the part of the company’s investment. Also, good investment ratios that is the dividend cover, earnings per share. Its remuneration strategy is a good one as it safeguards both the interest of the executives and the shareholders. Based on the quality of management, potential for growth and the performance of the company, it is my recommendation that Tesco is a viable investment choice.

In conclusion, profits, liquidity and gearing which are important for short term investment are good.

Tesco’s earning per share indicates a growth potential to keep up earning in d future.

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