Financial Ratios

Abstract
Financial Ratios are one of the key tools used by different users to evaluate company’s performance before making important decisions. The purpose of this paper is to the importance of financial ratios in understanding and evaluating a firm’s performance using Tesco company annual reports. The first part of the paper discusses on importance, advantages and disadvantages of using financial ratios to evaluate firm’s performance. The second part of the essay evaluate Tesco performance over the years using Liquidity Ratios, Profitability Ratios and other nonfinancial factors such as competitive strategy among others. The next part discusses the impact of current developments in international financial reporting on Tesco.

Introduction
Financial Ratios are important in evaluating a company’s performance over time. The key purpose of financial data is to give a true and fair view of financial performance, position and changes in the financial position of an organization (Brigham & Houston, 2011). Such information obtained from financial ratio analysis is utilized for different purposes by various stakeholders. Financial ratios analysis is useful in two ways. First is to track the individual performance of a company over time and secondly is to make a comparative judgment concerning company performance (Hofer et al., 2012; Saunders & Cornett, 2012; Modern, 2012)). Company performance is appraised using trend analysis. That is, computing individual ratios and keeping track of their values over time. These ratios can be used to identify traits that may influence the performance of the company such as the decline in company’s liquidity status.
Secondly, financial ratios are used to make comparative judgments concerning the performance of different firms. For instance comparing a company’s profitability to that of a major competitor in the market or observing how a company compares with industry average. This information is important to enable a user of financial ratios to form a judgment regarding primary areas such as management effectiveness and profitability of the company (Brigham & Ehrhardt, 2013).
Strengths and weakness of financial ratios
Strengths
Financial Ratio Analysis is an important tool that helps in understanding the financial position of an organization. Financial Ratio analysis is useful because it helps in comparison, industry analysis, stock valuation, planning, and performance.
Comparison: financial ratios offer a standardized technique with which to compare firms operating in the same industry. Financial ratios are crucial for a firm to determine how well it is performing as compared to other companies in the same industries (Brigham & Daves, 2012).
Industry Analysis: Financial ratios also reveal trends in particular sectors, creating benchmarks against which the performance of all other companies in the industries can be evaluated.
Stock Valuations: Financial ratios are important to help analysts and investors to measure and communicate the strong points and weakness of a firm or industry before investing capital.
Planning and performance: Financial Ratios are important for developing business plans and preparation of presentations for investors and lenders (Chandra, 2011). Industry trends and analysis provides benchmarks that small businesses can use to set performance goals. Companies can use financial ratios to institute future trends of its financial performance. Therefore, a financial ratio is useful in formulating the firm’s plans.
Judging efficiency: Financial ratios are imperative for evaluating a firm’s efficiency with regards to the company’s management and operations (Weygandt et al., 2015). Financial ratios assist to judge how well a firm is able to utilize its assets and earn revenue.
Limitations of using financial ratios to evaluate performance
Inflation is not taken into account when using financial ratios; financial ratios may not provide a true picture of corporate performance because inflation effects are not considered when computing financial ratios. Assets are recorded using historical rates in the statement of financial position and, therefore, may not have the same value currently as a result of inflation (Hill et al., 2014).
Financial ratios may not help in comparing corporations belonging to dissimilar industries: Financial ratios are limited only to comparing companies belonging to the same industry only. This is because different industries have a different market, trends, capital structure, industry averages among others.
The difference in accounting practices adopted by different firms: Different firms may adopt different accounting practices (Snieška, 2015). For instance, inventory valuation, estimates, assumptions, and depreciation method may differ. Therefore, comparing ratios of such corporation may not depict a true picture of how things are.
Use of historical data: Financial ratios use historical data to explain the relationship between past information. On the other hand, users of accounting information are more interested in current and future information.
Tesco background information
Tesco is a British multinational company that was founded in 1919 by Jack Cohen. Tesco is one of the largest retailers today in the globe. The company’s core business is retailing in the UK, Europe, Asia, Far East, and West Coast America (Turner, 2012). Tesco has the widest range of food in the UK. The company’s main food brands are everyday value and its finest ranges. Tesco deals with grocery electronics, books, baby products, pet supplies, alcohol categories, tobacco, and household among others. The company has expanded its operations into 12 countries worldwide including Ireland, Poland, Hungary, China, Malaysia, Czech Republic, and India. In the Year 2013, the company employed more than 530,000 employees. The company operates under the philosophy of “Every Little Helps” to identify themselves with employees, customers, and community (Tesco PLC, 2015). Tesco provides a great shopping experience for customers in their store and through online shopping.
Analysis of Tesco financial performance and current position
This section uses profitability, efficiency and liquidity ratio’s to determine Tesco performance.
Liquidity Ratio
2013 2014 2015
Current Ratio 0.83 0.88 0.96
Quick Ratio 0.22 0.24 0.28
Liquidity ratio is used to determine if a company can pay off its short-term debts (Hitt et al., 2012). The Current ratio as at 31st Jan 2015 for Tesco is 0.969 which is almost equal to 1 indicating that the company has a high level of cash generation and turnover to enable the company to meet short-term obligations.
Profitability Ratio
These ratios are used to measure a corporation’s profitability. They include Return on Equity and Return on Capital Employed.
2013 2014 2015
Return on Equity 0.22 0.21 0.20
Profit margin 0.04 0.03 0.03
The Return on equity for Tesco has been decreasing indicating that the profitability of the company is decreasing. This implies that Shareholders of the company have been losing confidence in their investment (Zentes et al., 2012). The profit margin is also decreasing indicating that the company profitability is drastically reducing.
Evaluating Tesco Performance future prospects and strategy analysis
Competitive Strategy
Tesco competitive strategy is developed based on customer value and choice, cost leadership, online grocery stores, diversification, club card loyalty scheme, and property development (Turner, 2012). Tesco targets to give maximum value and choice to clients so as to attain organization sustainability. The company’s strategy aims to achieve product differentiation and low prices compared to other key players in the market (Haddock-Millar & Rigby 2015). The company products are differentiated into low-cost brand Tesco value and Premium brands such as Tesco Finest.
The company also launched online grocery stores to serve more clients across the globe. The company has also diversified its products to include non-food products. The company also provides club card membership scheme to enable loyal customers claim bonuses and other rewards (Turner et al., 2012). The scheme also provides customer shopping database to enable customers understand their shopping patterns. The company regularly launches competitive promotional offers, brand development, price and provision of product range.
Tesco also operates on differentiated store formats such as Tesco Metro, Tesco Online, Tesco Express, Tesco Home Plus, Tesco superstore, and Tesco extra. Different store format has varied the size and product range. The company also form ventures with partners such as Royal Bank of Scotland, O2, and Samsung to be successful in its operation.
Tesco Corporate Social Responsibility
One of the paramount elements of Tesco strategy is Corporate Social Responsibility. The company is socially responsible to the community it operates and the environment. The company recycles sections of in their superstores, mobile phones and also recycles printer inks to save the environment (Chan et al., 2012). The company also launched Green club card tip for customers who reuse Tesco green bags to reduce pollution. Tesco participates in community welfare and organizes a race for life campaigns annually.
SWOT Analysis
Strengths
The Tesco was awarded the retailer of the year in 2008 that helped increase the company’s reputation to all stakeholders (Tesco PLC, 2015). The company is also regarded as the third largest retailer in the globe.
The company is tracking property development strategy to offset returns to shareholders and also fund expansion programs. The companies also have significant freehold property that can be used for expansion programs.
The Tesco company brand is build based on value creation for clients and thus attracting loyal customers.
Tesco club card database tool enables the company understands shopping pattern of the company’s clients in different locations.
The company posses the strong range of brand to satisfy different clients, for instance, Finest, Healthy Living, Discount, Value, etc.
Weaknesses
The increase in bad debts, household insurance claims, and arrears of credit card, therefore, reducing the profitability of the company.
Over dependence on a joint venture, for example, the company depends on Royal Bank for personal fiancé and O2 for communication purposes.High store operating cost hence reduction in profitability of the company.
Opportunities
Acquisitions as a strategy for expansion opportunity in international markets
Use of E-commerce and catalog shopping pattern to is projected to expand (Liu, 2012). Therefore, this expansion will provide an opportunity for the company to extend and reach new markets across the globe.
Tesco mobile is becoming more profitable, and the customer base is increasing. Therefore, further expansion can be achieved in this line of products.
Threats
The Tesco face stiff competition Wal-Mart Company. The company proved to be competitive and competes with Tesco in terms of price and product range . In the UK primary market, Tesco also faces competition from Sainsbury retail stores who have a diversified product range to offer to the market (Metzger, 2014; Maynard; 2013). The decline in purchasing power of customers with increasing the cost of inputs resulting in low profits
Impact of contemporary developments in international financial Reporting on Tesco
Financial statements are important for enabling companies to communicate with investors and other stakeholders of a company (Collier et al., 2015, Zentes et al., 2012). Securities and Exchange Commission has been developing roadmaps to facilitate companies in shifting from the country’s accounting standards to International Financial Reporting Standards. These changes and new development will usher in easier access to capital from major capital markets such as U.S. capital market ( Page, 2014). Developments in international financial reporting have the following impact on Tesco:
Increase access to capital: Modernization of international financial reporting helps to simplify the way in which financial information is presented. This plays an important role for Tesco because it will simplify the process and reduce the cost of acquiring capital from different capital markets in the world significantly (Van Greuning et al., 2011). International Financial Reporting Standards (IFRS) is more flexible as compared to GAAP. Because stock option and bonus schemes often give managers incentives to increase income, this will provide an opportunity to increase Tesco income more often than it will be adopted to decrease income.
Discretion in the company’s valuation of Assets: International financial reporting standards are more flexible, therefore, provides more discretion in evaluating assets. As a result, Tesco will be able to write back up assets that were written down because of impairment. This is likely to increase Tesco income. Modern International Financial Reporting Standards are more flexible and lenient in an area of development and research cost and intangible assets valuation (Nobes, 2014; Philippon & Reshef, 2013). This implies that IFRS permits development cost to be incorporated in the company’s assets, thus not expensed against revenue.
Impact on investors: The adoption of international financial reporting help to simplify financial reports for investors. Investors can easily decipher financial reports delivered in IFRS. Therefore, this information can impact on investor’s decision-making process of whether to invest or not to invest in Tesco. Investors use earning volatility to make a judgment on a company’s underlying health. This implies that change can be minimized by reducing earning volatility using earnings management techniques. Investors can find important information by accessing earning patterns over the years. This shows that use of International Financial Reporting is more informative as compared to the GAAP reports and thus influencing investor’s decision when deciding to invest in Tesco (Nobes, 2011).
Recommendation
It is therefore recommended that Tesco should find a way to stabilize existing investment till the hard economic conditions are sort out (Metzger, 2014). This is because tough economic condition due to depression has made the client be price sensitive and goes for cheap products yet prices of goods are skyrocketing. After sorting out the economic conditions, the company can go ahead and start pursuing a continuous growth strategy.
The company should also research on the financial performance of each store depending on product line and regions. The company should also use more of economic realities such as BCG growth-share model rather than accounting so as to give a clear picture of the company’s monetary performance (Saunders and Cornett, 2012).
The company should also develop competitive strategies that can help reduce their cost of production as well as improve their competitive edge in the market. Therefore, the company should devise ways that can help outshine their immediate competitors Wal-Mart and Sainsbury.
Conclusion
Financial ratios are important in assessing the financial performance of a company. Financial Ratios enables the users of financial information to track the individual performance of a company over time and secondly is to make a comparative judgment concerning company performance. Financial ratios enable investors and other stakeholders to understand company’s fundamentals before making decisions relating to investing or developing company’s strategic plans.
Tesco has been successful in conduction their business operations. Investors have been attracted to Tesco because of relatively good profitability ratios. Investors are therefore willing to invest their money in Tesco since the company business operations are successful. The company also does not have a lot of expenses and the company’s liquidity ratios indicate that the company can easily offset its short-term debts (Barther &Tucker, 2011). Therefore, investor’s dividends tend to be higher because the company can pay its bill and liabilities using the Tesco’s internal resources. However, solvency ratios indicate that Tesco’s dependence on external borrowing is higher than the use of equity finance.
From the strategic analysis, Tesco business performance and firm’s financial health is good as compared to its main primary competitor in the UK market Sainsbury (Chen, 2014). The performance of Tesco is consistent over the years due to beneficial growth strategy in diversifying their product range and marketing in the retail industry. The company has an efficient supply chain mechanism that reduces the cost of production. However, it is imperative to note that Tesco is not efficiently utilizing their resources. The company pursues cost leadership strategy yet it is hard for them to generate profit margin through premium price. This could have helped increase the company’s margin by efficient utilization of resources.
By adopting international financial reporting, Tesco can finally be able to increase access to capital from international capital markets such as United States Stock Exchange. International financial reporting can enable the company to compare its financial reporting with companies from different nations (Botzem, 2012). On the same note, it will be easy for investors to understand the company’s financial information and, therefore, help makes investors make a better decision whether to invest or not to invest in Tesco Company.

References
Brigham, E., & Houston, J. (2011). Fundamentals of financial management. Cengage Learning.
Brigham, E., & Ehrhardt, M. (2013). Financial management: theory & practice. Cengage Learning.
Hofer, C., Eroglu, C., & Hofer, A. R. (2012). The effect of lean production on financial performance: The mediating role of inventory leanness. International Journal of Production Economics, 138(2), 242-253.
Brigham, E., & Daves, P. (2012). Intermediate financial management. Cengage Learning.
Chandra, P. (2011). Financial management. Tata McGraw-Hill Education.
Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2015). Financial & Managerial Accounting. John Wiley & Sons.
Hill, C., Jones, G., & Schilling, M. (2014). Strategic management: theory: an integrated approach. Cengage Learning.
Snieška, V. (2015). Research into international competitiveness in 2000–2008.Engineering Economics, 59(4).
Morden, M. T. (2012). Principles of strategic management. Ashgate Publishing, Ltd..
Saunders, A., & Cornett, M. M. (2012). Financial markets and institutions. McGraw-Hill/Irwin.