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In the year 1919 Jack Cohen founded Tesco. He started out modestly, selling groceries from a small stall in the East End of London. Few would have guessed that eighty years later the business would stand as a multi-national phenomenon, an enterprise so successful and diverse it is recognised the world over.
A retailer of food and associated products, it also deals in electrical goods, music, videos, books, clothing, games, health and car insurance. Moreover it now offers a full range of online and financial services and operates in the UK, Europe, North America and Asia. Today it is the world's third largest retailer based on revenue, behind Wal-Mart and Carrefour, It ranks second in terms of profit, surpassing Carrefour. Other big competitors include fellow British organisation Marks and Spencer who have also evolved from food retailing into other areas of competitiveness.
The desire to grow and expand is well embedded in the Tesco philosophy, as their strategy shows:
'Tesco has a well-established and consistent strategy for growth, which has allowed us to strengthen our core UK business and drive expansion into new markets'
Tesco Plc (2010a)
The objectives underpinning this strategy are;
To be a successful international retailer
To grow the core UK business
To be as strong in non-food as in food.
To develop retailing services - such as Tesco Personal Finance, Telecoms and Tesco.com
To put community at the heart of what we do.
Tesco Plc (2010a)
Aim and Objectives
The overriding objective of this report is to provide a comprehensive evaluation of Tesco Plc's business performance. This will be done through the application of financial accounting concepts and principles, as well as ratio analysis. Other areas touched upon will include, corporate financial reporting standards and the impact of such standards, benchmarking against competitors and past economic trends. The report will conclude with an evaluation the company's future outlook.
Financial accounting concepts and principles and their role in evaluating business performance
Britton and Waterston (2006, pp.3) maintain 'Financial accounting is concerned with the recording, processing and presentation of economic information after the event to those people outside the organisation who are interested in it'.
The presentation of this economic information comes in the form of the 3 main financial statements, these being, the profit and loss account, balance sheet and cash flow statement. The analysis of these statements provides knowledge into the performance of companies, such as Tesco for example. It also enables the reader to understand the reporting standards adopted by the firm and the various accounting policies embraced.
Britton and Waterston (2006, pp.53) highlight the reason to familiarise oneself with the accounting concepts when evaluating a company's financial statements;
'Given that such underlying theoretical principles can radically change the view the financial statements give an entity, it should be obvious that preparers and users of those statements should be very clear about the particular principles that have been applied'.
Key accounting policies adopted by Tesco Plc
Property, plant and equipment assets are carried at cost less accumulated depreciation and any recognised impairment in value. (Tesco Plc 2009, pp. 75).
Interest income on financial assets that are classified as loans and receivables is determined using the effective interest rate method. (Tesco Plc 2009, pp.74)
The tax expense included in the Group Income Statement consists of current and deferred tax. (Tesco Plc 2009, pp.77)
Current tax is the expected tax payable on the taxable income for the year, using tax rates enacted or substantively enacted by the Balance Sheet date. (Tesco Plc 2009, pp.77)
Deferred tax is provided using the Balance Sheet liability method. (Tesco Plc 2009, pp.77)
The financial statements are prepared on the historical cost basis, except for certain financial instruments, share-based payments and pensions that have been measured at fair value. (Tesco Plc 2009, pp.74).
It could be argued that adopting an historical cost basis for asset valuation is a somewhat outdated method and may not accurately reflect true value and financial position.
Changes in accounting standards
In 2006 Tesco stopped using UK GAAP (generally accepted accounting principles) and starting to adopt IFRS (international financial reporting standards); thus impacting on the company's financial reporting.
Ratio analysis and associated advantages
Ratio analysis proves to be a useful method of interpreting a business's financial performance. As McLaney and Atrill (2008, pp. 222) point out; 'Financial ratios provide a quick and relatively simple means of assessing the financial health of a business'. Going on to describe the process they explain;
'A ratio simply relates one figure, appearing in the financial statements to some other figure appearing there (for example, operating profit in relation to capital employed) or, perhaps, to some resource of the business '
There are five categories of financial ratios, each associated with a specific aspect of financial performance. They are:
By employing a small number of ratios, one can generate useful insight into Tesco's performance as a business.
As was already alluded to, Tesco Plc is a corporate giant that knows no bounds when it comes to expansion. No company would (or could) think about expanding, if it was not already profitable in its existing operations. It therefore seems logical to analyse Tesco's profitability.
The return on capital employed ratio is a key profitability ratio and useful measure of business performance. The ratio reveals the relationship between the operating profit created during a period and the average long-term capital invested in the company during that time. In other words compares inputs with outputs, an important comparison in measuring how effectively funds have been deployed. (McLaney and Atrill 2008, pp.229).
Results show Tesco's ROCE ratio to be at its lowest in 6 years, decreasing steadily from 2007. This will be an unwelcomed situation for the firm, especially when its long term debts and liabilities increasing year on year. However, the company's annual reports show that; total assets minus liabilities remains to be a positive figure.
It is important to note that these figures also equate to the businesses shareholder funds or owners equity, as such Tesco Plc's shareholders will welcome this information as it increasing their value of interest in the organisation.
Another important profitability ratio to consider when examining Tesco Plc's financial performance is the return on ordinary shareholders' funds ratio. This compares the amount of profit for the period available to the owners with the owners' stake in the business. McLaney and Atrill (2004, pp. 152)
Obviously the shareholders of Tesco will want this percentage to rise as much as possible, past trends show there has been little fluctuation over recent years, however return to shareholders has steadily decreased in past 3 years. Shareholders will be hoping it does not slip further.
The financial crisis that has been sweeping the world economies since 2007 has caused many businesses to collapse due to liquidity issues. Liquidity has always been paramount to successful business however, now it is more important than ever with lending practices becoming more prudent. For these reasons it is essential to analyse Tesco's liquidity position.
'The current ratio compares the 'liquid' assets of the business with the current liabilities.
The results show that current assets do not quite cover current liabilities. The ratio has been rising favourably since 2006 and is at a 6 year high. This would usually indicate the business is experiencing some liquidity issues and a cause for concern, however in some instances it may not. For example if a firms inventory turns over at a faster pace than current liabilities become due, a low current ratio will be acceptable, causing no problems to the organisation. Tesco Plc's core business is in retailing, more specifically food, with supermarkets all over the globe. This industry is noted for speedy stock turnover, providing some possible explanation and understanding for the low current ratio.
Moreover as already stated total assets do cover total liabilities, indicating Tesco either holds a lot of long term assets or very few long term liabilities.
This brings us to our final area of investigation, assessing Tesco's level of gearing. 'Gearing is the relationship between the amount financed by the owners of the business and the amount contributed by outsiders'. McLaney and Atrill (2004, pp.169) More specifically the gearing ratio determines to what extent long-term lenders factor in to the long-term capital structure of the firm. Due to the nature of borrowing from outside parties (where you take on the financial burden of having to pay back the initial loan plus interest), Tesco's level of gearing will be a good indication of the level of risk inherent to the company and its dealings.
As is shown, the company's level of gearing is high, particularly in 2009 increasing dramatically. This finding combined with the business's current ratio standing indicates that Tesco has a large amount of long term assets. This is because current assets are not meeting current liabilities and we now know the company's capital structure does contain high levels of long term debt, therefore we can deduce this is the case. Being highly geared is somewhat of a double edged sword bringing both unfavourable and favourable consequences. As already mentioned the nature of borrowing leads to significant financial burden, if Tesco borrows too much they run the risk of not being able to keep up with interest and capital repayments, thus putting both shareholders and lenders at risk in the process. Lenders may not get their investment back and shareholders may be disadvantaged due to lower amounts of dividends paid out by the firm at the end of the year. At worse Tesco could risk financial peril and become insolvent if managers do not keep this under control. But what good can come from being highly geared? The answer is simple, the more you borrow, the more money you have; and the more money you have, the more projects (assets) you can invest in. Returns and profit will increase substantially if the value of the asset rises.
So far there has been some comparison work through benchmarking ratios against previous years; however the analysis should not stop here as it only enables us to see half of the picture. These results must be also benchmarked against a similar business to Tesco's, in order to prove greater insight into the performance of the company.
Figures 1-4 are graphs showing how Tesco's financial ratios compare with those of Marks and Spencer.
Figure 1 show's Marks and Spencer's has a much higher return on capital ratio overall indicating the company may deploy its funds better.
Here results indicate that Marks and Spencer generate a greater return to their shareholders than Tesco.
The ratios show that Tesco's current ratio has been superior in the last 3 years when compared with Marks and Spencer whose results have declined rapidly since 2004.
Here we see Marks and Spencer's gearing ratio to be much higher than Tesco, showing that the business has a greater proportion of long term debt in its capital structure. As was already mentioned this can be dangerous for business and may go some way in explaining Marks and Spencer's impressive results.
Although the calculation of financial ratios is simple and straightforward, they can prove problematic to interpret. As such, it is imperative to understand that they act only as a starting point and further in-depth investigation is needed in addition, unfortunately this is beyond the scope of this report. McLaney and Atrill (2008, pp. 222) elaborate on this matter; 'Ratios help to highlight the financial strengths and weaknesses of a business, but they cannot, by themselves, explain why those strengths and weaknesses exist or why certain changes have occurred'.
Britton and Waterston (2006 pp.204-205) add that there are seven principle limitations of ratio analysis:
Differences in accounting policies.
The historical nature of accounts.
Absence of suitable comparable data.
Differences in the environments of periods compared.
Hidden short-term fluctuations.
Changes in the value of money.
Other non-monetary factors.
All these factors must be taken into consideration when comparing Tesco's financial ratios with them of Marks and Spencer. Marks and Spencer's accounting policies may differ slightly to Tesco, therefore distorting the ability to create a true comparison. Furthermore the companies are not identical in their activities; they compete in many areas but not in all areas. These are matters which need greater investigation to provide better insight.
The role of management accounting in the evaluation of business performance
So far financial accounting has been at the forefront of this report, now it is time to take a look at the role of management accounting and the role it plays in evaluating the performance of businesses such as Tesco Plc.
According to Horngren et al (2008, pp.5), management accounting is;
'The branch of accounting that produces information for managers within an organisation. It is the process of identifying, measuring, accumulating, analyzing, preparing, interpreting and communicating information that helps managers fulfil organizational objectives'
Lucey (2003 pp.1) adds that management accounting is an integral part of management and can be used for;
Planning and controlling activities;
Optimising the use of resources;
Disclosure to shareholders and others external to the entity;
Disclosure to employees;
From the above we can conclude that management accounting is very much an internal process focused on those internal to the organisation, as opposed to financial accounting which is produced to satisfy the needs of those outside the firm.
Information will flow on a daily basis to Tesco Plc management to enable them to monitor and evaluate the business's performance whether good bad or indifferent, whether goals are being met and strategies are working.
Weetman (1999 pp. 438) expands on this issue, stating managers can use management accounting to make judgements i.e. about the performance of various products or services of the organisation as compared with those of competitors or the performance of different divisions with the company. It also comes in useful when making important decisions. For Tesco such decisions are likely to be linked to their growth and diversification strategy i.e. should they; penetrate a particular market? Build more stores? Offer additional products or services?
Sollenberger and Schneider (1996, pp.5) sum up how management accounting can help evaluate performance, whilst writing;
'After decisions have been made and actions taken, actual results flow in. How did we do? Comparing actual to plan tells a story. Analyzing differences help evaluate the performance of managers, business segments, or even the entire firm. Comparing actual to plan may also give insights into where changes should be made-perhaps into where and how to improve resource use'
From this information we can gather that for a company the size of Tesco Plc a great deal of emphasis will be placed on management accounting and the important role it plays in evaluating the organisations performance.
Non-financial critical evaluation using other management strategy techniques
'Diversification is typically defined as a strategy which takes the organisation into new markets and products and services'
Johnson et al (2006, pp.282)
They go on to state 3 potentially value creating reasons for diversification;
There may be efficiency gains from applying the organisations existing resources or capabilities to new markets and products or services. I.e. economies of scope.
There may be gains from applying corporate managerial capabilities to new markets and products and services.
Having a diverse range of products or services can increase market power. By Tesco having a diverse range of products and services, the organisation can afford to cross subsidise a product from the surpluses earned by another, in a way its competitors may not be able to.
It is important to note that diversification is also an effective approach to spreading risk.
Further performance evaluation
In today's dynamic and complex world of business it is no easy task to be successful; the current economic climate makes this undertaking even more arduous. However, Tesco's make this job seem effortless, they keep going from strength to strength, and its ambition and passion for growth knows no bounds. Profits continue to rise year on year, even during the turbulent financial crisis, group sales rose from £58,588 million in 2008 to £59,426 million in 2009. Tesco annual report (2009, pp.4). With these kind of results the future looks like it will continue to shine for Tesco Plc.
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