Essay: Financial Analysis
An Example of a Financial Accounting Essay based on A £1,000 investment in a United Kingdom Public Limited Company (PLC)
The sector chosen was (food) retailers and the two companies, which were selected, were Sainsbury and Tesco. Sainsbury made a profit before tax of £104 million; for the 52 weeks to 25 March 2006. Tesco made a profit of £2,235 million for the same period.
Company reports for 2006 were downloaded from the Financial Times website. Information on ratios was taken from McKenzie (1998). The following investment ratios were examined (see appendix in more detail).
2.1. Earnings per share. It is the profit attributable to ordinary shareholders divided by the number of shares in issue.
2.2. Dividend cover. This measures how many times the dividend could be paid out of available profits.
2.3. Dividend Yield as at Wednesday 6th December 2006. It outlines the percentage that the investor can expect to get in dividend if the share was bought.
2.4. The Price Earnings multiple is given at Wednesday 6th December 2006. The share price is divided by earnings per share.
2.5. The return on equity examines the return on the shareholder’s investment. It looks at the investment in the context of the ‘book value’ i.e. the value of the company in the accounts; and not the value of the shares or market capitalisation (share price * number of ordinary shares in issue).
2.6. The return on capital employed. This is similar to the return on equity but instead examines the net profit before interest and tax. It is one of the main investment ratios.
2.7. This section is the profit margin which compares profit divided by sales.
2.8. This is the current ratio which compares current assets with current liabilities.
2.9. This is gearing which compares (closing) net debt against equity.
2.10. This re-examines how many times the dividend is covered by profit.
3.1. Earnings per share for Sainsbury was 10.5 pence per share while it was 20.2 pence per share for Tesco.
3.2. Dividend cover was calculated on an individual share basis (see 7.1.). The dividend cover was 1.31 for Sainsbury and 2.34 for Tesco.
3.3. The dividend yield for Sainsbury was 2.0 while the dividend yield for Tesco was 2.2
3.4. The price earnings ratio for Sainsbury was 105.3 whereas the same ratio for Tesco was 19.6
3.5. The return on equity for Sainsbury was 1.46%; while it was 16.68% for Tesco.
3.6. The return on Capital Employed for Sainsbury was 6.73% and for Tesco it was 24.14%.
3.7. The net profit margin for Sainsbury was 2.17% and for Tesco it was 5.78%.
3.8. The current ratio for Sainsbury was 0.8 compared to Tesco which had a ratio of 0.52.
3.9. Sainsbury’s gearing was 36%, while for Tesco it was 48%.
3.10. The (re-calculated) dividend cover for Sainsbury was 0.44, while for Tesco it was 3.57 (see 7.10).
Sainsbury had an increase in cash (and cash equivalents) of £142 million while Tesco had an increase in (net) cash of £165 million.
Tesco has better earnings per share (20.2 pence) than Sainsbury (10.5 pence). Tesco also has a better dividend cover when calculated on an individual share basis. Also Tesco is offering a slightly better dividend yield at 2.2 versus 2.0 for Sainsbury.
Sainsbury has a much higher price earnings ratio of 105.3 compared to Tesco of 19.6. The Sainsbury p/e ratio should be examined in more detail. Shares in Sainsbury’s have risen sharply on the belief that there might be a takeover (Financial Times 16/11/2006 – The Lex Column). Therefore, Sainsbury shares could be seen as expensive as the high share price may be due to the possibility of a takeover rather than due to the underlying financial strength of the company.
Tesco has a higher return on equity (16.68%) than Sainsbury (1.46%). Also Tesco has a better return on Capital Employed (24.14%) than Sainsbury (6.73%).
Tesco has a better profit margin (5.78%) than Sainsbury (2.17%). This may be because Sainsbury has sought to cut prices, £400 million has been invested in reducing prices, (Financial Times 16/11/06), to make sure that it is perceived to be price competitive with customers. This should be popular with customers but it has come at the expense of ‘profit margin erosion’, which means lower profits for investors.
The current ratio for Sainsbury (0.8) and Tesco (0.52) are both lower than 1. This could be a concern as it suggests that current assets are lower than current liabilities, which could suggest that the companies may find difficulty paying off their liabilities. However, both companies could be able to sell their goods to customers, before they have to pay for them. This is the case if the two supermarkets, pay their suppliers such as farmers in 90 days. This may lead to criticism from producers but it is good for investors, in the short term at least, because the supermarkets are receiving money quickly but paying slowly. The companies can hold fewer current assets, such as cash, which means the supermarkets can use more of their money elsewhere e.g. on expansion.
Tesco had a higher gearing at 48%, compared to Sainsbury’s gearing of 36%. Tesco’s gearing is not low as the net debt is close to half the value of the equity. However, this level of gearing can be explained by Tesco’s international expansion; particularly in America.
The re-calculated dividend cover is perhaps the most useful of the ratios outlined. The profit available to shareholders, after all deductions such as interest and tax, is relevant. It shows that, using this profit figure, then Sainsbury was unable to cover its dividend. Sainsbury’s dividend cover was 0.44, while for Tesco it was 3.57. This shows that Sainsbury may have difficulty paying its present level of dividend.
Qualitiative conclusions from the company report
Sainsbury’s diversification into other products areas, such as banking, may not have been as successful as Tesco’s. For example, Sainsbury made a £10 million loss on its banking operations. However, it has made a number of prudent decisions such as increasing contributions to its pension schemes, bringing back I.T. operations in house, to save money, and re-structuring its debt. It has increased sales and launched a new marketing plan to encourage customers to purchase from a wider variety of products. These prudent decisions make Sainsbury a reasonable investment.
Tesco too has increased sales. It has also been prudent by buying shares in the market to maintain earnings per share. Also, it has tried to make itself acceptable to wider stakeholders by investing in environmental activities such as recycling. The success of its expansion into America remains to be seen. However, Tesco has been challenged over its high market share in Britain and therefore may be wise to expand elsewhere to reduce potential criticism from British competition authorities.
The crucial factor is that Sainsbury has not covered its dividend. Moreover, it has only provided company accounts from the past two years; perhaps to avoid comparisons with earlier years, which were less successful. In comparison, Tesco provides accounts for the five-year period. Perhaps, this indicates that Tesco is more confident about is performance.
Recent commentary of Tesco’s performance suggests that this successful performance has continued. Tesco has outlined a 9.6. per cent rise in third quarter sales and its market share of the (120 billion) UK grocery market has increased to 31.6%. Moreover, it has a strong non-food offering which now represents 20 per cent of UK sales (Daily Telegraph 6/12/06)
In comparison to Sainsbury’s, Tesco’s profits are stronger (they cover dividends) and are more sustainable (they have grown over a 5 year period). Also their profits seem to be continuing as suggested by the Telegraph article. There are problems such as the cost of international expansion, criticism from non-governmental organisations (over Tesco’s market share) and potentially a slowdown in consumer spending. However, Tesco can be described as a ‘defensive stock’ as its sales, such as food and cheap clothing, should remain strong even if there is a slowdown in the British economy. This is because it is price competitive and even in a recession; the public need to buy food and clothing. For these reasons Tesco is recommended. It would require Tesco to fail in its international expansion for Sainsbury to become more attractive as it has lower gearing. However, Tesco’s international expansion seems to be successful at the moment, such as in Slovakia (Daily Telegraph 6/12/06).
Daily Telegraph, Tesco defies pre-Christmas gloom, 6/12/06
Financial Times 16/11/2006 – The Lex Column
McKenzie W. (1998), Guide to Using and Interpreting Company Accounts, Chapter 14: The Investor’s Perspective, Second Edition, Financial Times / Prentice Hall
7. Appendix with ratios
7.1. Earnings per share calculation
Profit attributable to ordinary shareholders
Number of ordinary shares in issue
This was taken from www.thisismoney.co.uk as a figure for ordinary shares was unavailable in the accounts. The same is true for 7.2.
7.2. Calculation of dividend cover by individual share basis -
Earnings per share
Dividend per share
Sainsbury 10.5p/8.0p = 1.31
Tesco 20.2p/8.63p = 2.34
7.3. Dividend Yield.
Dividend per share
Today’s Market Share Price
7.4. Price Earnings Ratio
Today’s market price for the share
Earnings per share
7.5. The return on Equity
Profit attributable to ordinary shareholders
Capital and Reserves
Sainsbury £58m / £3965m = 1.46%
Tesco £1,576m / £9,444m = 16.68%
7.6. The return on Capital Employed. This is:
Underlying profit before tax
Net assets or Total Equity
Sainsbury £267m / £3965m = 6.73%
Tesco £2,280m / 9,444m = 24.14%
7.7. The net profit margin
Underlying operating profit
Sainsbury £342m / £15,731m=2.17%
Tesco £2,280m / £39,454m=5.78%
7.8. Current ratio
Sainsbury £3,845m / £4,810m = 0.8
Tesco £3,919m / £7,518 = 0.52
7.9. Gearing ratio (net) debt equity
Sainsbury £1,415m / £3,965m = 36%
Tesco £4,509m / £9,444m = 48%
7.10. Dividend Cover
Profit after tax
Sainsbury £58m / £131m = 0.44
Tesco £1576m / £441m = 3.57
8. Appendix with information derived from the company reports
Sainsbury’s report states “Sainsbury Bank … offers excellent value products with extra benefits, delivered in a simple and accessible way” (page 4).
“Our Bank is an important part of our customer offer but it had a difficult year, making an underlying operating loss of £10 million due to additional charges for bad debt” (page 21).
“A one off contribution of £350 million (was made) into the pension schemes. Annual contributions by Sainsbury’s into the schemes will also be increased by £18 million to £38 million per annum” (page 5).
“This year we increased sales (inc VAT) by 5.8 per cent to £17,317 million and we increased like-for-like sales by 3.7 per cent, delivering a fifth consecutive quarter of like-for-like sales growth. We also increased our market share”.
“The idea for ‘Try Something New Today’ came about because we wanted to encourage people to visit their local store to experience the improvements we had made. The insight behind the campaign was that although an average supermarket stocks around 30,000 products, customers tend to purchase from around the same 150 products each week” (page 18)
The Group’s debt restructuring (will lead to) interest savings of £12 million.
“The Group completed the migration of IT services back into the Group, resulting in a one off charge during the year of £63 million, (but) future cost savings are expected to pay back in less than two years”.
Tesco report (page 6)
“In the early years of diversification, heavy investment held back returns as we built a platform to raise our sustainable growth rate to industry leading levels”.
“We’re investing hard in our strategy and capital expenditure will rise to be around £3 billion this year, partly due to our move into the United States”
“Our growth has been broadly-based, with the four parts of our strategy – international, the core UK business, non-food and services – all playing their part.
“At least £1.5 billion, or more than twice our annual dividend payment of approaching £700 million, will be used to eliminate future earnings per share dilution by buying Tesco shares in the market to match scrip, option and staff share scheme issuance”
“Our sales have grown by 13% and our market share has increased”.
“In February, we announced that Tesco would enter the United States in 2007. We are developing a completely new format, modelled on Express, for the American consumer”.
“We are also leading the way on the wider issues that are important to customers and communities. We have made significant new commitments in areas like nutritional labelling and the environment”.