Capital management of Tesco
Disclaimer: This work has been submitted by a student. This is not an example of the work written by our professional academic writers. You can view samples of our professional work here.
Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of UK Essays.
Published: Mon, 5 Dec 2016
In this assignment, I will write a report assessing the working capital management of Tesco. I will identify and explain the main component of the working capital and carry out the relevant calculation. I will also interpret the ratios calculated to assess adequacy of working capital management and suggest suitable improvement.
Working capital is amount of money that is available to Tesco for its day to day purpose. It can be calculated by using (current assets – current liabilities). Working capital is used to buy resources, such as raw materials, components, vehicles, fuel and to meet other costs such as wages, utility bills, rent, fees and insurance. The working capital is the amount of the money left over after all short term debt has been met. It is the quantity of liquid assets owned by Tesco less the amount of money owed by the business in the short term. Liquid assets are those that can be converted into cash within a year.
Possession of working capital depends on the nature of business. Tesco tends to hold less working capital because most of their sales are for cash which is immediately available for making payments. Tesco should have current assets twice and one and a half times the size of its current liabilities. Tesco has a total current assets amounting £4576m, while their current liabilities is £3576m for year 2006. The value of current assets is about 1.3 times the value of the current liabilities. This is not an ideal but satisfactory comparison. Though Tesco doesn’t have ideal ratio it is not really worrying matter because Tesco is retailer and all of its sales are usually for cash. It does not have to wait for customers to pay, that’s why they can still operate in less working capital and in additional to that Tesco is a food retailer business.
Current assets are the assets which can be sold usually within period of one year. Tesco current assets consist of Inventories, Trade and other receivables, derivative financial instruments, current tax asset, cash and cash equivalent.
An inventory is amount of goods and materials themselves available in stock by business. Inventories consist of goods held for resale and properties held for, or course of, development and are valued at the lower of cost and fair value less costs to sell using the weighted average cost basis. From 2005 to 2006 Tesco’s goods held for resale appears to increase from 1457m to 1911m by 454m which is an increase of 23.7%.
It is not healthy for Tesco to hold large amount of stock and it is not a great indication, an increase issues arise where capital is tied up in stock earns a zero financial return. This year Tesco’s 454 m is stuck in stocks. Tesco could have used this money to input its expansion project. The storage and handling is another issue. Tesco have to spend money in warehousing space, lighting, heating and labour. Having large amount of stock can also lead to perished or become outdated. Tesco can also constantly face stock being theft and shrinkage. Large stock holding can also become target for theft by staff and others. Tesco’s inventories also include development properties and developing properties amounting 20m. Last year the development properties amounted 7m, total increase of 13m by 65%.
Trade and other receivables
Under Tesco’s current assets includes trade and other receivables including debtors. These are the amount money that debtors owe to Tesco. Tesco prepayment and accrual income for year 2006 is 128m, which is an increase of 42m compare to last year.
It is very good that Tesco has increased its income though Tesco should be able to receive money as soon as possible because the risk of debt increased as more time is given to debtors. Tesco also lease equipments and different premises to different groups. Tesco has recently entered into leasing arrangement with UK staff for certain of its electronic equipment as part of the computer for staff scheme. The fair value of the groups finance lease receivables at 24 February 2006 is estimated 12m (2005 = 17m). It is also very surprising that even though the sales growth has decreased compare to last year, from 23.0% to 17.9% their revenue still tends to be high.
Derivative financial instruments and current tax assets
Another important part of the current assets is the derivative financial instruments and current tax assets. Tesco uses the interest rate swaps and cross currency swaps to hedge the fair value of fixed assets bonds. The total national amount of outstanding swaps used for fair value hedging is £2033m till 2033 but for this year the amount for interest rate swaps is £12m. Tesco also uses forward foreign currency contracts and currency options to hedge the cost of future purchase of goods for resale, where purchase are dominated in a currency other than the functional currency of the purchasing company. The total amount of forward foreign currency contracts are £96m. The total amount for derivative financial instruments is £108m (£12m + £96m). The current tax assets amount to £8m.
Cash at hand and cash in bank
Cash at hand and cash in bank is the amount of money that Tesco can use when it needs. Tesco also has short term deposits. This is the amount of liquid resources Tesco has available to fund its daily trading. In this year Tesco has cash amounting £902m. The amount has drastically decreased by 62m which is 6.8%. There are various reasons as why Tesco might have reduced its cash. It has recently invested £89m establishing operation in United States and the investment is steadily increasing to £250m by this year. Dividend to share holders has increased by 14.4%.The trade and payables has also increased by £963m which means more money is paid hence reducing cash.
It is very vital for Tesco to have large amount of cash at bank and cash at hand. Tesco can be better off having more cash than unused assets because it might take time for Tesco to sell its assets (at least 12 month) when cash is needed. It is not great sign for Tesco to reduce its cash as it might create working capital problems.
The non-current assets classified as held for sale consist mainly of properties held for sale, including the UK assets disposal. For year 2006 non current assets classified as held for sale is £408 m, an increase of £240m compare to last year.
Current liabilities are debt or liabilities that have to be settled in cash with in fiscal year. Tesco’s current liabilities includes Trade and other payables (creditors), Financial liabilities such as borrowing and derivative instruments and other financial instruments and other liabilities, current tax liabilities and provisions.
This year Tesco has current liabilities of £3,576m, decrease of £23m compare to last year. The major reduction is in derivative financial instrument and other liabilities, total reduction of 152m.
Tesco has been able to reduce £152m by decreasing interest swaps and similar instruments by £61m and foreign currency contracts by £114m. The interest swaps and similar instrument amounted 170m last year, while this year it is 56m which is total reduction of 61m.
Tesco has also reduced its borrowing by 92m, which helped Tesco immensely to reduce its current liabilities. Though Tesco has high bank overdraft and bank loan compare to last year they are able to get rid of different other liabilities such as unsecured deep discount loan stock, medium term note and other MTNs amounting £527m. Rather than borrowing, Tesco has used other source of finance such as retained profit to finance its business. It is interest free money which has no risk and can be used without any obligations and issues without any repayment worries.
For this year Tesco has to pay its creditors or suppliers the amount of £6046m, which comes under trade and other payables. All these expenses has incurred during the process of buying, importing, transportation and cost of raw material and goods, tax, social security, dividend and joint ventures and associates.
Property provisions comprise of rents payable, provision for terminal dilapidations and provisions for future rents above market value on unprofitable stores. Tesco current provision is 4m while noncurrent provision is 25m adding to 29m but we only take account of 4m because it is the cost due to fiscal.
Current asset is important to Tesco because an increase of current assets to total debt is a positive sign, showing Tesco has better ability to satisfy its debt obligation using current assets. Current assets are important because Tesco can pay its obligation by selling its current assets when required. Current assets can be turned into cash within one year. Current assets can also increase the value of business, hence increasing the share price.
Working capital cycle
It is the amount of cash or other liquid resources into and out of the Tesco PLC. It is also known as operating cycle. Managing working capital properly will help to generate cash and help improve profits and reduce risks. Tesco will run out of cash and expire if they are not able to generate cash surpluses. The working capital cycle can be portrayed in diagram. The diagram shows different cash sources and how cash are drained from the business. In Tesco’s working capital the main source of cash into the business is from selling its shares in stock exchange market.
The traditional and modern approach to working capital management:
Traditional method of managing working capital would include obtaining trade credit from suppliers, use bank overdraft to make payment such as utility bills or short term expenditure. Traditional method is very logical and can be very important way of managing working capital. Tesco has t be very careful, it is completely insensible for Tesco to buy raw material using bank loan because bank loan repayment period usually extend for long time while the resources will be used and paid by customers with in short period, and thus this makes the loan payment impossible and sunk Tesco in debt.
The basic concept used in traditional method of managing working capital is to use right source of finance for right expenditure. Tesco has to make £3,317m payment for its trade payable which includes utility bills, rent, leases etc. Tesco has more advantages of using bank overdraft than bank loan in this case because it is easy and flexible and interest is only paid when Tesco is overdrawn. Using bank loan can be potentially disadvantage because the payment will be in long term and such resources have either been used already or will be used soon.
Debtors Collection period
Debtors collection period = Debtors / Turnover * 365
This number shows how effectively Tesco is able to collect money owed from its customers. The reducing period of time each year indicates the increase of efficiency and progress. For year 2002 Tesco’s debtor collection period was 7 days (debtors days=£454m / £23,656m * 365), for year 2005 it was 8.5days (debtors days = £ 892m/ £38,300m * 365) and for year 2006 it is 8.5days (debtors days = £1079m/ £46,600 * 365)
The trend does not seem to be very impressive as instead of lowering the number of days it has increased. Though the increase is not so drastic it is still vital for Tesco to reduce its number of debtor collection period. Late payment erodes profit and they can also lead to bad debt. Ensuring the quick collection from debtors will help to run the cash flow smoothly. Tesco’s debtors do not include customers who buy goods and service from Tesco. All payments and transaction are made when the customers exit the stores as no trade credit is provided to customers. Tesco’s main debtors are joint ventures and associates (£168m), lessee or tenant (£12m), prepayments and income (£128m) and other receivables (£771). Morrison seems to be collecting its money faster than Tesco. In 2005 Morrison debtors collection period was 5days (£157.4m /£12,114.8 * 365) while in 2006 it was 4 days (£150.6/£12,451.5 * 365). There are various reason as why Morrison have better debtors collection period perhaps one could be they have better method of collection such as they urge their debtor to pay earlier by providing cash discount. Another reason might be Morrison doesn’t tend to lease its property as Tesco therefore it does not have to bother about collecting rent. Though reducing debtor’s collection period might help Morrison to run its cash flow smoothly it does not guarantee profit. Morrison has better debtors collection period but Tesco still makes more profit compare to Morrison.
Tesco can ensure that the collection is done as soon as possible by taking different measures such as invoice promptly and clearly, charging penalties for overdue account, consider accepting debit and credit cards as payment options, be professional when accepting new accounts, continually review and set limit for each customer, monitor debtor balances and ageing schedules, and don’t let any debts get too large or too old. Check out each customer thoroughly before offering credit. Use different agencies such as credit agencies, bank references, industry sources etc to check the credit history; if Tesco can take these measures they can definitely improve the debtor collection period figures.
Creditor’s payment period
Creditor payment period = Trade creditor / cost of goods sold * 365
Creditor’s payment period shows how long it takes Tesco to pay its supplier for goods that have been bought on credit. Creditor’s payment period can vary and can be negotiated with creditors. Tesco will always have benefit if it can extend the credit payment period as long as it can without damaging relationship with suppliers.
For year 2002 Tesco’s creditors payment period is 80days (£4,809 / 21,866 * 365), for year 2005 it is 51days (£ 5083/ 36,426 * 365) and for year 2006 the creditors payment period is 15 days (£6046/ £39,401*100). In year 2002 it was 80 days but the days has gradually declined to 51 and finally 15. It is always benefiting for Tesco to extend its creditors payment period as much as it can. Increasing the amount of creditor’s payment period means Tesco has money in bank which earns interest. Delaying the payment can always benefit Tesco but Tesco has to be also very careful because too much delay can damage relation between suppliers and Tesco. Morison has a better figure for creditor’s payment period, for year 2005 it was 46days (1471.2/ 11793* 365) while for 2006 it was 46.3days (1501.1/11825.5 *365). Morrison tends to have better creditors payment period.
This shows that Morrison is more organized in both paying and collecting. Tesco should compare its both debtors collection period and creditor’s payment period. Tesco will be in better position if the debtor’s collection period is shorter than the credit payment period. Tesco will suffer from poor working capital if debtors collection period is longer than credit payment period because Tesco has to pay its supplier and if the debtors haven’t paid them it will be harder for Tesco to pay its supplier hence creating shortage in working capital but since the creditors payment period is shorter than debtors the problem doesn’t seem to exist.
Stock turnover = Stock/ Cost of goods sold * 365
Stock turnover measures how well Tesco coverts stock into sales. It is closely similar to assets turnover and is also a measure of efficiency. Stock turnover is basically the indication of sales volume. It measures how well Tesco is making use of the part of its working capital that has been invested in stock.
For year 2002 Tesco stock turnover amounts 16days (£929/ 21866 * 365), for year 2005 Tesco stock turnover amounts 15days (£1464 / £36,426 * 365) and for year 2006 it is 18days (£1931/ £39,401* 365).It is very common to have quick turnover for supermarket such as Tesco because they sell the value of their average stock every two to three weeks. All supermarkets have very quick turnover for example Morrison, for year 2005 the stock turnover was 12 days while for 2006 it was 11 days. Tesco has made improvement in 2005, in 2002 it took 16 days to sell stock while in 2005 it went to 15 days but in 2006 it got worst. The stock took 18 days to get sold. Tesco should try to lower the stock turnover because the money is then tied up for less time in stocks. A quicker stock turnover means that Tesco gets to make its profit on the stock quicker, and it should be more competitive. Morrison have a very quick stock turnover, it does not even take 2 weeks to sell all its stock. It can also reduce the cost of storage and mess in warehouse.
We cannot still assume that every business have very short stock turnover. Manufacturers usually have much slower turnover because of the time spending processing raw material. Business like luxury cars and expensive items have low turnover because consumers are limited, production is rare and stock turnover is very high but this doesn’t means that those business is making loss.
There are several ways Tesco can improve its stock turnover figure. Tesco must grasp just- in- time technique to reduce stock holding, which involves ordering stock when they are required in the production process. If necessary start different offers such as buy one get one free, buy one get another half price.
Current assets = Total current assets / Total current liabilities
Current ratio show how much working capital does Tesco have. It examines if the company liabilities can be covered by company assets. It is an ideal if the current ratios of business are between 1.5 and 2.
For year 2005 current ratio for Tesco is 1.08:1 (£3,919 / £3,599) while for year 2006 it is 1.27:1(£ 4,576 / £3576). If Tesco can sell its assets within 12 months such assets are current assets. Current Liabilities are amount that are due to pay within the coming 12 months. For year 2006, 1.27 times means that Tesco should be able to lay hands on £1.27 for every £1.00 they owe. Less than 1 time e.g. 0.5 means that Tesco could have liquidity problems and be under pressure to generate sufficient cash to meet oncoming demands but Tesco does not seems to have any problem with current ratios. Compare to its counterpart Morrison, Tesco is more adequate and optimistic. For year 2005 Morrison has current ratio of 0.9:1, while for year 2006 it has 1:1. The ratios shows Morrison have liquidity problem. As ratio of 2006 it shows that Morrison has current assets of 1 for every current liabilities of £1, meaning they have problem covering their day to day expenses and Morrison’s current assets would hardly cover its liabilities. Tesco is doing very well compare to Morrison. Compare to last year it has been able to improve too.
The Current ratio shows the status of relation between current assets and liabilities of business. Tesco have neutral level of current ratio but not ideal it has to be still careful as if the ratio exceeds above 2 it might be said that the business has too many non productive liquid resources.
Acid Test Ratio
Acid test ratios = Current assets- stock / current liabilities
It is the test that indicates whether Tesco has enough short term assets to cover its immediate liabilities without selling its inventories. The ratio should be at least above 1 to make sure that all liabilities are sufficiently covered.
For year 2005 acid test ratio is 0.68(£3910-1464/ 3599), while for year 2006 it is 0.73 (£4576 – £1931/ £3576). This means that for every pound Tesco’s current liabilities, the firm has 0.68 and 0.73 of very liquid assets to cover those immediate obligations. Compare to its counterpart Morrison Tesco’s has better figure but still it is not ideal. In year 2006 Morrison has acid test ratio of 0.20(£749.6-£367.9/£1806.8) while for year 2005 it was 1.16 (£692.1-£399.4/£1806.8). It is always consider as the higher the ratio, the more financially secure a company is in the short term but in case of Tesco and Morrison we have low quick ratio which means that Tesco and Morrison is over- leveraged, struggling to maintain or grow sales, paying bills too quickly, or collecting receivables too slowly.
This is well below ideal of 1. This suggests that both of them could have inadequate working capital. They both are supermarket therefore there are lot of things they can do to improve working capital. Tesco and Morrison should start spending less money in storing stock and try to work with Just In Time approach. Try to get rid of all the stock as soon as possible by introducing different offers which will lead to sell of stock and flow of money hence improving the working capital. Computerized stock control is also another way of keeping tight control on stock levels. Computer can be used to decide when and how much stock to order hence reducing the stock being accumulated. Another way of improving working capital is by doing close cash flow forecasting. Cash flow forecast shows the expected cash in flow and outflow each month for future period. Based on this cash flow and the money that the business had to start with, it is possible to calculate the expected monthly cash balances which will allow improving working capital.
Assets turnover = Turnover/ Net assets
It indicates Tesco’s efficiency of using its assets and generating sales revenue. The ratio calculates the total sales for every pound of assets Tesco owns. The highest the number is the better the performance.
In 2005, Tesco had turnover of £38,300m and £10,571m in assets respectively therefore the turnover rate was 3.6. In 2006 Tesco’s turnover was £46,600m while net assets valuing £8,444m when applied to assets turnover formula, we find that Tesco’s turn rate of 5. There are several general rules that should be kept in mind when calculating assets turnover. First, assets turnover is meant to measure Tesco’s efficiency in using its assets. The figure for 2006 is higher than 2005 which indicates that Tesco is making good use of its assets available. The figure means that figure is 3.6 for year 2005 and 5 for year 2006 bigger than total assets. Another way of saying that is Tesco was able to generate sales of £3.6 for every £1 of assets it owned for the end of year 2005 while for the end of the year 2006 it was able to generate £5 for every £1 of assets it owned. If we compare to its counterpart Morrison who had assets turnover of 3.17(£12461.5/ £3927) for year 2006 and 3.32 (£12,114.8/£3648.5) for year 2005, Tesco seems to be very well organized and efficient when using the assets that they owe.
The only way Morrison can improve its figure is by selling all unwanted assets. All the assets that are not productive and useable have to be brought to market. Increasing sales with same amount of assets,Same volume of sales with reduced assets, increase sales more than relative increase in assets. Point is to make most efficient use of assets possible.
There are many ways in which Tesco can reach the ideal boundary while Morrison improves its figure. They should both desperately try to sell off their stocks, below the cost if necessary, as soon as possible as selling stock means money coming into business. Tesco and Morrison should start selling their more shares hence raising fund to pay all the creditor and debt. They can also increase their long term loan or overdraft to pay creditors. They should consider selling off their unwanted assets that are not used and if possible sell the current owned assets too and lease them back. They should cancel non vital expenditure and reduce drawing as much as possible. Morrison might consider selling its debt to debt factor. If these steps are taken methodically, Tesco and Morrison can improve their working capital.
Business Studies, Third Edition A Level Applied Business for EDEXCEL
Cite This Work
To export a reference to this article please select a referencing stye below: