Financial Analysis – Tesco PLC

Tesco PLC Financial Ratio and Trend Analysis

1 Background

Tesco is the largest retail and discount stores chain in the UK. Including UK, Tesco also has operations in 14 countries around the world with total sales of £59.4 billion. According to 2009 data, Tesco is the third largest retailer in the world behind only Wal-Mart of the US and Carrefour of France. There are about 470,000 employees working for Tesco including all of its subsidiaries. Tesco has a very wide variety of businesses in its portfolio which includes groceries, clothing, white and brown goods, financial services, insurance products, music, internet services and software. Already having established its supremacy over other competitors in the UK, Tesco has been focussed on expanding its operations to a number of developing countries. This has been part of its core strategy to improve the top-line through geographical diversification. In 2009, Tesco acquired 36 hypermarkets from E-land, a domestic retailer in South Korea. Besides these acquisitions, Tesco also added nine million square foot of floor space to its existing chain of supermarkets in South Korea (Tesco, 2009). Tesco also has ambitious plans for China and India, two of the most populous countries in the world. The company already has 70 stores in China employing almost 20000 workers. Tesco has planned a foray into India’s nascent market for branded retail goods through a joint venture with Star Bazaar. In the UK, the home market of Tesco, there are 2306 stores with a total staff strength of 286,384. In one of the hottest battle grounds, Tesco is competing with the giant of retailing -Wal-Mart, in its home turf at US. Tesco already has 115 stores in the US and employs more than 2500 workers in these stores. In spite of its presence in Asia and North America, Tesco is still seen as a predominantly European company as it derives 66% of its total income from European countries. Clearly, the biggest challenge for Tesco will be the US market, though the largest in the world, at present accounts for just 1% of the total revenues of the company.

The biggest strength of Tesco has been its well diversified portfolio of businesses. From financial services to groceries the company has laid its hand successfully on a number of different businesses which mitigates the business risk to a significant extent. Also the groceries retailing business, which is considered the bread-and-butter of the company, is to a great extent inelastic in nature with respect to incomes. This also reduces the business risks. The major issues with respect to Tesco could be that it is seen as an overly aggressive company with little respect for ethics in business. Besides, the planned foray of Wal-Mart into Europe could have devastating consequences for Tesco. The Asian region is considered the major growth region for the company with e-tailing being one of the core growth verticals. The remaining part of this report analyses the company’s performance and position using ratio analysis and trend analysis techniques based on which recommendations are made.

2 Ratio Analysis

Ratio analysis presents an efficient and simplified way of comparing the performance of two companies or for comparing the performance of a company across different time periods (McLaney and Atrill, 2007). In this report, the performances of Tesco plc over the five year period between 2005 and 2009 are compared using ratio analysis and critical analysed. Five different categories of ratios are calculated and analysed. They are as follows:

2.1 Profitability Ratios

Gross Profit margin indicates the ability of the company to price its products well above the direct labour costs and material costs. It is observed that the gross margin of Tesco has been stable over the last five years. It has remained very close to 8% mark with minor fluctuations. The gross margin of 7.76% witnessed in 2009 is very close to the 5 year average of 7.81%. This shows that the company has managed to retain its pricing power in spite of adverse economic conditions. The net margin has seen a minor decline from 5.93% to 5.44% in 2009. Typically the net margin for the four preceding years had remained between 5.5% and 6%. Return on Capital Employed (ROCE) is considered an important measure of returns generated by the business for all investors (equity shareholders and debt-holders) together (Glynn et al., 2008). In 2009, ROCE of Tesco fell to 12.25%, the least value in the last five years. During the previous three years ROCE had remained above 15% mark. Even though Tesco has managed to retain gross margin, its inability to control overheads has resulted in declines in net margin which has reduced the ROCE. The company appears to have been adversely impacted, to an insignificant extent, by the overall decline in the retail industry witnessed as a result of the economic recession in the country.

2.2 Efficiency Ratios

Using a set of ratios, the company’s efficiency is measured in terms of its ability to turnaround stocks and debtors, its ability to delay payments to its suppliers and its ability to leverage assets to generate revenues (Dyson, 2004). Inventory turnover ratio of Tesco has seen a remarkable decline from 40.61 in 2005 to 18.77 in 2009. This slowdown in the pace of inventory turnover could be an important problem for Tesco particularly during periods of declining inflation rates. This has been the case with accounts receivables turnover as well. The receivables turnover ratio has seen a steep fall from 44.04 in 2005 to 30.22 in 2009. The average collection period has increased by 4 days between 2005 and 2009. This can cause significant lock-up of working capital. On the other hand, the strength of Tesco lies in its ability to negotiate better terms of credit from its suppliers. This is indicated by the payables turnover ratio of 5.88 in 2009. As Tesco has grown in stature through the years it has managed to secure better terms from suppliers. This is evident from the gradual decline in payable turnover as shown in the financial statements. One of the most important aspects of Tesco retail business model is that it buys from suppliers on credit and sells most of its inventory on cash basis. Only a small portion of the total sales is in credit form. The days payables outstanding of Tesco is more than the sum of days sales outstanding and days inventory outstanding. Because of these factors, the cash conversion cycle of the company is negative indicating that the company has no problem with liquidity and is usually flush with cash. This shows the efficiency of the company in managing its liquidity position which is considered critical for retail business.

The fixed assets turnover ratio has remained almost static during the last five years. On the other hand sales to total assets ratio has seen a decline from 1.68 to 1.18. This denotes that the sales has been outpacing the growth in assets of the company. This means that Tesco is becoming more efficient in using its assets to drive its business. The two most important measures of efficiency of a business are its return to assets and return on investment. The return on assets has seen a decline from 9% in 2005 to 6% in 2009. When seen in conjunction with an improvement in sales-to-assets ratio, this shows that Tesco in spite of higher efficiencies being realised in developing sales, has not been able to convert all of them into bottom line because of its inability to rein in overheads. The company has been exceptionally consistent in its return on investments. The ROI has fluctuated between 22% and 25% during the last five years. Even in 2009, the ROI of the company was 23%. This shows the efficiency of Tesco in terms of its financial and business performance has been phenomenal.

2.3 Liquidity Ratios

Liquidity has come to assume even more importance during periods of liquidity crunch as witnessed in many developed countries including the US. Current ratio which expresses current assets as percentage of current liabilities, has improved from 0.57 to 0.76. This is an important development for Tesco as even well-established companies with ready markets were finding it difficult to maintain their liquidity position and many resorted to external favours. However it has to be noted that this current ratio includes inventories which are mostly carried by the business on a sale-or-return basis from its suppliers. Therefore acid test ratio or quick ratio which excludes inventory may be of importance. The acid test ratio of Tesco declined from 0.34 in 2005 to 0.29 in 2009. This dichotomy between current ratio and acid ratio may be due to changes in inventory levels. The difference between current ration and acid test ratio has continued to widen over the last five years as it is observed that the company has focussed on increasing the level of inventory rather than reducing it. Both ratios, significantly less than 1, show that Tesco’s current assets are much less than the company’s current liabilities.

2.4 Gearing Ratio

Gearing ratio is a very important indicator of a company’s leverage position. While it is typical for companies to carry some amount of debt on their books, excessive exposure to debt can increase the level of finance risk carried by the company and deteriorate the credit quality of the company (Pizzey, 1998). From the financial statements of Tesco for last five years, it is evident that the company has doubled the ratio between debt and equity during the course of five years. Debt to networth ratio (also known as debt-equity ratio) was at 1.33 in 2005. It has risen gradually every year (except in 2006) and has reached a level of 2.54 in 2009. This shows that the debt carried by the company is 2.5 times of the total equity held in the company. The steepest rise has been seen in 2009 when the ratio increased from 1.53 to 2.54. This is due to 63% increase in long-term liabilities just in 2009. This shows that the company is likely to face problems with respect to repayment even if the economy recovers and the market stabilises. Besides, it is also possible that the credit rating of the company could get affected because of this sudden increase in leverage. Debt position remains a serious concern for the equity investors of Tesco.

2.5 Investment Ratios

Equity shareholders are the owners of a firm and the profitability of the firm, from the point of view of the equity shareholders, is determined by the amount of cash returned by the company to them in the form of dividends. Tesco has followed an incremental dividend policy wherein the dividends distributed annually to the shareholders are increased gradually every year irrespective of the performance of the company. Dividend yield, which measures dividends as percentage returns upon the share price, has increased steadily from 2.45% in 2005 to 3.59% in 2009 which augurs well for the shareholders. Because of this policy, the dividend cover of the company has fluctuated, though only marginally. The dividend cover declined from 2.47 times to 2.30 times in 2009 owing to steeper increase in dividends than in earnings. Nonetheless, a stable policy of increasing dividends helps the investors of the company because of the predictability of the dividend payments.

3 Trend Analysis

Trend Analysis is a commonly used technique to ascertain the trends in various items in the balance sheet and income statement in order to identify any failure patterns in the company. Trend analysis is based on a premise that any firm, before seeing a major decline in financial performance or financial condition goes through a period of gradual deterioration. During this period, using trend analysis, if it could be identified that the firm is on a decline, then investments in the firm could be avoided and a cautious approach could be adopted.

3.1 Rising trend in Liabilities

It is common for a fast-growing organisation to increase the level of debt on its books in order to make investments in fixed assets, which in turn help to increase the profitability of the company. A prudent organisation makes sure that the benefits derived from the additional debt are always more than the costs paid for the debt in the form of periodic interest payments. Because of this principle of prudence, long-term liabilities are typically used for the purpose of acquisition of fixed assets and not for current period purposes.

Tesco’s long-term liabilities have been on a steep rising trend during the last five years. Following graph shows the linear trend lines for fixed assets and long term liabilities of Tesco. Even though both the trend lines are on a rising course, it can be observed that the trend line of long-term liabilities is much steeper than the trend line for fixed assets. During the period between 2005 and 2009, fixed assets grew on an average of 7.96% per annum on a compounded basis. On the other hand, during the same period, long-term liabilities increased by 14.26% every year.


Following graph shows the comparison of trend lines of long term liabilities and networth of Tesco. It can be seen that the long-term liabilities have been growing much faster than the networth of the company. During the five year between 2005 and 2009, networth of Tesco increased by an average of 7.06% as against the compounded average annual growth rate of 14.26% seen in the long term liabilities.


Following graph shows the trend lines of total assets and total liabilities of Tesco. It is to be observed that the steep rise in long-term liabilities is causing a rapid increase in total liabilities. The pace of rise in total liabilities has far exceeded the pace of rise in total assets. As networth of the company is measured as the difference between total assets and total liabilities, if liabilities continue to rise steeply leaving behind the assets, it could easily lead to an erosion of the wealth of the company and its shareholders.


3.2 Rising trend in Inventories

Following graph shows the trends seen in inventories and sales. It is observed that inventories of Tesco have been rising steadily. It is normal for an organisation to increase its inventory holdings in anticipation of increase in sales. However, in the case of Tesco, the steep rise seen in inventories has outstripped the rise seen in sales. This means that the working capital is being locked up unnecessarily in inventories and the cash conversion cycle is getting prolonged.


It can be observed from the above graph that the increase in inventories has been steeper than the rise seen in sales. While the compounded annual growth rate of sales during the last five years has been 8.05%, inventories have grown by, on an average, 11.36% every year during the same period. In order to avoid excesses, Tesco should introspect and analyse its policy with respect to inventories. This is more critical during periods of declining inflation rates. Due to decrease in general price level and the common nature of the goods carried by Tesco, it is possible that the inventories could be losing value from the time they are recognised to the time they are turned around into sales. Therefore a more prudent inventory management policy may help to save the bottomline of the company.

3.3 Mounting Accounts Receivables

Typically in the retail business that Tesco is in, discounts are more common than credit sales. Companies sell mostly on cash basis and credit sales are extremely rare. Therefore accounts receivables in the books of retail companies are paltry in comparison to payables. This has been the case with Tesco as well. However it is noted that accounts receivables have been showing an increasing trend during the last five years of operations. Accounts payables used to be 6.34 times of accounts receivables in 2005. This ratio has declined steadily and has reached a level of 4.74 in 2009. It can be argued that accounts receivables tend to increase along with sales. However the following chart shows a different story.


It can be observed from the above chart that accounts recievables have seen a faster rise than sales during the last five years as indicated by a steeper slope in the trend line of accounts receivables than of sales.

3.4 Subdued share price performance

Between 26 February 2005 and 26 February 2009, the compounded average annual return from the stock of Tesco plc in London Stock Exchange is a paltry 1.5%. On the other hand, during the same period, the EPS has grown on an average by 7.91% every year and the networth of the company has increased by 7.06%. This shows that the stock market has grossly understated the performance of the company. Following graph shows the trend lines of market price and networth of Tesco.


It can be observed that the market price has been almost flat while Networth has seen a steep rise. There could be a number of differences between performance on the books and in the secondary market. It is stated that market always tries to discount the future while the accounting numbers reflect the past. Thus the market appears to suggest that the future could be difficult for Tesco. Another reason could be that during extreme conditions, market tends to get ahead of itself. As UK and other developed countries plunged into recession, the financial markets around the world have seen significant negative returns during the last year. The price as shown in the trend line may have been subdued due to the macroeconomic conditions rather than company-specific factors. If it were the case, then there appears to be an opportunity to make significant positive returns in near term as market appears not to reflect the realities of the company.

Thus mounting long-term liabilities, increasing accounts receivables, rising inventory levels and subdued market prices are some of the important failure patterns visible from the trend analysis that has been carried out.

4 Summary and Conclusion

Tesco is a market leader in discount stores and general merchandise. The objective of this report is to ascertain the financial position of Tesco using various techniques and to make a suitable recommendation on the stock of Tesco plc. The first part of the report deals with the analysis of the present condition of the company using ratio analysis taking into account the changes during the past five years. Five different categories of ratios are analysed to obtain information about profitability, efficiency, liquidity, gearing and investment. The profitability ratios show that the gross margin of the company has remained stable in spite of worsening macroeconomic conditions. On the other hand, net margin and ROCE has declined indicating that the company has not been able to control its overheads. Efficiency ratios indicate that the company’s inventory turnover and receivables turnover have declined significantly during the last five years. However a similar decline in account payable turnover has ensured that the company is flush with cash and does not have any working capital crunch. In spite of a decline in ROCE, the ROI of the company has remained stable over years. Liquidity position of the company is quite strong as there has been an increase in current ratio. The gearing ratio has been increasing sharply which could be a cause for concern. Finally, the investment ratios indicate that the company follows an incremental dividend policy and so dividends have been increasing gradually irrespective of the fluctuations in the underlying performances. Trend analysis which follows ratio analysis shows some signs of failures in some respects. The total liabilities, particularly the long-term liabilities have been seeing very sharp increases in recent times exposing the company to significant finance risk. The account receivables have also been increasing faster than sales. The company has been building up inventories at a rate faster than warranted by its sales. Finally, it is seen that the market price of the company has not reflected the rise that has been witnessed in the networth of the company.

Based on the results of ratio analysis and trend analysis, as presented in detail in the report, it can be concluded that Tesco is a strong player in its industry and the company can offer positive returns to investments made in its stocks. The regularity and predictability of its dividends are an added advantage to investors venturing into this stock. However this opinion is subject to the risks that have been identified in the books of Tesco such as increasing leverage position, increasing accounts receivables and poor management of inventory. It is believed that any action of the company taken to rectify the problems as identified above could lead to better performance of the stock. With the economy standing over the recession which jus concluded, it is possible that the macro economic factors may turn more favourable to Tesco leading to superior performances than predicted by the later financial statements and news flows.