Economic downturns


Section A

If one certainty about economic downturns is that they will ease soon, another is that traditional retailers recover slowly. Recent McKinsey research (Noble, Shenkan, and Shi, 2009) indicates that over the last two economic recessions (1990-1991 and 2000-2001), growth had slowed for nearly every retail subsector in the United States. 93 percent of the retailers surveyed that existed during both downturns had experienced slowing revenue recovery in one of the economic shocks, and 59 percent endured it in both.

This suggests that, unfortunately for retailers, their vulnerable position on the front lines of consumer spending doesn't translate into a rapid recovery when the general economy experiences a subsequent uptick (Kotecha, Leibowitz, Mackenzie, 2008). The average retail subsector growth rate during the first year of recovery following the 1990-91 and 2000-01 downturns was 0.3 percent. 12 of 15 retail sectors lagged behind even that rate of growth during one or both aftermaths of the economic downturns. Such a slow growth rate has significantly resulted in such a prolonged recovering period that retailers cannot afford. In this sense, the period when retailers are undertaking performance recovery is pivotal to determining the final winners and losers in the retail sector.

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Of course, companies with reasonable cash reserves and ready access to credit lines, for instance, have options, such as investing in stores, people, or acquisitions that weaker competitors simply lack. Thus in this paper, I should take a rigorous look at the health of their balance sheets, liquidity, and overall operating performance. Hereby I choose two global retail giants, Wal-Mart and Tesco, the financial performance of which is believed to provide a firm-level investigation about how retailers weather the ongoing financial crisis.

As we start by looking the balance sheet, we find a pair of negative correlated trends for the D/E ratio movements in these two companies. It is noteworthy that despite a stable decline between 2002 and 2004, the D/E ratio had raised up by almost 7% since the beginning of the ongoing financial crisis. Since the retailer has confirmed its continuous efforts of taking over the bankrupt Woolworth's chain stores, such a moderate rise of D/E ratio suggest its inclination on relatively cheaper debt financing for its retail network expansion. As to Wal-Mart, the ratio has been maintained at rather stable level. This is probably due to the retailer's sustainable inflow of considerable profit from its enormous sales volume and huge buying power, which has been supported by its global reaching business network. Retail Forward, a research firm in Ohio, U.S., projected that the number of Wal-Mart Supercenters may triple by 2010 and that its share of the grocery business may rise to 35 percent.

Since the investors' first care is the capital growth, we now turn to the comparison of ROE ratio for both companies. Chart 2 suggests that TESCO witnessed a steady increase of ROE ratio during 2004-2008, while the payoffs to common shareholders in Wal-Mart remain stable around 20%. On one hand, it is to be noted here that although a rising level of debt financing implies a shrinking return for equity stakeholders due to the rising interest expenses, fortunately such an anxiety for TESCO's shareholders has been offset by an almost-doubled increase of sales. This in turn indicates that the British retailer continues to maintain its momentum of steady growth. On the other hand, the ROE ratios for both Wal-Mart and Tesco have outperformed their peer groups by 5.37% and 2.2% respectively, which suggest that two retail giants might benefit from economies of scale given their leading status in the retailing sector. Besides, we suggests that such a benefit will provide retailers with a large number of options for efficiency improvement, to sort through the ongoing economic downturn, ranging from cutting costs by shutting stores or restructuring support functions, to increasing revenue by refreshing stores or overhauling promotions. A main challenge for retailers remains how to speed up the circulation of inventories, thus to reduce the relative cost for goods to be sold. Latest data shows that both companies have managed inventory issues quite well. Ratio of sales to inventories for both Wal-Mart and Tesco surpass their peer group by 2.04 and 9.25 respectively, which indicate the companies' comparatively higher efficiency of asset utilization. Indeed, recently two business giants have registered erosion in profit margins, due to a series of promotion scheme which has aggressively expand the price-cut ranges. However, as we take a rigorous look at the formula of ROA, the aforementioned efficiency in assets utilization has help to cushion the shock from deflated sales, thus maintain the ROA at a sound level.

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Because credit market has been locked up since the beginning of financial turmoil, almost all of the retailers are hit by the persistent liquidity constraints with equity capital drying up and their debt financing getting harder to service. For companies relying on debt financing for its business expansion, liquidity issue, therefore, is another useful determinant of credit worthiness. Liquidity refers to the availability of cash to the business. Generally speaking liquidity is a function of profitability, which indicates that the more profitable the business, the more cash available. However, given the aforementioned shrinking profit margin, how to manage the cash flow efficiently becomes more prominent for retailers. From Chart 3's comparison, we find that there is no significant improvement in terms of efficiency of managing the account receivable for either of them. Nevertheless, compared with the peer median value of 5.92 days, we suggest both companies have performed fairly well. This is especially the case given the enormous sales volume paid by credit card, which indicates more difficulty for the retailers' sales-cash conversion.

For creditors, quick ratio is another useful indicator to measure a company's liquidity. A look at the numbers for the period ending the December of 2008 shows that, both companies have registered quick ratios significantly below the peer median level of 37.0%. We wonder whether this is a common phenomenon in the retail sector. As we turn a look at the same ratios of their main competitors, namely Kohls and Falabella, for the same time period, they are found to well outperform the sector's median level during 2002-2008. This in turn, suggests Wal-Mart and Tesco's relatively poorer performance in controlling the short-term insolvency risks. Chart1 shows that both retailers are highly leveraged compared with the median value of peer group (23%), and thus are battling with the growing interest payment. Despite the 3.3% and 9.4% increase in 2008's EBIT for Wal-Mart and Tesco respectively, interest expenses in the same year have been raised by 8.4% and 21.7%, which shows expenses have impacted the profitability for both retailers significantly.

Although the results from various financial ratio comparisons contain both praise and blame, both companies have witnessed a steady growth of ROE in the last year, suggesting the company's still in good financial health in such a mature industry filled up by fierce competence. It is no wonder why both retail giant go on the offensive, taking actions to quickly increase sales volumes by attracting more customers through compelling offerings and ensuring that staff is ready on the floor for the assisted sales.

For example, Wal-Mart has recorded a moderate 8.3% increase in selling and administrative expenses, despite U.S. bearing the brunt of the financial turmoil in late 2007. As aforementioned in the very beginning, the downturn dynamics, say declining profit margin followed by a sluggish recovery period, mean that retailers should implement effective measures to minimize performance deterioration.

Another unaddressed issue remains what is the capital market's perception of their performance. To answer this question, we take a first look at the P/E ratio comparison between these two companies. One year ago Tesco was considered as "almost cheap" due to its P/E ratio below 10. But compared this number with those of today, the P/E ration for Tesco has been standing at a much higher expected level for the current year of over 15, suggesting a recovering market sentiment for Tesco financial health. Meanwhile although one of the company's recent statements asserts that the dividend payment will be boosted up by 9%, the high standing share price since last November is set to lower the prospective yield to investors. Above all, British retailing sector is about to suffer a much tougher time than last year. This is mainly because the consumers' expenses on daily goods are likely to be squeezed by more job losses and VAT rises.

As to Wal-Mart, we take a slightly change to our analytical method. We find that despite a minor decrease, the latest ROE ratio has remain at a rather sound level of 20.29, 0.35% above its industry level. However, Wal-Mart continues to expand its business profitably trough its worldwide retail network, particularly in ememrging markets with positive prospects for earlier recovery from the economic downturn. This is has been reflected by a rather significant increase its P/E ratio: the P/E ratio for the company has been raised up by 1.59 up to 15.49 over the last year. Generally speaking, investors' community holds rather optimistic opinions for the stock performance of two retail giants, though the Tesco's shares might be slightly over-priced. In addition to the high standing P/E ratios, it is not surprising to find both companies retain several common features from other financial indicators. These include: increasing level of profit retention, maintaining a sound reliance on debt financing, strong revenues generation from assts, and efficient inventory management.

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In addition to analysis of key financial ratios, comparison between two companies requires a brief understanding of the key differences between two accounting standards based according to which the financial statements have been built up. Generally speaking, the US GAAP accounting standard has been regarded as a rue-based one with copious and detailed guidance on implementation is to be effected, while the IFRS standard is more principles-based, setting forth only the general guidance and leaving the interpretation to the judgment of auditors (Epstein, Nach, and Bragg, 2009). While there are numerous differences in details, the significance of these differences will vary with respective individual companies, depending on such factors as the nature of company's operations, the industry in which it operates, and the accounting policies it has chosen (Deloitte, 2004). With regard to the two retailers we have chosen, perhaps the most prominent difference unaddressed is how to determine the inventory cost. While in the IFRS system the Last-in First-out (LIFO) method is prohibited, it is generally acceptable in the US GAAP system. Correspondingly, for the US GAAP system, inventory is measured at the lower of historical cost or market value. Market value is defined as the current replacement cost as long as market is not greater than net realizable value (estimated selling price less reasonable costs of completion and sale) and is not less than net realizable value reduced by a normal sales margin. According to the IFRS guidance, inventory is carried at the lower of historical cost or net realizable value. Thus best estimate of the net amounts inventories are expected to realize. This amount may or may not equal to fair value (Ernst & Young, 2009).

In conclusion, without a sustainable protection on the yield it used to enjoy, we recommend that the stock price for Tesco is overvalued, thus may fall back as speculative investors' cash out. By contrast, in addition to a fairly sustainable profit inflow, Wal-mart's capital structure remained stable, which means the growth of dividend yield is less likely to be squeezed by the increasing interest expenses. In other words, Wal-mart can be a better choice to invest for maximum capital growth in the longer term.

Section B

In November 2004, the FASB issued the code of FAS 151 Inventory Costs to address a narrow difference between US GAAP and IFRS related to the accounting for inventory costs, in particular, abnormal amounts of idle facility expense, freight, handling costs and spoilage (Ernst & Young, 2009). Indeed, at a broader level, recent empirical studies suggest that there is an ongoing transition from the US GAAP system to IFRS, as a number of changes has been called for and made both internationally and domestically (Herz, 2007). The Financial Accounting Standards Board (FARB) and the International Accounting Standards Board (ISAB) have been cooperating on converging the US GAAP and IFRS for over 7 years. Although the FASB and ISAB have made significant progress in converging their two set of standards, important differences still persist. For example, while the US GAAP retains a comprehensive set of accounting standards for insurance contracts and other extractive industries, there is still no comparable IFRS in the same areas. Moreover, such a noticeable divergence in accounting standards results in the difference between two systems in the determination of listed companies' income and equity (Herz, 2007). For example, the chairman of FARB admitted such an impact on the listed companies' earnings performance, as for approximately a quarter of the companies in a recent survey, IFRS earnings exceeded US GAAP earnings by more than 20 percent. However, the growing pressure from economic globalization may demand convergence on a more rapid basis. In the case of two retailers chosen here, the dual listing status for Tesco requires the company compliant with both the IFRS and US GAAP standards. Thus the rapid development of international capital market emerges as an important source for the convergence of accounting standards, especially when there is a growing number of multi-national companies undertaking cross-border listings. Their accounting and governance practices are set to exert significant impacts on the development of accounting standards in other developing economies.

Listed companies in the US and UK stock markets are almost featured by a rather disperse ownership structure. The supervision and implementation of accounting standards relies on a well functioned market and a group of well trained professionals. Thus the compatibility of IFRS with the current US regulation is rather high, which facilities and smooth the transition for the US GAAP towards international standards. However, this raises another question, should we hold such an optimistic view on the convergence process if all aforementioned factors are in absence? A premise underlying such a convergence argument is that a superior form of accounting system, like other productive technologies, must serve to enhance economic efficiency while minimize, if not eliminate, transactional costs. At the same time, comparative scholars start to treat the institutional variations as having competitive consequences. Thus with its implication of a Darwinian "survival of the fittest" struggle, scholars have been debating the relative merits of these rival models for a decade and more to find out a model of superiority for the prospect of evolution (Coffee, 1999). However, once accounting standards are taken as a set of institutional arrangements, the convergence prospects become much more complex than expected.

First, the changing the while set of accounting standards involves input from related stakeholder, including listed companies, drafters, auditors, and educator, which indicates a high degree of any institutional transformation. Hail, Leuz and Wsocki argued that the effects of accounting standards cannot be viewed in isolation from other elements of a country's institutional infrastructure. In a well functioning economy, the key aspects of its institutional infrastructure not only fit, but also reinforce each other. Therefore amending one elements of the institutional system can result in unexpected outcomes for an economy as a whole, even though the institutional transformation unambiguously improves the economic efficiency.

Second, as Gilson (2001) puts it, the form on which various national systems will converge, depends on the prosperity of the economy in a country compared with other countries at the time of the debate. For example, till the bursting of Japan's economic bubble, the main bank system of crossholding represent the most superior form of governance. Not long thereafter, the Japanese economy bubble burst, and the American economy boomed. The Anglo-American model then became the apparent end of the corporate governance evolution, a later consensus that appears clearly from the IMF and the World's Bank's response to the 1997-1998 East Asian Financial Crisis. However, ironically the ongoing financial crisis with maybe even deeper magnitude derived from the collapse of the American Supreme Mortgage Market again put the seemingly superior Anglo-American model under serious criticisms. This might in turn cast serious doubt on the direction for convergence.

Last but not least, the transportability of the accounting system can be hampered by resistance from the vested interests groups. This is especially the case for those transitional economies and European Continental Countries, in which concentrated ownership structure and related-party transactions are rather popularized. Thus increasing the level of transparency for them inevitably led to institutional entrenchment since the rent-seeking opportunity will be under greater public supervision. Peerenboom (2007) finds that rather than all states converging on a similar form of market economy with common institutions, policies and modes of production, distinctive varieties of capitalism have arisen as a result of the embeddedness of institutions, cultural difference and dissimilarities in the political economies. Indeed, reforms in regulatory realm that are needed to bring about the institutional convergence are likely to be politically difficult at least in the short to medium run (Denis and McConnell, 2003).

While we see rather optimistic prospect for the convergence between US GAAP and IFRS, there are still plenty of unaddressed issues remained in a short term. We see two systems are converging towards a more investor oriented direction, despite numerous differences in details. Thus in the words of Gilson (2001), we view the current transitional stage a "functional convergence" rather a real "formal" one.


Ernst & Young, 2009, US GAAP vs. FIRS: the Basic, Ernst & Young, 2009

Coffee, J. C., 1999. The Future as History: The Prospects for Global Convergence in Corporate Governance and Its Implications, Northwestern Law Review, 93, pp. 641-707.

Gilson, R. J., 2001. Globalizing Corporate Governance: Convergence of Form or Function. American Journal of Comparative Law, 49, pp. 329-363.

Hail, Luzi, Leuz, Christian and Wysocki, Peter D., 2009, Global Accounting Convergence and the Potential Adoption of IFRS by the United States: An Analysis of Economic and Policy Factors (February 25, 2009). Available at SSRN:

Herz, Bob, Speech by FASB Chairman on Convergence to International Accounting Standards, GAAP Update Service, Vol. 07, Issue 23, December 15, 2007.

Kotecha, A. A., Leibowitz, J., and Mackenzie, I., 2008, MaKincey Quarterly, September 2008

Noble, S., Shenkan, A. K., and Shi, C., 2009, MaKincey Quarterly, October 2009.

Peerenboom, R., 2007. China Modernizes: Threat to the West or the Model for the Rest?, New York: Oxford University Press.