Part 1: Obtaining information for decision making using a pro forma
A Pro forma income statement is going to be produced for Tesco plc which will project their future but not track their past. This makes for an important tool for future business operations like decision making about prices which helps with the strategic growth of the company as a whole.
Assumptions will be made on the expected percentage increases over the coming year(s), that is, in sales, cost of goods sold and expenses. These assumptions will reflect the economy change and also carrying out a sensitivity analysis will help the forecast for Tesco plc to cover for other changes like job cuts and recessions.
Future sales are forecast using past sales, and the chart below helps us predict this likely growth in sales.
The company past sales are plotted against their period of occurrence (years).
FIG 1: SALES Vs YEARS
Based on the trend line above, the sales for this company are likely to still go up which may be as a result of any future changes in both the industry and Tesco plc's operations, also the company believes that more people are opting to stay at home hence shop rather than go out. Despite this predicted growth however, the company costs are likely to go up in order to achieve that increase, for example salaries and several expenses are likely to increase. This would be through creation of new jobs and expansions (acquiring new assets) of the business plus new ventures.
Factors that might affect this predicted growth may include; currency conversions, consumers demand in some countries, competitors, and help given to families with stretched budgets, online and catalogue offering of non-food products. Some of these may boost the growth or not.
From the above (table 1), the projected sales growth for 2010, for Tesco plc is at around 60,000x (millions of GBP) which provides a sales growth of approximately 11%. Interest charges have not been decided yet, thus they are unavailable (N/A) and the assumed increase in tax is 5%.
The Pro forma Balance sheet below on the other hand forecasts increase in Assets and spontaneous liabilities as a percentage of the sales (sales growth rate), which is 11%. This will show how Tesco plc will be managing its assets and thus the financial soundness of the company as a whole.
From the results below (table 2) however, the assets are exceeding the claims and therefore the company will need to raise additional funds to rectify this. AS THE Long term debt has been kept constant, change in this could raise the additional funds needed.
The two techniques to be used for this appraisal of Tesco plc are;
A). Net Present value (NPV): this is the total present value of cash flows in a given period of time. This technique is to show how much value a given investment is to add to Tesco plc.
In order to work these out, we need to attain both the cash inflows and outflow for the company within the period of appraisal. For the cash outflow, the amount from investing activities for 2009 will be used. The Net Incomes from the projected years, 2010, 2011 and 2012 will be taken into account as the cash inflows.
After working out the NPV from the Net incomes (cash inflows) in table 3 above, the cost of investment are subtracted from result as they occur in a different period. The NPV produced shows that this kind of investment will be beneficial to the company and hence is acceptable.
b). Internal Rate of Return (IRR): this is the interest rate received for an investment and income occurring at same times of each period, that is, what an investor will receive by putting their own money into this company. It determines what the return on an investment is going to be.
From the results above, the investment after 3 years will return 17%, which is greater than the cost of capital (discount rate) of 10%, hence acceptable to the company.
Part 3: Interpreting financial statements using Ratio analysis (The ratios below are in millions of GBP)
This is done using ratio analysis, which helps to highlight the strengths and weaknesses of Tesco Plc.
Days Sales Outstanding:
This ratio shows the time on average it takes this company to turn their receivables into cash and the number of days of its accounts receivable. This ratio uses information from Tesco plc's balance sheet and income statement.
DSO = (Total Accounts Receivables/Total Credit Sales) x Number of Days in the period whose analysis is being done.
Total accounts receivable are from the balance sheet and total credit sales (revenue) are from the income statement.
Inventory turnover ratio:
This ratio is used to test how efficient a given company is, by showing how rapidly a company, like Tesco is able to move its goods.
Inventory Turnover Ratio = Net Sales / Inventory
Accounts payable to sales (%):
This ratio will show us how much of their suppliers' money Tesco plc uses to fund its sales. If this ratio is high, then Tesco plc's working capital is funded by their suppliers.
Accounts Payables to Sales Ratio = [Accounts Payables / Net Sales] x 100
Total credit sales (revenue) = 54,327
Total accounts receivable = 1,379
Number of days = 365 days (1 year)
rom the ratios above it takes Tesco plc a very short amount of time to convert their accounts receivables in to cash.
This company is able to rotate its inventory in sales more than 19 times, making it very efficient.
Based on the accounts payable to sales ratios worked out above, on average, Tesco plc has a very low ratio, which means that this company has about 8.57% of its sales being funded by its suppliers.
These ratios will be used to show how successful Tesco plc is in terms of generating profits from any investment activities done.
Return on sales or profit margin:
This ratio is used to determine how Tesco plc withstands competition and any changing conditions both in the current market and the future.
Return on Sales or Profit Margin = (Net Profit / Net Sales) x 100
Return on Assets:
This ratio is used to determine how efficient and effective Tesco plc is at utilising its assets in order to attain a good return.
Return on Assets = (Net Profit / Total Assets) x 100
Return on Equity or Net worth:
This ratio is used to measure Tesco plc's ability in generating returns for the capital that the owners of this company have invested. This will help in providing desirable dividends to the company owners and funds needed for their growth in the future.
Return on Equity or Net Worth = (Net Profit / Net Worth or Owners Equity) x 100
Table with profitability ratios for Tesco plc for the period, 2007 to 2009
From the results tabulated above, the average return on sales or profit margin of Tesco plc is about 4.3%, which means that this company makes on average about £4.3 on every £1 of sale, making it efficient.
On the other hand however, their profit margin, return on assets and return on equity are seen to drop since 2007 and the prediction for 2010 may be that this may go on unless this company overcomes the adverse conditions that are causing this.
The company generates on average 6.45% return on assets that they employ in their annual operations and about an average of 17.56% return on the capital that the owners of the company invested.
- Credit Guru. (2009) financial statement analysis [online] Available from: http://www.creditguru.com/ratios/ratiopg1.htm Date Accessed: 05/01/2010
- About.com. (2010) Investing for beginners [online] Available from: http://beginnersinvest.about.com/od/incomestatementanalysis/a/table-of-contents-lesson-4.htm Date Accessed: 05/01/2010