TESCO is a UK-based multinational grocery and general merchandise retailer operating not just in the UK but also in other countries across Europe, Asia, and North America (Tesco). It is the UK's leading food retailer with a market share of 30.7% whereas third-largest retailer of the world in terms of revenues (after Wal-Mart and Carrefour). J Sainsbury is the third largest food-retailer in the UK with a share of16.9% of the total market (grocery news). Following, Morrisons is the fourth largest chain of supermarkets in the UK with 443 stores across the UK, and has a market share of 11.7% (grocery news). All three supermarkets are a part of the FTSE 100 Index Companies and the reason for choosing these companies is because on a first look of their balance sheet statements it could be noticed that all three companies have a negative working capital, and it would be interesting to learn how these companies could meet their short term obligations and how they finance their working capital with an ultimate goal of making as much profit as possible.
2.2Working Capital
According to Guthmann and Dougall (1948) working capital is defined as the excess of current assets over the current liabilities. Current assets of a business mainly include, cash, trade receivables, inventory and current liabilities are those items owed to employees (payables due) such as wages and salaries, and other items such as account payables, taxes. Therefore working capital measures how efficient a company is and how quickly can meet its short term financial obligations. According to Investopedia, working capital ratio is calculated as:
Working Capital= Current Assets - Current Liabilities.
If a company has a positive working capital, meaning that current assets are large enough to cover the current liabilities, means that the company can pay off its short-term liabilities and ensure a reasonable margin of safety. On the other hand, when a company cannot meet its short term liabilities with its current assets and the working capital is negative, means that the company cannot maintain a satisfactory level of working capital and it's likely to become insolvent or may be forced to bankruptcy (Kumar, 2001).
Details
Tesco
J Sainsbury
Morrisons
Working Capital
(£6386m)
(£1104m)
(£981m)
Working Capital Turnover
10.1
20.2
18
2.3Working Capital Trade offs
In order to analyse the working capital trade-offs of each company, the main items of current assets and current liabilities need to be considered. From the balance sheets extracted, it can be said that Tesco holds a large amount of cash in hand (£2,305m) and it is likely that this company is able to meet its financial obligations if an immediate expense comes up (Moles et.al, 2011). However, having large cash balances, Tesco's returns on cash may be low even when it is invested in an interest paying bank account. Sainsbury holds £739m cash in hand which is a reasonable amount and also it can pay its short term obligations. On the other hand Morrisons holds a significantly small cash balance of £241 compared to the above companies and this may indicate that Morrisons may run the risk that it will be unable or facing difficulties paying its bills. However, Morrisons is a smaller business than Tesco or Sainsbury which can justify the smaller cash balance of the company.
Analysing the trade receivables of each company it can be said that Tesco and Sainsbury have large financial services (banking subsidiaries). However, Sainsbury and Morrisons do not have large amounts of unpaid credit to debtors and having relatively small amount of debtors reduces the risk of losing too much monetary funds in case those debtors become bad debts. Tesco, however, seems more of a risky company in an attempt to increase profitability. Tesco offers credit both to other businesses and to customers in order to boost sales and stay competitive in the market place, as other competitors are also offering such credit terms to customers. The disadvantage is that Tesco has huge amounts of debtors and loans and advances to customers which create trouble to the firm. This is because evaluating if a customer is credit worthy can be very expensive, and not be able to manage their credit operations, Tesco's bad debts may increase because of large amount of credit given (Moles et.al, 2011).
Furthermore, from the balance sheets of each company it shows that Sainsbury holds £938m of stock, Morrisons £759m and Tesco £3598m of stock. Having stock available in case a product has run out gives the company the advantage to increase sales and satisfy the customers in terms that when they enter one of their stores, customers can find in stock what they like and what they are looking for (Brealey, 2011). Tesco shows a large amount of inventories and holding so many inventories it can be expensive. According to Moles et.al (2011), large inventories require space and warehouses which are expensive to build, and that inventory needs to be protected from theft and breakage but also it runs the risk of becoming obsolesce. To further analyse this fact a turnover ratio can aid to determine if the companies are managing their inventories efficiently. This ratio is defined as how many times the entire inventory of a company has been sold in an accounting period (Investopedia). This is a major factory to success in any business that holds inventory; therefore a higher inventory turnover is better because inventories are the least liquid form of the assets. Sainsbury's turnover ratio is 23.76 times, Morrisons 23.27 and Tesco is 17.93 the average turnover of the industry is 20.21 times and Sainsbury and Morrisons are selling its stock more times than the average which means that both companies are doing extremely well in the market. Tesco has the lowest times 17.93 which suggest that the sales might not be doing as well as other companies. However, Tesco is quite close to the average of the industry and it is likely that it may not be facing difficulties managing their inventories. These numbers, however, do not always mean better performance since Sainsbury who is at 23.76 times could be producing a low amount of stock so it can sell it and move on which means they will suffer in sales in the long run. Even Morrisons which at 23.27 could be overstocking in the product or marketing efforts and inventory has zero rate of return as high storage cost. Companies should not over stocking/under stocking since this would lead them in a loss of cash.
Furthermore, to analyse the working capital trade-offs, it is needed to take also into consideration the accounts payable of each company. "Accounts payable are trade credits provided to firms by their suppliers. Suppliers usually offer a grant period to companies to pay for their goods they have ordered and but with no interest" (Moles et.al, 2011). Therefore, trade credit is a great source of financing since companies do not need to pay immediately their bills and many companies take advantage of this. In this case, Tesco may use this attractive source of financing as its account payables is large (£11234m) compared to Sainsbury (£2740m) and Morrisons (£2025m). However, suppliers must be paid on time and firms must not delay to pay their obligations as this may results in a monetary penalty or the suppliers may no longer want to sell goods to that company.
From the balance sheets extracted it can be suggested that Tesco, Sainsbury and Morrisons use an aggressive policy with regards of the level of their working capital as the companies choose to hold a minimum level of current assets hoping to earn greater returns by investing in long term investments (Watson, 2007). According to Watson (2007) an aggressive policy will increase profitability since less cash are being tied up in current assets but it will also increase risk that the firm will not have adequate cash to meet its obligations or the risk of running out of stock will be increased. In addition, these companies may use this policy in order to use the maximum amount of short term debt relative to long term debt, in order that short term debt will be less expensive, thus increasing returns by lowering costs. However, there is the possibility that firms may not be able to refinance short term debt as it comes due but as well as interest rates may rise and the new short term debt will become more costly.
2.4Working Capital Financing
All businesses require capital in order to invest in plant, machinery, inventories, account receivables and all other assets (Brealey, 2011). Normally these assets are not purchased at once but obtained gradually over time. Therefore in order for firms to grow their capital requirements they need to find ways of raising funds to finance their working capital.
The main sources of financing are short term finance and long term finance. Short term financing will provide the firm with the adequate capital needed in order to keep up with the daily operations. Short term sources of capital include overdrafts, short term bank loans and trade credit (Watson, 2007). Short term sources will help the firm to increase inventory orders and the supplies needed for their daily operations but also the wages and salaries of the employees. Therefore, in this case the company will borrow as much or as little as it needs in order to meet its short term requirements. According to Watson (2007), short term sources are usually cheaper and more flexible than long term ones. This is because short term interest rates are lower than long term interest rates, however, short term finance is riskier because borrowings may not be renewed for the firms or maybe renewed on less favourable terms.
When a company needs financing for more than a year it is best to use long term financing. Long-term sources mainly include the raising of finance between the choice of equity finance (shareholders) and the debt finance (from lenders). There are various ways of raising equity finance and some of these include the issuing of share, right issues, bonus issues and internally generated funds through the use of retained earnings. Retained earnings are the best source of finance as these earnings belong to shareholders and do not pay out all their earnings as dividends and use them as a source of expanding their business. The types of long-term debt finance are fixed deposit, long term loans, mortgages and convertible notes (Lasher, 2010).
Furthermore, there three basic strategies used to finance working capital. When a firm uses both short term and long term borrowings to finance its working capital, then it is said that the strategy used is the Matching Maturity Strategy. If the firm uses long term debt to finance its fixed assets and working capital then it is using the long term finance strategy. The third strategy is the aggressive strategy where all working capital is financed from short term debt (Barely et.al, 2011).
Tesco, Sainsbury and Morrisons are using the matching maturity strategy in order to finance their working capital. Matching maturity strategy refers to the "financing of assets so that the duration of the asset's financing coincides with the asset's lifespan in order to reduce the firm's financial cost risk and refinancing risk"(Investopedia).The maturity structure of debt matches the maturity of projects or assets held by the firm. Short-term assets are financed by short-term debt and long-term assets are financed by long-term debt. "In accounting terms, this means that revenues associated with expenses within a given period should be reported in that same period. Matching the revenue and expenses means that it is easier to assess the profit or loss of a particular activity "(LSE). When considering how supermarket groups work, they have long-term assets (land, property, and equipment) and short-term assets (items for sale). They therefore structure their borrowings accordingly. A major strength of supermarket groups is their excellent cash flow - they are bringing in huge amounts of cash every day. This means that they can service their debt relatively easily. Also, although they receive cash every day they tend to delay paying their suppliers which gives them access to cash for a longer period.
Using this strategy all three companies have a balanced amount of short term debt and long term debt, thus meaning that there is balance between cost and risk, resulting also in a balance of profitability and liquidity. The financing of working capital approach adopted by a company is very important since it will have an impact on its profitability and liquidity. It is also important for companies to consider other factors apart from cost and risk in making such financing decisions with regards to its working capital financing. (Satish, 2003)
2.5Working Capital Efficiency
Working capital efficiency is a measure of how well a company maintains the money it is owed by customers from sales and money invested in inventory goods against money it owes for obtaining the inventory. The time taken for the firm to pay for the goods, owing for goods and waiting to be paid for goods is called the cash conversion cycle (Moles et.al, 2011). When a firm is efficiency managing the cash conversion cycle, the higher is its level of working capital efficiency.
There are two tools to measure a company's working capital efficiency, the operating cycle and the cash conversion cycle. The operating cycle is at the point where the company uses cash to purchase raw material and ends at the point where the firm collect cash payments on its credit sales (Moles et.al, 2011). In order to help determine the operating cycle two measures are available the Days Sales Outstanding (DPO) and the Day Sales in Inventory (DSI). DSO measures the number of days the company takes to receive its outstanding receivables after the sale has been made. DSI measures the number of days the company keeps its inventory before selling it. (Moles et.al, 2011). The operating cycle is thus calculated when adding DSO and DSI.
According to Moles et.al (2011), the cash conversion cycle is the length of time between the cash outflow for material and the cash inflow from sales. To measure the cash conversion cycle we need to calculate the days payable outstanding (DPO). DPO calculates the days a firm takes to pay its suppliers for their cost of inventory. The cash conversion cycle is calculated when subtracting the operating cycle from DPO.
Furthermore, the table below illustrates the cash conversion cycle of Tesco, Sainsbury and Morrisons.
Details
Tesco
Sainsbury
Morrisons
DSO
15.03days
4.68days
6.13days
DSI
22.15days
16.24days
16.84days
DPO
69.17days
47.44
44.94days
Operating Cycle
37.18days
20.92days
22.97days
Cash conversion cycle
(31.99)days
(26.52)days
(21.97)days
Sainsbury and Morrisons have a very low collection period of sales outstanding, 4.68days and 6.13days respectively. The average of the three companies is 8.6days and both companies are below the average, meaning that the selling department of the companies are more efficient than Tesco. Tesco has 15.03 DSO which means that receivables are collected 15days after the sale of product and it is above the average number of days. Therefore, Tesco has room for improvement because the faster you receive the revenue the more cash will be available in the company at the given time to allocate in other areas for example Tesco has the highest debt ratio and this could be because they are not collecting the revenue faster to aid their investments in other aeries.
Therefore, Tesco can change its policy on how many days is allows receivables to run and bring it at least to the average days, one way to do this is to make sure that the company's employees are trained better to try and make a sale with a lower DSO.
As the DSI is concerned again Sainsbury and Morrisons have the lowest DSI (16.24 and 16.84days). The average of the three companies is 18.41days and both companies operate under the average. This means that both companies can move out their inventory quickly enough and shorten their period of holding stock, hence making them more efficient in managing their inventory. Tesco is moving out its raw material above the average period at 22.15days holding inventories longer than the other companies.
DPO for Tesco Sainsbury and Morrisons is at 69.17days, 47.44days, and 44.94days respectively. This is the amount of days the firms make to pay their suppliers for the raw materials obtained. Morrisons is repaying their suppliers faster than any other company and this may be due to its low DSI and DSO as inventory is moving quickly and credit sales are received faster. However, all three companies their cash conversion cycle is negative which means that all companies are receiving payments for tis goods before they have to pay their suppliers for those goods.
2.6Comparing working capital performance
According to Kumar (2001), liquidity and profitability of a business are directly affected by working capital management performance. All three companies have a negative working capital but in the case of supermarkets, where they have high inventory turnovers, all three companies make business on a cash basis and they do not need a large amount of working capital available since cash is generated very quickly.
In order for firms to increase profitability they will be forced to increase their risk as well. Tesco, Sainsbury and Morison's use the aggressive policy of working capital structure which are trying to increase profitability but at the expense of increasing the risk. Furthermore, Morrisons has the lowest cash conversion cycle, but this may be due to its small size. Tesco is the biggest retail sector in the UK with stores in other countries and this could be explaining the large amounts of current assets and liabilities. All in all, Tesco is adopting a more risky strategy than the other stores, in an attempt to increase sales and hence profitability of the business it increases the risk of financial problems. Although Tesco has the largest cash conversion cycle it is the most profitable business than the other two companies and can easily gather money to pay off its obligations as they come due but they also need to adopt a better policy of getting their funds more quickly from trade receivables.
3.0Section B
This section will be focused on Volkswagen AG, Daimler AG and Renault SA. All three companies are operating in the auto manufacturing industry and a closer look will be provided into its statements of financial position and each firm's share price of equity.
3.1Financial Position and Shareholder's Equity
Details
Volkswagen AG
Daimler AG
Renault SA
Non- current assets
€52,543m
€87,014m
€33,280m
Current Assets
€23,123m
€61,118m
€39,654m
Non-current Liabilities
€28,877m
€51,940m
€9,413m
Liabilities
€27,330m
€54,855m
€38,954m
Working Capital
(€4207m)
€6263m
€700m
Shareholder's equity
€19,459m
€41,337m
€24,567m
Shareholder's equity= Total Assets-Total Liabilities
According to Investopedia, shareholder's equity is defined as "the amount by which a company is financed through common and preferred shares. Shareholders' equity comes from two main sources. The first and original source is the money that was originally invested in the company, along with any additional investments made thereafter. The second comes from retained earnings which the company is able to accumulate over time through its operations". From Daimler's balance sheet, it is noticeable that Daimler AG is largely financed by the shareholder's equity (41,337m) in contrast with Volkswagen AG (19,459m) and Renault SA (24,567m). Daimler AG is issuing a large amount of shares and establishes relationships with owners referred to as shareholders. Shareholders are owners of a company until it ceases operations or transferred to another party (Pratt, 20). Daimler has a high working capital and this is may be due to the fact that the company is largely funded by shareholder's equity (Vernimmen et.al, 2011). Although this long term funding can help Daimler in its day to day operations, it could also be disadvantageous. Large amount of investors in the company may influence corporate management as these shareholders hold the right to vote in the election of the board of directors and take important decisions for the company. Volkswagen AG and Renault SA have a lower amount of shareholders' equity and this may be the amplification of the negative working capital of Volkswagen and the relatively low working capital of Renault.
3.2Price History and News for each company
3.2.1 Volkswagen AG
Volkswagen AG closing share price on 11th of January 2013 was at €164.60. On January 2nd 2009, the share price of the company was at €249. 45, but until the end of the year its share price has fallen to €77. According to Bloomberg in 2009 Volkswagen AG has made a new acquisition of assets to Karmann Motor Vehicle manufacturer with a large cash investment. Investors saw this opportunity and in the following year in 2010 the share price of the company had more demand hence, increasing its share price to €105.90. In addition, Volkswagen has purchase 19.9% of Suzuki Motor Corporation and later in 2010 the company acquired 90.1% stake in the Lamborghini Holding S.P.A, making the Italian firm a member of the company's group. Following these investments, the share price of the company in 2011 and 2012 has increased, due to the demand of shares as investors wanted to buy more shares into the company rather than sell their shares. In 2013, as stated before the company has a share price at €164.60 making the firm able to increase their profits in a timed crisis environment. Another important asset of Volkswagen is the Audi luxury brand which is intended to overtake the premium market leader BMW (Bloomberg). Volkswagen fortunes are continuously increasing and by having a variety of brand names under their group makes the company one of the biggest car makers in Europe.
3.2.2 Daimler AG
Daimler share price on 11th of January, 2013 was at €43.09. In January 2009, share price of the company was at €22. In 2010, the share price of the company has continuously being increasing as they were selling more vehicle units leading to a more profitable year and an increased demand of the shares. In 2011, the share price at the start of the year was at €53.42 but because of the volatile economic environment and debt crisis in Europe the natural disaster in Japan, share prices were significantly falling until the end of year. However, in 2012, share prices started to climb as the profitability of the company has boosted. Now Daimler AG share price maybe expected to rise as there was news that the China Investment Corporation is looking to buy shares into the company.
3.2.3 Renault SA
Renault's SA current share price as of 11th of January is at €40.13 In order to analyse the price history of the company is best to study the news and releases if Renault's SA. According to Yahoo Finance, the closing share price of the company in January 2009 was at €13.50 and until the next year the share price has dramatically increased to €33.52 (January 2010). After the major financial crisis in 2009, has expanded its market into other countries such as Russia, Brazil and Turkey and this boosted its sales in new vehicles and grew by 20%. (Bloomberg). During 2010, Renault also increased its market share in the industry by 14% (Wikiinvest). In 2011, the company's share price has continued to increase at €43.33, meaning that the company was still growing and making profits. On January 2012, Renault's share price has fallen to €26.76 and this could be resulted from the Eurozone crisis and the reduction of car registration drivers. Subsequently, investors did not see a good opportunity at that time of buying shares into the company, and as the demand has fallen, share price has fallen as well. However, now the current share price of the firm is at €40.27. According to Bloomberg news Renault has sold their shares of Volvo for £1.92b in order to reduce debt and invest in France, Russia and China and the share price of Renault may be expected to rise more than the current price.
3.3Best Investment
In order to decide which company is the best investment, Market-to-Book Ratio will be applied along with the information gathered for each company. Market-to-Book Ratio is the ratio of the current share price to the book value per share. It measures how much a company worth's at present, in comparison with the amount of capital invested by current and past shareholders into it. The market to book ratio is used by security analysts to determine if a stock is undervalued or overvalued. If a stock is undervalued, the price is expected to rise. If it is overvalued, the price is expected to fall (Herbert, 2011). Investors looking for value stocks often look for low market to book companies. Market to book looks at the value the market places on the book value of a company.
Daimler AG is the top overvalued company of the three which is at 1.11 as the lowest is Renault AG at 0.44 which means that the company is undervalued. The reason behind this could be because as we can see that Daimler AG is building for the future and is investing a lot of its capital back into the business for future and investors seem to be seeing this and they believe that they should invest in Daimler AG because the future looks bright for them but they need to be careful since they are paying over the actual value of the company and that bubble could always burst, on the other hand Renault SA seems to be an undervalued company with a lower ratio that reflects either poorer future opportunities or potentially a bargain and the reasons being that either investors do not believe the company has a bright future or they are not able to see that the company is undervalued and if there is no major problem then this ratio should rise in the future to at least 1times which means that share value will rise. Therefore, now that Renault is investing in expanding its market in other countries this could be an opportunity for investors to buy shares, as the company has the possibility to grow and gain from more profits. Therefore, the share price of Renault would rise and investors will increase their earnings, making Renault the best investment.
