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A comparison of financial performance of a luxury brand fashion retailer and a mid-market fashion retailer before and during 2008/09 recession in UK.
The UK recession has led to a reduction in the level of consumer confidence and disposable income as well as increasing percentage of price deflation and damaging most retailers' financial statements after a steady growth in sales and profits from 2003, before the recession 2008.
Luxury brand fashion retailers are expected to gain relatively more sales in the recession due to part of the consumers tend to buy less, but seeking more expensive, with better quality and long-lasting, staple clothing and accessories. However, as profits are said to be falling for every retailer, and for the mid-market fashion retailers having lower gross and operating profits than luxury brand retailers, perhaps the mid-market retailers have also been suffering as well.
This study aims to examine the financial data on two contrasting fashion retailers to test the hypothesis that even though a luxury brand fashion retailer has suffered more than a mid-market fashion retailer in terms of financial performance using a wide range of financial ratios.
This study will examine the main financial ratios of Gucci and Zara in UK for the previous 5 years to 2009 using data from FAME to identify trends and weaknesses compared to each other and to analyse the implications for stakeholders.
The initial way to see how the company has operated is by analysing the year-over-year sales growth and simply calculating the percentage of turnover increased from previous year and companies seek to generate a constant growth year by year. The year-on-year sales growth researched by Verdict (2008) shows that UK retail sales in 2008 declined 13% from 2007, mid market is losing shares with negative growth but luxury brands with increased sales of 13.9% by year ended 2007. For the year ended 31 Jan 2008, Zara UK's sales growth decreased by 12% comparing growth of 30% for the year ended 31 Jan 2007.
Inspecting and comparing only the figures in two companies' balance sheets and profit and loss accounts has no real meaning in terms of the company performance unless having to calculate the relevant ratios needed, provided that the companies comparing are in the same market segment, and in this study will be the retail market. (Wood & Sangster, 2005)
Ratios are very useful in helping to understand, analyse and furthermore compare the relationship and performance between two numbers as there are vast numbers of parties including shareholders, lenders and competitors interested in the financial performance of the company such as year-over-year sales growth and therefore ratios have to be handled very carefully or otherwise very misleading. In order to interpret a comparison on financial performance, we need the ratios of profitability, sales and profit growth, cost, liquidity, gearing and interest cover.
Profitability targets of a company can be established by financial ratios of return on ordinary shareholders' funds (ROSF) and return of capital employed (ROCE), which they express the relationship between the profit generated in a particular period and the owners' stake or the long-term capital invested in the company respectively, measuring the returns payable to suppliers, lenders as well as shareholders' dividends, which is said to be the fundamental measure of financial performance, and is calculated by the below formula: (Maguire & Wayte, 2007)
ROCE = x100
Capital employed = Total assets less liabilities + Shareholder's fund
Zara UK's ROCE for the year 2008 is:
ROCE=x100 = 4.87 %
Companies tend to aim as high a value as possible in ROCE, provided that they do not take on anymore risk. (Maguire & Wayte, 2007)
In order to evaluate the operational performance of a company in past years, the most appropriate way is to measure the net profit margin ratio, which represents the percentage of net profit over the sale revenue during a certain period, is expressed as: (Maguire & Wayte, 2007)
Net profit margin = x100
For the year 2008, the net profit margin for Zara UK is:
Net profit margin = x100 = 2.01 %
There are vast number of factors will have a significant effect on the net profit margin including competitions in the market and the risk level of the company as well as the gross profit, which is representing the difference and relationship between sales revenue and the cost of goods sold. This ratio is a percentage expressing the profitability of goods selling and buying before any expenses take place, and is expressed as: (Maguire & Wayte, 2007)
Gross profit = Sales revenue - Cost of goods sold
Gross profit margin = x100
For the year 2008, Zara UK's gross profit is:
Gross profit margin = x100 = 58.31 %
Verdict (2008) suggested that higher margins are established within the luxury brands having signature looks with less direct competitors on price. Before the UK recession, gross profit margins vary from 50% for mid-market retailers and 70% for premium market; it indicates that Zara UK is operating in the mid-market with reasonable gross profits. (Verdict, 2009) Market and investment analysts can only access a company's success after they have calculated and compare the above ratios in a few years of financial statements.
Liquidity of a business is vital as it indicates the ability of a company paying debts as well as the ability of its debtors to repay the company. It is very important for lenders and suppliers identifying the ability of a company to pay bills and for stakeholders including shareholders and employees knowing the company they are working for is going to stay operating or not. Generally liquidity can be calculated in two ratios: current and acid test. Current ratio shows whether the company has sufficient current (short-term) assets, those can be converted into cash quickly, against current liabilities: (Wood & Sangster, 2005)
Current ratio =
In year 2008, Zara UK has current ratio of:
Current ratio = = 0.86 times
High level of liquid corresponds to a high current ratio, and it is more preferable, though it may be indicating cash is tied up or being wasted in the company. (Maguire & Wayte, 2007) Wood & Sangster (2005) suggests the norm for retailers in this ratio is often below 1:1 for having adequate liquidity. However, for many companies, stock may not be able to convert into cash quick enough all the time to meet the current liabilities and so the second way of investigating liquidity is by acid test ratio:
Acid test ratio =
Acid test ratio of Zara UK in 2008:
Acid test ratio = = 0.57 times
If the acid test ratio is far from the norm, which should be around 1, then the company may be experiencing liquidity problems covering the current liabilities. (Maguire & Wayte, 2007)
Stakeholders especially banks are most concern about the companies' gearing ratios, which is the ratio of long-term debt (liabilities) to capital employed which can be expressed as shareholders' funds in balance sheet including long-term liabilities. Companies tend to raise their capital by debts including long-term loans and debentures and gearing is used to evaluate the long term financial risk. In principle, company usually sets a target gearing ratio, however, does not tend to achieve in practice. Company with higher gearing ratio represents more borrowing and risks it has, looking at the bright side, this company has more possibilities enhancing the return to shareholders by making more risk and volatile return. (Walton, 2002) Gearing ratio is calculated as below:
Gearing = x100
Capital Employed = long-term liabilities + shareholder's funds
Zara UK's gearing ratio of year 2008 is:
Gearing = x100 = 8.74 %
A company with a high percentage gearing (65%+) is considered to be high geared, indicating borrowed more money and at high risk; whereas with a low percentage (0-30%) is said to be a low geared (risk) company. Companies with high gearing tend to charge relatively higher product prices making sure the profits cover the bills. After reviewing gearing ratio, lenders such as banks are likely to take a further step investigating the interest cover ratio of the companies especially high geared, whether there is sufficient cash flow to keep the business running as well as to repay the loans and interests, and thereby decide whether they should lend more money to the companies. (Walton, 2002) Interest cover ratio can be calculated as:
Interest cover ratio =
For the year 2008, the interest cover of Zara UK is:
Interest cover = = 16.40 times
The lower this ratio is, the greater risk for the company being unable to cover the loans and interests, the greater risk for the banks to lend money, moreover, increased risk to shareholders that banks may take over the company to repay the loans and interests. (Maguire & Wayte, 2007) In good times, banks would expect the interest cover of or more than 5 times in order to consider lending money, however, it is not unusual to see this coverage drop as low as 3 times. (Walton, 2002)
For both retailers, I have interpreted 5 years of financial ratios, ZARA UK from 2005 to 2009, however, due to 2009 data of GUCCI UK is not been published on FAME, I have calculated from 2004 to 2008 instead and having to calculate the ratios for both retailers, we can now compare and identify their trends.
Mintel (2008) reported that for luxury brands, there was "solid performance" on sales during first quarter of 2008 when they were starting to see the effects from economic downturn, but Gucci experienced "softer growth", indicating Gucci was doing slightly better than other retailers in UK luxury market.
Table 1a shows Gucci UK is improving in ROCE, which its stakeholders such as suppliers and lenders would be happy to see this growth for Gucci may be repaying loans and debts, though by looking at figures of shareholder's funds, Gucci seems to be asking shareholders to invest more but not paying dividends in return. Zara UK is not operating as good (see Table 1b), there is a significant decrease in 2008, indicating the return to lenders and suppliers is less though Zara is eliminating the long-term debts, and stakeholders may be worried continuous declining for the recession will not be recovered till 2011 as forecasted by Verdict (2009).
Turnover of both Zara and Gucci in UK increases steadily (see Table 2), however net profit declined rapidly in 2008 due to recession, interpreting a negative growth in net profit margin, though by calculating the gross profit margin, both retailers are doing as good with steady trend in past five years within 7% up and down even during the downturn in UK. Nevertheless, before recession gross profit margin for luxury markets researched by Verdict (2008) should be around 70%, indicating though Gucci's margin is not bad, though perhaps it is not operating as good as the rest of market segment. The trend (see Table 2c & 3c) of net profit ratio for both retailers is not quite healthy relating to the gross profit, perhaps suggesting for both retailers having more expenses including VAT, store rentals. For year 2010, VAT is announced to increase back to 17.5% from 15% in 2009, and if Gucci UK keeps expenses and sales unchanged, then its net profit most likely will decline continuously.
The norm for both current and acid test ratio is said to be around 1, by reviewing both ratios for Gucci and Zara in UK (see Table 4 & 5), the ratios of Zara are not too far off from the norm, is trying to keep to a stable level of risk and operating business in a better way having sufficient cash flow. Stakeholders would be pleased to see these ratios especially after the recession in 2009; the liquidity level does not drop to a very low level. Comparatively, Gucci UK is not operating as good, having low current and acid test ratios during recession and as predicted by Verdict (2009) the recession is going for a prolonged period, perhaps these ratios will drop further in 2009, and it is not a good sign for all stakeholders that this company will be at higher risk then previous years and more possibilities not paying bills on time.
By reviewing the gearing ratio (see Table 6), perhaps Zara is doing better than Gucci in UK with declining financial risks. Zara UK adopts Just-in-time strategy, successfully reduces long-term liabilities and lowers gearing ratio, showing Zara UK is not borrowing huge amount of money, thereby with less risk and at the same time paying more dividends to shareholders, making shareholders with more confident and satisfactory. However, it is also caution to have too low gearing for the business not holding enough money to expand whereas competitors may grow faster using debts. Table 7 shows increasing ability to repay the interests and loans to lenders and suppliers until 2009 by looking at the interest cover ratio decreased to -23, also suggests that perhaps Zara UK is not able to repay interest in 2009, fortunately Zara holds reasonable amount of stock in the account which can then be generated into cash and cover the bills.
On the other hands, Gucci UK stays on the high geared level indicating its financial is at high risk most of the times in past five years, shareholders in particular will not be satisfied to see this as they tend to prefer lower risk, at the same time not receiving any dividend. There will be more risk for lenders may not be able to get money back on time whilst Gucci requires extra capital to keep business running, and reviewing the interest cover ratio, Gucci UK is not been able to repay interests since 2007, banks are unlikely to make their situation more risky by lending more money to Gucci. One way of decreasing gearing ratio is by selling stocks, generating more profits and sales to have sufficient cash flow, for which Gucci launched temporary store and outlet in London this year trying to attract more customers buying its products. (Drapers, 2009) High gearing may be one of the factors that drives Gucci products so expensive, so will Zara UK increases prices in the coming years in order to improve its interest cover ratio?
In terms of profitability performance, Gucci UK is performing at the marginal level in the premium market, whereas Zara UK is gaining relatively high profit in mid-market. Both retailers are affected by the recession in 2008 with declining percentage of profit. Liquidity of Zara UK is generally better than in Gucci UK due to its adoption of Just-in-time strategy, which also reduces its financial risk by obtaining less debt over suppliers and lenders, resulting building more confidence from stakeholders. Gucci UK maintains with slightly poor performance comparing to Zara UK both before and during the recession, having higher risks, less liquidity, even gross profit margin, although product prices can be marked up even higher to cover the bills. It is crucial to have adequate cash flow especially in this downturn while retail market is adversely impacted by lack of liquidity; also companies need to be prepared for extra expenses including increasing VAT in 2010, without taking up anymore debts and risks. Most of ratios in both retailers are going down in the recession and are likely to decrease more till 2011 when this economic downturn is going to be recovered.