Tesco’s 2012 Annual Report: A Critical Analysis of Operational and Financial Conditions Through Ratio Analysis

Tesco was established in 1919 and now has become the largest retailer in the UK, the second largest retailer measured by profits and third largest retailer measured by revenues in the world. It has operations in 14 countries with 520,000 people employed and millions of customers served every week (Tesco, 2013). Tesco’s 2012 Annual Report has just published, through which we can critically analyse the company’s operational and financial conditions.

There are numerous relationships between the figures published in the annual report, and ratios have been commonly used for conducting a quantitative analysis of these relationships (Atrill and McLaney, 2013). They are calculated by comparing the current year numbers (2011-12) with previous years (2010-11) and other companies. Hence, J Sainsbury plc (known as Sainsbury’s) is chosen since it is the major competitor of Tesco at home. The ratios can be classified into five categories, namely profitability ratios, liquidity ratios, activity or efficiency ratios, gearing ratios and investment ratios. When using the ratios to assess two companies’ performances, relevant social, political and economic changes will all taken into account.

Profitability Ratio

Profitability ratios are the ratios used to assess a company’s capability to generate earnings in comparison to its expenses and other relevant costs. Major profitability ratios include return on investment (ROI), return on capital employed (ROCE), gross profit margin and net profit margin. Firstly, ROI is a concept evaluating the efficiency of an investment, and equals to ‘net profit after tax’ dividing ‘shareholders’ funds’. For Tesco, its ROI for the financial year 2011-12 was 15.8, decreased by 1.9% from previous year. Nevertheless, it is still better than Sainsbury’s, which got only 10.6%. Therefore, it can be argued that in general the investment on Tesco is more efficient and you can get better return.

Besides ROI, ROCE is a similar concept which is a relative profit measurement demonstrating the return the business generated from its gross assets. A higher ROCE shows that the company is using its capital more efficiently. In consequence, ROCE should be higher than company’s capital cost, otherwise it tells us that the company is not employing its capital effectively and is not generating shareholder value.

It is calculated by ‘profit before interest and tax’ diving ‘shareholder’s funds + long-term debt’. Tesco’s ROCE for the financial year 2011-12 was 13.3%, higher than previous year’s 12.9% and Sainsbury’s 11.1%. The rise of ROCE to some extent resulted from the discontinued operation of Japan. From this point of view it can be argued that Tesco made a right decision to exit from Japan where its investment failed to generate good returns (The Telegraph, 2012).

Moreover, gross profit margin and net profit margin are the other two commonly used profitability ratios. The former is defined as the percentage between ‘gross profit’ and ‘sales’, whereas the latter is the percentage between ‘net profit’ and ‘sales’. For Tesco, the two ratios both decreased compared to previous year: The gross profit margin reduced from 8.5% to 8.2% and the net profit margin reduced from 6.0% to 5.9%. It means that this year the company failed to control cost as well as last year. The reduction was caused by various reasons. First of all, the economic downturn in the UK, particularly the high petrol prices and falling real incomes affected customers’ discretionary spending significantly(BBC News, 2012). In addition, 2012 was a transition year for Tesco .

The company not only changed its chairman, CEO and a number of other senior managers, but also made some adjustment on organisational structure and business focused. Finally, the company decided to increase investment so that to improve customers’ shopping trip, making trading profit declined. In spite of these challenges, Tesco still outweighed Sainsbury’s on profitability, which got 5.4% and 3.6% respectively.

Liquidity ratios
The second category of ratios called liquidity ratios, which are utilized to determine the ability of a company to pay off its short-term debts. There are important as companies must ensure that these ratios are liquid otherwise they may have problem in paying back its creditors. Two important liquidity ratios are current ratio and acid test ratio.

Current ratio measures ‘current assets’ (cash +debtors + stock) against ‘current liabilities’. Tesco’s current ratio in 2012 was 2.01, reduced from 2.12 in 2011. The current asset was rising, but it failed to offset the bigger rising of current liabilities, which was mainly led by the increased short-term borrowings. In 2012 there was a €1500 million medium term note (MTN) matured. Nevertheless, it still outperformed Sainsbury’s, whose current ratio was 1.84 in 2012. Because Tesco’s current ratio for the past two years were both greater than 2, it means that the company has no problem to meet creditor’s demands.

Acid test ratio differentiates current ratio by excluding stock from the equation as stock may not easily be converted into cash. Tesco’s acid test ratios for the past two years were 1.56 (2011) and 1.45 (2012) respectively. Though decreased by 7.1%, it still great than 1 and Sainsbury’s 0.99, again indicating that Tesco has enough short-term assets to cover its short-term liabilities without selling inventory.

Activity/Efficiency Ratios
This category of ratios, which mainly includes ratios such as asset turnover, stock turnover, debtor days and creditor days, measures how well a company utilizing its internal assets and liabilities.

Primarily, asset turnover, which equals to ‘sales’ dividing ‘total assets’, measures how efficiency a company is in using its assets to achieve sales revenue to the company. Tesco’s asset turnover ratio in 2012 was 1.27, lower than its previous year’s 1.28 and Sainsbury’s 1.81. Since those companies with low profit margins tend to have high asset turnover ratio whereas companies with high profit margins tend to have low asset turnover ratio, Tesco has bigger profit margin than Sainsbury, and this advantage has been expanded. We should also realize that companies in the retail industry like Tesco and Sainsbury tend to have higher asset turnover ratio than companies in other industries because of their competitive even cutthroat pricing.

In addition, the stock turnover ratio indicates how many times a company’s stock is sold and replaced over a period, for instance a year, and is calculated as ‘cost of sales’ divided by ‘stock’. According to this formula, we can get the results of 17.50 and 16.48 for Tesco in 2011 and 2012 respectively and 22.48 for Sainsbury’s in 2012. The numbers are within the appropriate interval. A very low stock turnover rate may indicate overstocking whereas a overtop rate may point to stock shortage, which further result in the loss in business. From this point of view, both of the companies manage the stock appropriately.

Thirdly, debtor day measures the number of days, on average, that customers take to pay. The formula is ‘debtors (accounts receivable) / sales * 365’. Companies should ensure that its debtor ratio is neither too high nor too low. Otherwise it may face potential risks of either losing customers or losing profit by bad debt. Since most of the retailing business is cash business, supermarkets usually have very short debtor days. Tesco’s debtor days for the past two years were 14 days (2011) and 15 days (2012) respectively while Sainsbury’s has a even shorter debtor day of 5. Creditor day, on the other hand, measures the number of days, on average, that companies take to pay its suppliers.

It is calculated by ‘accounts payable / cost of sales * 365’. From the formula we can get that Tesco had 60 creditor days for the past two years. Together with a very short debtor day, it is evident to see its bargaining power in the market. This helps Tesco maximize profits. Sainsbury also has a big creditor day of 47 days, indicating its strong bargaining power as well.

Gearing Ratios
Another category of ratios is defined as gearing ratios, including gearing and interest cover ratio. Gearing is defined as the portion of net assets financed through debt rather than equity, and the calculation formula is ‘long-term debt / shareholders’ funds + long-term debt’. The aim of the calculation of gearing ratio is to see whether the company is able to get a healthy long-term financing. Tesco and Sainsbury’s both have good gearing ratios. For Tesco, its gearing ratio in 2012 was 38.4%. In comparison with 40.8% in 2011, it reduced by 5.9%. The decreased gearing reflected Tesco’s stable debt position despite the investment in assets growing. For Sainsbury’s, its gearing ratio in 2012 was 31.7%, meaning that it used even smaller portion of debt to finance net assets.

Investment Ratios
The final category of ratios is referred to as investment ratios, which are mainly calculated to meet the interests of shareholders and potential investors of the company. The most commonly used shareholder returns rations include dividend per share, dividend yield, and earnings per share (EPS).

First, dividend per share, equalling ‘dividend paid’ divided by ‘number of shares’, reflects the belief of the company’s management towards its future growth. For instance, a growing dividend means that the company’s management is confident that the growth can be sustained. Tesco’s 2012 full year dividend was 14.76p, which was an increase of only 2.1% on last year, but lower than Sainsbury’s 16.1p. Although the company continued the record of consecutive years of dividend growth in the FTSE 100, for its shareholders, 2012 was a tough year. The company’s management explains that this was due to their new strategy to forego some short-term profit to re-invest in the long-term health of the business.

Second, dividend yield shows how much a company pays out in dividends each year relative to its share price. In the absence of any capital gains, it equals to the return on investment for a stock. Dividend yield can be calculated according to the formula ‘dividend per share / Market price per share’. On 30th March 2013, Tesco and Sainsbury’s dividend yield were 4.24 and 4.14 respectively.

Furthermore, earnings per share, known as EPS and calculated as ‘profit after tax’ dividing ‘number of shares’, shows the profit (or loss) made by every issued share. It is an important indicator of a company’s profitability, and also the single most significant factor in determining the share price. In 2012 Tesco’s EPS was 37.4p, increased by 2.1% from 2011 and higher than its competitor Sainsbury’s 28.1p. Consequently, we can argue that Tesco achieved a modest profit growth in 2012 and it is more profitable than Sainsbury’s.

Non-financial performance analysis
Financial information particularly the ratio analysis has its limitations. Therefore, we need to analyse non-financial information as well. Primarily, from the scale of the business, Tesco definitely enjoys a larger business scale. It has businesses in 14 countries throughout the world and the total stores numbers is 6,234 in 2012. By contrast, Sainsbury’s on operates in the U.K. with around 1,000 stores. Additionally, from the brand reputation and value aspect, Tesco in general outweigh Sainsbury’s to a large extent, particularly in global markets. Nevertheless, at home Sainsbury’s brand awareness is almost as famous as Tesco since the company is using competitive pricing strategy and providing fresh goods to improve customer loyalty.

Conclusion
To sum up, this essay has used five categories of ratios to critically assess the financial performance of Tesco in view of previous year’s results and the competitor Sainsbury’s. Generally speaking the company delivered modest profit growth in a challenging economic environment, with a strong international performance largely offset by a reduction in UK profits. Owing to strategic changes on organisational structure and business focused, Tesco’s financial performance was negatively affected. Nevertheless, in many aspects such as profitability and liquidity it still outperformed its major competitor Sainsbury’s. It is confident that the company is able to pass the period of change and development smoothly and its future prosperity can be expected.

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Tesco’s 2012 Annual Report: A Critical Analysis of Operational and Financial Conditions Through Ratio Analysis. (2016, Jul 15). Retrieved from https://phdessay.com/tesco-plc-2012-annual-accounts-compare-them-with-sainsbury-plc-as-appropriate/

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