Financial Ratios to Analyse Companies - Essay Example

INTRODUCTION Financial ratios are an important indicator of the how the firm is performing financially. Financial ratios allow the management, shareholders and investors to compare the financial performance of the company with its performances in previous years or with the performances of its competitors or overall industry (McLaney, 2009). This report analyses the financial performances of Tesco in the last 2 years i.e. 2012 and 2011. Different financial ratios are calculated using the financial statements of the company for the year 2012 and 2011 and then analysis of these ratios have been presented. FINANCIAL RATIOS Profitability ratios Profitability ratios are used to analyse how the firm has generated profits (McLaney, 2009). There are different types of profitability ratios and some of them are: Gross profit margin of Tesco The gross profit margin of Tesco has declined by almost 4% as shown in Table 2: Gross profit margin. The ratio shows that the costs of goods of the company have increased and it is unfavourable for the company if the same trend is followed because it will further reduce the profits of the company. Therefore the management needs to make sure that gross profit ratio is increased. Net Profit margin of Tesco The net profit margin of Tesco in the year 2012 is 4.36% however it was previously 4.42% thus it is showing a decline of 1.31%. Net profit margin of the company can be seen in Table 3: Net profit margin. Decline in the net profit is unfavourable for the Tesco as it is showing that the costs and expenses of the company have increased from last year. By further analyzing the financial statements, it can be found that the total revenue as well as net profit of Tesco has increased as identified in Table 1: Key Elements from Financial Statement, but by carefully analyzing the profit margin ratio it can be seen that the costs and expenses have increased at a higher rate than last year which has reduced the profit margin ratio. Return on Equity of Tesco ROE of Tesco has decline by 1.6% as calculated in Table 4: ROE and it is unfavourable for Tesco as the profits of Tesco has been declining and thus it has also influenced the ROE of the company as well. The equity as well as profits have increased as indicated in Table 1: Key Elements from Financial Statement but the rate of increase in profits is less than the increase in equity thus it has resulted in declining the ROE. Return on Assets (ROA) of Tesco ROA of Tesco has shown a decline by 2% as revealed in Table 5: ROA and this is unfavourable for the company as the profits have not increased at the same rate in comparison to the increase in assets as identified in Table 1: Key Elements from Financial Statement. Thus it has resulted in declining of the ROA ratio of the company. Operating Profit Margin of Tesco Table 6: Operating Profit Margin reveals that Operating profit of Tesco has declined by 4.7% and thus it is also unfavourable for the company as it shows that the ratio of costs and expenses of the company have increased to last year (Table 1: Key Elements from Financial Statement) and it is reducing the net profit margin as well as the operating profit margin. The overall profitability of Tesco has declined and the management needs to take steps to reduce the costs and expenses so that the profitability ratio can be improved. Liquidity Ratios Liquidity ratios of the company are used to analyse the liquidity position of the company i.e. to analyse the ability of the company to quickly convert its current assets into cash (McLaney, 2009). There are different ratios categorized in the category of liquidity ratios and these are: Current ratio of Tesco The current ratio of Tesco is very low as shown in Table 7: Current ratio. The ratio of 0.67 and 0.68 of Tesco in the years 2012 and 2011 respectively clearly shows that the company has too many current liabilities and very few current assets as shown in Table 1: Key Elements from Financial Statement. Therefore even if the company sells all its current assets to pay off its current liabilities, the company would still left with a substantial amount of current liabilities to pay. Therefore, it is important for the company to increase its current assets or keep more liquid assets so that it is able to manage its current liabilities. Quick Ratio of Tesco The quick ratio of Tesco is also not very promising as revealed in Table 8: Quick Ratio. Tesco has too many current liabilities and for that, there are very little quick assets to meet these obligations. Therefore the quick ratio of the company has to be improved so that the company does not suffer from liquidity crisis. Leverage ratios Leverage ratios are used to analyse the ability of the company to repay its long term debt (Ross, Westerfield, and Jordan, 2009). There are different ratios included in this category and most important among these have been discussed below: Debt ratio The debt ratio of Tesco has increased in the year 2012 from 2011 thus showing that the risk of the company has increased as shown in Table 9: Debt Ratio. It is recommended that some portion of debt should be included in the capital structure as it allows the management to take advantage of leverage and increase their profits, and therefore the management of Tesco needs to identify the right debt ratio in the capital structure and try to adjust the debt ratio accordingly so that the profits are maximized and at the same time there is not too much risk in the capital structure. Gearing Ratio Gearing ratio of Tesco has increased (Table 10: Gearing ratio) and thus it is showing that the ratio of long term liabilities in the capital employed has increased. Therefore it shows that the risk of the company has increased. Increase in gearing and debt ratio of Tesco indicates that the debt in the capital structure of the company is increasing and with it, the fixed interest cost of the company will also increase. Therefore, the management needs to make sure that they do not include too much debt in their capital structure as increasing debt results in increasing fixed cost and thus risk increases. Asset Management Ratios Asset management ratios are also called the efficiency ratios and these are used to analyse the efficiency of the company (Besley, & Brigham, 2007). Some of the ratios that are included in this category of financial ratios are: Trade receivables period The trade receivable period of Tesco has increased by 50% i.e. from 26 days in the year 2011 to 39 days in the year 2012 as calculated in Table 11: Trade receivables period. Thus it is highly unfavourable sign for the management as the receivables need to be received at the earliest. Payables’ turnover period There has been only a slight change in the payables’ turnover period as shown in Table 12: Payables’ turnover period. However Tesco needs to try to reduce this period as it is very high in comparison to the receivable periods. Inventory Turnover The inventory turnover period has increased by 1 day which is negative for the company as shown in Table 12: Payables’ turnover period. The ratio is showing that the company is taking more time in converting its inventory into cash. The management needs to make sure that the cash conversion cycle is reduced so that the company is able to convert cash as quickly as possible. CONCLUSION The performance of Tesco generally has decreased in the year 2012 in comparison to the year 2011. The financial ratios of Tesco reveal that the although the sales, net profit, gross profit and operating profit of the company have increased in 2012, however the net profit margin, operating profit margin, gross profit and return on assets and return on equity have decreased in comparison to 2011. Therefore, it is important for the management to analyse the areas where the costs and expenses have increased so that the profitability can further enhanced. In addition to this, the management needs to make sure that it has sufficient current assets to meet its current liabilities as the liquidity ratios of Tesco are alarming and it can influence the operations of the company. Moreover, Tesco needs to make sure that it is able to receive its receivables earlier and try to increase the payable time period so that it is able to have cash for more days. List of references Besley, S., & Brigham, E. (2007). Essentials of Managerial Finance, 14 edn. USA: Thomson Higher Education. McLaney, E. (2009). Business Finance: Theory and Practice, Pearson Education: New Jersey. Ross, S., Westerfield, R., and Jordan, B. (2009). Fundamentals Of Corporate Finance Standard Edition, New York, McGraw-Hill. pp. 19-21. Tesco. (2012). Annual Report. Available fromhttp://www.tescoplc.com/files/pdf/reports/tesco_annual_report_2012.pdf [Accessed 21 January, 2013] Appendix Table 1: Key Elements from Financial Statement 2012 2011 Net Income 2814 2671 Equity 17801 16623 Gross Profit 5261 5125 Revenue (ex,VAT) 64539 60455 Current Assets 12863 12039 Current Liabilities 19180 17731 Inventory 3598 3162 Cost of Sales 59278 55330 Trade Payables 11234 10484 Long-term Debt 7431 6751 Capital Employed 31601 29475 EPS 0.3488 0.3294 Price 338.5 373.25 Assets 50781 47206 Operating Profit 3985 3917 (Tesco, 2012) Table 2: Gross profit margin Ratio 2012 2011 % Change Gross profit margin 8.15% 8.48% -3.84% Table 3: Net profit margin Ratio 2012 2011 % Change Net profit margin 4.36% 4.42% -1.31% Table 4: ROE Ratio 2012 2011 % Change ROE 15.81% 16.07% -1.62% Table 5: ROA Ratio 2012 2011 % Change ROA 5.54% 5.66% -2.06% Table 6: Operating Profit Margin Ratio 2012 2011 % Change Operating Profit Margin 6.18% 6.48% -4.70% Table 7: Current ratio Ratio 2012 2011 % Change Current ratio 0.67 0.68 -1.23% Table 8: Quick Ratio Ratio 2012 2011 % Change Quick Ratio 0.483 0.501 -3.514% Table 9: Debt Ratio Ratio 2012 2011 % Change Debt Ratio 52.40% 51.86% 1.044% Table 10: Gearing ratio Ratio 2012 2011 % Change Gearing ratio 23.52% 22.90% 2.67% Table 11: Trade receivables period Ratio 2012 2011 % Change Trade receivables period 39 26 50% Table 12: Payables’ turnover period Ratio 2012 2011 % Change Payables’ turnover period 69.17 69.16 0.02% Table 13: Inventory turnover period Ratio 2012 2011 % Change Inventory turnover period 22 21 6.21% Read More