Tesco is a leading food and grocery retailer. It is UKs leading retailer and also operates in Europe, US and Asia. It has 4,331 stores in 14 countries worldwide. Tesco is operating in single segment that is retail. But it can examine by its stores formats: Express, Metro, Superstore, Extra and Homeplus. There are 960 Express stores, 170 Metro stores, 450 superstores, 175 express and 270 homeplus. Tesco not only offer products in stores, it also offer retailing services through its online shopping channels, tesco.com and Tesco Direct. Tesco also provide other services such as Tesco broadband, Tesco Mobile and Home Phone through a joint venture with O2. It also provides financial services to its customers through Tesco Personal Finance which offers a choice of 28 products ranging from savings accounts and credit cards to car and travel insurance. In short it can be said that Tesco is main dealing in retailing with different product lines.
SWOT Analysis:
The researcher used SWOT analysis because it is a useful technique for summarising the key issues arising from an assessment of a business "internal" position and "external" environmental influences.
Strengths
Low Cost
Market Leader
Investment in IT for efficient operation
Weakness
Product recall in 2009
Opportunities
Investment in New Stores
Entering new markets
Threats
Recession
Competitors in UK market (Asda, Sainsbury, Somerfield etc.)
Analysis:
As researcher has selected Tesco to do the financial analysis, now the researcher will go through all topics which have been studied in this module to analyse the financial position of Tesco.
Investment Appraisal:
Investment is the key decisions of financial management. It is financial manager's responsibility to allocate all financial resources to attain the organisational objectives. The main objective of an organisation is to maximise the share holder wealth. So it is important that financial manager understand the short, medium and long-term capital requirement for investment in fixed assets and working capital that will maximise the share holder wealth and fits with the overall strategy of an organisation.
To design the financial strategy of an organisation, investment appraisal techniques are used. Following are the possible investment appraisal techniques:
Payback Method
The payback method is a technique to evaluate an investment project. The payback method focuses on the payback period. The payback period is the length of time in which organisations recover the initial cost of the project. This period is sometimes referred to as" the time that it takes for an investment to pay for itself." This payback period is than compared with the acceptable period. If the payback period is less than acceptable period and there are no other constraints, it is more likely that the project will go ahead. The other premise of the payback method is that the more quickly the cost of an investment can be recovered, the more desirable is the investment. The payback period is expressed in years. When the net annual cash inflow is the same every year, the following formula can be used to calculate the payback period. (www.accountingformanagment.com)
Formula
The formula used for the calculation of payback period is as follows:
Payback period = Investment required / Net annual cash inflow*
*If new equipment is replacing old equipment, this becomes incremental net annual cash inflow.
Accounting Rate of Return (ARR)
This method of estimating the rate of return from an investment using a straight-line approach (not discounted or compounded). The investment inflows are totalled and the investment costs subtracted to derive the profit. The profit is divided by the number of years invested, then by the investment cost, to estimate an annual rate of return. The method is not as sophisticated as a discounted approach, which is used by modern accountants. (www.allbusiness.com)
Formula
The formula for the calculation of ARR is as following:
Average annual profit
X 100
Project Investment
Net Present Value (NPV)
In this method determine whether the expected financial performance of a proposed investment promises to be adequate when measured against a cost of capital. If the NPV is positive, it means that the project will increase the wealth of an organisation. The main of the organisation is to maximise the wealth of the share holder. By selecting the project with positive NPV help the organisation to achieve its objectives.
Calculation of NPV
Following is the recommended format to calculate NPV in this module:
Year
0
£000
1
£000
2
£000
3
£000
4
£000
5
£000
Receipts
X
X
X
X
Payments:
Wages
(X)
(X)
(X)
(X)
Material
(X)
(X)
(X)
(X)
Variable/Fixed overheads
(X)
(X)
(X)
(X)
Administration/Distribution expenses
(X)
(X)
(X)
(X)
Taxable Cash Flows
X
X
X
X
Tax: Corporation Tax
(X)
(X)
(X)
(X)
: Capital Allowance
X
X
X
X
Initial outlay
X
Net Realisable Value
X
Working Capital
(X)
X
Net Cash flows
(X)
(X)
X
X
X
(X)
Discount rate (e.g. 12%)
1
0.909
0.826
0.751
0.683
0.621
Present Value
(X)
X
X
X
X
(X)
Net Present Value £XXX
Sensitivity Analysis
"This analysis is in which key quantitative assumptions and computations (underlying a decision, estimate, or project) are changed systematically to assess their effect on the final outcome. Employed commonly in evaluation of the overall risk or in identification of critical factors, it attempts to predict alternative outcomes of the same course of action. In comparison, contingency analysis uses qualitative assumptions to paint different scenarios." (www.businessdictionary.com)
The aim is to seek out which of the variables of the project could have the most adverse impact on the profitability of the project. The aim is then to consider the most that these variables could move to before NPV of the project becomes zero. e.g. sales could fall by 10% or costs may rise by 20% or output could fall by 10% or discount rate could increase by 5%. In this analysis, the organisation has to take in consideration the impact of these variable before making an investment.
Implementation on Tesco
Tesco is leading retail store chain. As it had been discussed before that the primary objective of the organisation is to maximise the shareholder wealth. To achieve this objective, Tesco also invest in different projects. Their main aim is open new stores and launch new products, so Tesco can out number their competitors. But while doing so Tesco have to consider that the investment it is making will fits with the overall strategy. If we examine the overall operation of the Tesco, its main investment is to open new stores around the world. Before Tesco open a new store, Tesco might use different technique to determine that the investment they are make is a profitable venture for their shareholders.
Tesco might use different approaches for its new investment. If we consider new product launch by Tesco, it will ask different questions to itself e.g.
How much it will cost?
How long it will take to make profit on it?
Which stores are in high demand of this product?
When we should launch it?
How long it will take us to recover the cost?
These are few example questions which Tesco might ask itself before doing an investment. To answer above questions Tesco will use different technique like ARR, NPV, Payback method etc. e.g. NPV. If Tesco use NPV technique on this investment, it knows that if NPV is positive it will take this project into consideration and if its negative it will not go ahead with this investment. By this technique it will take account of the time value of money and therefore the opportunity cost. Tesco can also adjust the discount rate to take account of the different level of risk inherent in this investment. It can also combine this technique with sensitivity analysis to quantify the risk of the investment.
The Weighted Average Cost of Capital (WACC)
To understand WACC, we have to understand the cost of equity and the cost of debt.
The Cost of Equity - Ke
The cost of equity is the rate of return the shareholders expect to receive on their investment. The cost of equity can be calculated by two models:
The dividend valuation model with constant dividends
The dividend valuation model with constant growth
The Dividend valuation model with constant dividends
Ke = d/Po
Source (Corporate Finance Environment, Study Notes)
Where Ke = Cost of Equity
d = Constant dividend
Po = the ex div market price of the share
The Dividend valuation model with constant growth
Ke = d1/Po x g
Source (Corporate Finance Environment, Study Notes)
Where g = Constant growth in dividends
d1 = Dividend to be paid in one year's time
The Cost of Debt - Kd
The cost of debt is the rate of return that debt providers require on the funds that they provide the organisation. The value of debt is assumed to be the present value of its future cash flows.
Debt is tax deductible and hence interest payments are made net of tax.
Debt is always quoted in £100 nominal units or blocks.
Interest paid on the debt is stated as a percentage of nominal value. This is known as the coupon rate. It is not the same as the cost of debt. The amount of interest payable on the debt is fixed. The interest is calculated as the coupon rate multiplied by the nominal value of the debt.
Debt can be: irredeemable or redeemable at par or at a premium or discount.
Interest can be either fixed or variable.
Source (Corporate Finance Environment, Study Notes)
WACC
WACC is a calculation of an organisation's cost of capital in which every source of capital is weighted in proportion to how much capital it contributes to the company. e.g, if 75% of a company's capital comes from stock and 25% comes from debt, measuring the cost of capital weights these accordingly. A high WACC indicates that a company is spending a comparatively large amount of money in order to raise capital, which means that the company may be risky. On the other hand, a low WACC indicates that the company acquires capital cheaply. (www.financial-dictionary.freedictionary.com)
Procedure for Calculating the WACC
Following are the steps involved in calculating WACC:
Calculate weights for each source of Capital.
Estimate the Cost of each source of Capital.
Multiply the proportion of the total of each source of capital by the cost of that source of capital.
Sum the results of step 3 to give the weighted average cost of capital.
Formula
ko = keg [VE/VE+VD] + kd [VD/VE+VD]
Source (Corporate Finance Environment, Study Notes)
Implementation of Tesco
Tesco have to raise funds for its investment in to products or new stores. To raise capital Tesco either have borrow money or offer shares to public. While doing so Tesco have to keep an eye on WACC because if spend high amount of money in raising capital. It means Tesco is putting itself into risk and people will not invest in it. So if Tesco want to continue to invest in new venture, it should try to acquire capital as cheaply as possible.
Capital Structure
In most of the organisations capital consists of two thing equity and debt. The value of the organisation changes with the change in capital structure. Organisations have different choices to finance their investment. This financing can be through equity, debt and their various mixed forms or through retained earnings. The organisations always try to find best mix of equity and debt to minimise the cost of capital. Cost of capital of a company is the minimum expected return from that company or project that is being undertaken by that company.
The organisation's gearing level represents how much debt is being used by that organisation in comparison to equity. According to Modigliani and Miller (1958), when there are no taxes and capital markets function well, it makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure. Implications of MM theorem are that gearing is unimportant and firm's value will be determined by its project cash flows (Damodaran, 1997). The cost of capital does not change as gearing level of the company increases. As a firm increases its leverage, the cost of equity will increase just enough to offset any gains to the leverage.
MM theory can be criticised on grounds. MM theory assumes that there are no taxes but in reality taxes do exist and. Also, in practice, interest on debt is tax deductible where as cash flows on equity (like dividends) are not. This theorem also assumes that there is no agency cost i.e. managers maximize shareholder's wealth. Another assumption is that markets are perfect, in other words, corporate insiders and outsiders have the same information. But later Modigliani and Miller (1963) amended their model and include corporation tax in it. By the implementation of this model M & M conclude that geared companies have advantage over ungeared companies, i.e. they pay less tax and will, therefore, have a greater market value and lower WACC.
Implementation on Tesco
As it had been discussed before, that Tesco have to be carefully while raising finance for investment. While deciding about capital structure, it should keep in consideration that if Tesco will attain cheaper debt than equity which will cause the WACC to fall. It will be good for them. But if Tesco gets debt on higher interest rate, it has adverse effect on its position. Tesco should also look into all the associated factors like tax implications, agency costs, default risk, bankruptcy costs, cost of servicing the debt, business risk before deciding its capital structure.
Working Capital
Working capital refers to cash that firms need to pay for their daily operations. They have to pay bills, pay for raw materials etc. McClure, Ben (2007). Working capital is known as the net balance of sources of funds and operating uses. Positive working capital indicates that assets exceed liabilities and it needs to be financed. Negative working capital indicates liabilities exceed the assets, so the firm lacks the capability to spend. Vernimmen, P; Quiry, P.; Le Fur, Y (2006)
Working capital management
The decisions an organisation takes relating to working capital and short term financing are referred to as working capital management. This involves, how an organisation maintain the relationship between its short term assets and short term liabilities. The main objective of working capital management is to ensure that the organisation is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.
There are four main areas in which firms have to make decisions about working capital management
Cash Management
Inventory Management
Debtor Management
Short term financing
Implementation on Tesco
As defined above the working capital is the cash which is use continue the operation of an organisation and to have sufficient cash flow to satisfy both maturing short term debt and upcoming operational expenses. So it very important for Tesco to manage its working capital, Tesco can use two types of approaches to manage its working capital.
Aggressive Approach
Relaxed Approach
If Tesco uses aggressive approach, it has lower levels of current assets therefore lower financing costs. This low financing cost could result in better profitability. The quicker cash turnover also allows Tesco to reinvest and it will result in to expansion of business. On the other hand, if Tesco uses relaxed approach, it has less risk of running out of cash. Tesco had more ability to meet a sudden surge in sales demand. This relax approach can lead Tesco to relax its credit policy for receivables which may improve its sales.
Whichever approach Tesco takes it should keep some sort of reservoir of cash just like a reservoir or petrol in a car which is only to be used in emergency. This means that Tesco can respond to deteriorating circumstances while still pulling itself out of trouble. Tesco should not take all investment opportunities. In short, the whole success of Tesco is built around good planning.
Ratio Analysis
There are different types of ratio analysis which is used by the financial manager to see that is business is doing better than last year or not.
Profitability Ratio
Measures that indicate how well a firm is performing in terms of its ability to generate profit.
Gross Profit Ratio
Gross profit ratio indicates how efficiently an organization is producing goods and what changes can be made in the price of goods or services to avoid losses. To find gross profit cost of goods sold (COGS) is deducted from total sales and higher gross profit reflects the sound position of the company. Higher the gross profit the more will be net profit which can be found by deducting all operating and interest expenses.
Years
2009
2010
Tesco
7.76%
8.10%
Source: Tesco Annual Report (Appendix A1)
Analysis
From the above calculations we can see that Tesco's Gross profit ratio is increased from 7.76% to 8.10%. This increase can be of because there is a increase in Tesco sales in 2010. There is also possibility that Tesco has reduced its cost of good. These reasons an play a significant role in the increase or decrease in gross profit ratio.
Net Profit Ratio
Net profit ratio indicates overall profitability of the organization. This is the ratio that investor will be ultimately looking for. Low net profit indicates problem in the operations of organization. An organization with high net profit ration will be in a better position to overcome adverse economic conditions and can get competitive advantage over competitors. Although profit ratios are good indicator of organization's of financial position and firms with higher profitability ratios are considered good but one need to look at other aspects such as investment and capital introduced by the owners.
Years
2009
2010
Tesco
3.97%
4.10%
Source: Tesco Annual Report (Appendix A1)
Analysis
From the above variance calculations we can see that Tesco Net profitability is raising from 3.97% to 4.10% which clearly give an idea that Tesco is controlling its expenses very well. Tesco profit has increased in 2010 and its net profit ratio also increased, which indicates that Tesco is performing really well.
Return on Capital Employed Ratio (ROCE)
ROCE ratio is most effective of profitability in order to analyse the performance and efficiency of the business. ROCE tells us how effectively management has utilized the assets of organization over a specific period. It helps managers to take decisions.
Years
2009
2010
Tesco
22.83%
31.09%
Source: Tesco Annual Report (Appendix A1)
Analysis
Above calculation shows that there is increase in ROCE in 2010, it means that Tesco is using its capital really well. That's why the return on the capital is increased which will open door for new investment.
Liquidity Ratio
To measure the ability of the VM UK to pay off its short-terms debt obligations.
Acid Test Ratio
Acid test ratio also known as quick asset ratio and indicates extremely liquidate assets available to pay the short term liabilities. Usually any value below 1 to 1 indicates an influential "dependency" on stock or other current assets to liquidate short term liabilities.
Years
2009
2010
Tesco
252.96%
203.83%
Source: Tesco Annual Report (Appendix A1)
Analysis
Above calculation shows that in 2009 Tesco has more than 250% of current assets to pay its current liabilities. But in 2010, it decreased but still Tesco is in good position to pay its short term liabilities.
Current Ratio
Current ratio indicates an organization's capacity to meet its present short term liabilities. A higher current ratio indicates strong position of the organizations and shows organization can meet its current obligations effectively.
Years
2009
2010
Tesco
317.81%
276.82%
Source: Tesco Annual Report (Appendix A1)
Analysis
This calculation again shows that Tesco have significant amount of current asset to pay its short term liabilities. The current ratio is really high and Tesco is in really good position to all it current liabilities.
Overseas Investment
As Tesco is expanding its business to different countries, it can face these type of potential problems
Taxation
Political Problem
Restriction on Remittance
Intercompany Cash Flow
Tax
When Tesco is trying to do business in different countries, it can face problem with the tax rate. Because the tax there can be different tax rates in different countries, e.g. in US Tesco pay 25% tax but UK tax rate is 33%. So Tesco have to pay 8% more tax in UK.
Political Problem
Tesco can face different political problems while working in foreign countries. The Government can put different legislation on foreign organisation. Such as:
Minimum number of local employees
Temporary suspension of currency convertibility
Joint venture with local company
High tax on foreign firm
Invalidating patents
These are few examples of possible problem Tesco can face. There are other problems also which Tesco have to keep in mind before making any foreign investment.
Restriction on Remittance
Tesco can face this problem that it is not allowed to send its all profit to its host country i.e.UK. Because the Government can say that Tesco can only sent 20% of its profit to its home country, it can have adverse effect on Tesco operations.
Intercompany Cash Flow
Intercompany cash flows also impinge on the tax computations. In reality the whole issue of whether or not an inter company cash flow (such as royalty payments made by the US project to the UK parent) are or are not allowable for tax purposes in a very politically sensitive issue.
