Once an organization's financial statements have been created, the next step is to analyze them in order to deduce the actual implications of the figures obtained. Ratio analysis may offer a lot of information in terms of the current state of affairs in an organization, and its ability to remain a going concern in future (Peterson & Fabozzi 2012). Ratios are analyzed comparatively, either to those or other organizations in the same industry such as competitors, or to past results of the same ratios. Whenever the ratios obtained show that the organizations financial state is alarming, further investigations must be conducted in order to determine where the problem lies (Peterson & Fabozzi 2012). There are various types of ratios used in financial analysis, such as liquidity ratios, profitability ratios, and capital structure analysis ratios, among many others. Analyzed herein is the financial state of Tesco Plc, a British retail stores company.
Analyze the firm's financial performance during the last three years. Identify the financial actions taken and policies adopted during the last three years (2015-2017), as far as you can tell from the available information. Investigate and discuss to what extent you think the company has been able to increase shareholders' wealth through the financial actions you have identified.
Liquidity refers to the ability of an organization to fulfill all its current obligations on time. The current ratios for Tesco Plc in 2015, 2016 and 2017 were 0.60363, 0.8219 and 0.79449 respectively. These were computed by dividing the organizations current assets by its current liabilities according to each annual balance sheet (Raiyani et al 2011). This ratio measures the overall liquidity of the firm. In essence, in 2015, Tesco's liquidity position stood at 0.604 pounds for every pound owed. While the current ratio, therefore, improved steadily in 2016, and then dropped slightly in 2017. For a firm to be able to be able to pay off its current debt, its current assets should be equal to or exceed its current liabilities. Its current ratio should therefore be more 1 (Peterson & Fabozzi 2012). This means that Tesco plc currently does not have the ability to pay all its short-term obligations in time should they become due. Current ratios indicate a more favourable position as they become higher.
The changes in the current ratio can be attributed to the steady increase in Tesco's current assets, most notably the cash and cash equivalents and the short-term investments (Michael & Albert 2015). The current liabilities, however, decreased significantly in 2016, but almost reverted to their previous levels in 2017. This is mainly due to a 52% increase in those liabilities classified under the category "other current liabilities" from 2016 to 2017. There has also been a steady and significant increase in "other current assets" over the three financial periods.
Acid Test/Quick Ratio
Acid test or quick ratio is similar to current ratio except that excludes inventory from the current assets. Tesco's acid test ratios were 0.454, 0.686 and 0.676 in 2015, 2016 and 2017 respectively. This means that, for example, in 2015, the company only has the immediate ability to pay PS0.454 for every PS1 owed (Raiyani et al 2011). The acid test ratio has a higher level of accuracy compared to current ratio because it excludes inventory which, while being a current asset, is often illiquid (Rajasekaran & Lalitha 2011). Like the current ratio, the acid test ratio should be 1 (Michael & Albert 2015). While the acceptable levels of liquidity as indicated by this ratio may differ from one industry to the other, organizations with low quick ratios which are 1 are often treated with caution by suppliers and lenders (Raiyani et al 2011).
Inventory Turnover Ratio
Tesco's inventory turnover ratio was 18.37, 21.06 and 23.00 for each of the three years ending in 2017. It is computed by dividing the cost of goods sold by the inventories (Rajasekaran & Lalitha 2011). The inventory turnover is another liquidity ratio, as it is indicative of the number of times in a year that the inventory is converted into cash (Vandyck 2006). It may also show the average time that the inventory stays in stock before it is sold. This shows that the inventory turnover increased steadily over the three financial periods (Baker & Powell 2005). It 2015, the organization was able to turnover its stock 18.37 times. This can also be interpreted in terms of the time which the stock stayed within the organization, by dividing 365 days with the inventory turnover ratio (Lee et al 2009). In 2015, for instance, the inventory stayed in the organization for approximately 20 days before it was replaced. This time reduces as the ration increases. Thus, higher inventory turnover ratios are favourable as they indicate that the organization is able to move its sock much faster (Vandyck 2006).
Total Asset Turnover Ratio
The total asset turnover ratio for Tesco plc is 1.275, 1.215 and 1.206 for 2015, 2016 and 2017 respectively. This is a ratio of sales to total assets. In essence, it seeks to determine to what extent assets are being utilized for to generate sales (Goel 2016). In 2015 for instance, Tesco generated PS1.275 of sales for every PS1 of assets owned. This figure has since reduced steadily over the last two years, which is not a good trend. A higher total asset turnover ratio is generally more desirable because it indicates efficient use of assets (Fabozzi et al 2008). This ratio however often differs with different industries, whereby in some, asset turnover ratio is generally low for all firms.
The fluctuation in the total asset turnover ratio reflects the fluctuation in both the total assets and the total revenues for the three financial periods. The value of total assets fell in 2016 but increased significantly in 2017. Some of the components that caused the reduction of total assets in 2016 include the fall in the value of property, plant and equipment, net receivables, inventory, goodwill, intangible assets and deferred long term asset charges. There was also a slight decline in the value of long term investments, which continued in 2017. The significant rise in the value of total assets was caused by the increase in the value of deferred long-term asset charges, cash and cash equivalents, other current assets and property plant and equipment.
Fixed Asset Turnover Ratio
A variation of this ratio is the fixed asset turnover ratio, which narrows down to the usage of fixed assets. The fixed asset turnover rations for Tesco plc were at 2.759 in 2015, 2.981 in 2016 and 3.054 in 2017. The constant increase is a positive trend and indicates that the company is utilizing its fixed assets effectively (Sharan 2015). Fixed assets in this equation are composed of the property plant and equipment. Notably, this ratio conflicts with the total assets turnover ratio because it increases while the total asset turnover ratio decreases (Goel 2016). This effect can be attributed to the reduction of the company's fixed assets in 2016 and 2017 while the total assets generally increased in the same financial periods. This shows that these two asset turnover ratios are not necessarily indicative of increase in efficiency (Robinson 2015). The property plant and equipment, which are the fixed assets, declined in 2016 and then increased again in 2017. The same trend was observed in the total revenues. However, the fact that the fixed asset turnover ratio increased in 2016 shows that greater efficiency is being achieved in terms of asset utilization. It also indicates that the reduction of the fixed assets negatively affected the firm's ability to make sales (Gibson 2012).
Debt ratio for Tesco Plc was calculated by dividing the total liabilities by the total assets. It was at 0.840 in 2015, 0.804 in 2016 and 0.860 in 2017. This essentially means that in 2015, 84% of the organizations assets were financed through debt (Sharan 2015). The ratio reduced in 2016 and then increased to 86% in 2017. A low debt ratio is favourable to the company because it would indicate a high amount of assets and a low one for liabilities. The appropriate level of debt varies widely between industries (Libman & Feldman 2013). However, whenever this ratio exceeds 1, it means that the company has more liabilities than assets. This is not favourable for the company because its risk profile is very high among lenders and suppliers. Suppliers, for instance, may not want to supply goods to the company on credit, which would be injurious to business since inventory is the chief revenue generator for Tesco Plc.
The high debt ratio, especially in 2017, was caused by a significant increase in total liabilities between 2016 and 2017. There was a significant increase in the 'other current liabilities' as well as in 'other liabilities.' The trends in the movement of total assets and the total liabilities over the three periods are similar, indicating that the organization may have increased their debt in order to finance the additional assets (Peterson & Fabozzi 1999).
Times Interest Earned Ratio
The times interest earned ratio for Tesco Plc was computed by dividing its earnings before interest and taxes by its interest expense. In 2015, the ratio came to 0.244; in 2016, it was at 1.679 while in 2017, it was at 2.287. This ratio indicates the ability of the organization to finance its debts. In 2015, the organizations interest expense far exceeded the earnings before interest and taxes, which is a very dangerous financial position (Ehrhardt & Brigham 2009). At this point, the organization could not finance its debt. If this state persisted, the company would be unable to obtain any further debt financing as lending institutions generally avoid lending to such companies. However, the situation improved steadily in 2016 where interest consumed 59.55% of its earnings before interest and taxes. While this is still a potentially volatile situation, it indicates a far better financial position than that of the company in 2015. In 2016, the situation improved further, whereby interest expense took up 43.73% of its earnings before interest and tax.
It is therefore evident that a higher interest earning ratio is good for any organization. Moreover, if the interest earning ratio is below 1 it shows that the organizations operations are not generating enough income for the organization to be able to cover its interest expense. Typically, if the ratio falls b...
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