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Financial Statement Analysis of Target and Tesco

Glenny Alawag Michael Mekaru Shidler College of Business - ACC 460 April 30, 2013 Sung-hee Shin Keoni Yamashita

Introduction Two discount variety stores, Target (U.S.-based) and Tesco (U.K.-based), are compared in this financial statement analysis. Using the annual reports, common-sized financial statements were created, and profitability, liquidity, and solvency ratios for each of the companies were calculated. To further analyze the comparisons, the following general assumptions were made: 1. The industry average ratios are from the RMA Financial Ratio Benchmarks 2011. The ratios are based on NAICS 452990 (All Other General Merchandise Stores) and SIC 5331 (Retail-Variety Stores), where Target and Tesco belong. The ratios apply only to U.S. companies, but it is assumed to apply to foreign companies as well. It is also assumed that these ratios are fixed for the years under the analysis. 2. The fiscal year of Target and Tesco ends in January and February, respectively. For the ratio analysis, the fiscal year is adjusted to represent the calendar year. Thus, Balance Sheet as of February 2012 is herein referred to as year 2011. Tescos balance sheet is formatted without the general total labels (e.g., total assets, total current liabilities). These labels were included in the appendix.

Profitability The profit margins of the two companies are above the industry average (see Table 1). This means that the profit earned by each dollar of sales is higher than the other companies of the retail industry. Target, however, appears to be less profitable than Tesco using this ratio. On the other hand, using the asset turnover ratio, Target is more profitable than Tesco. Also, it should be noted that both companies fall below the industry average. Target Tesco Industry 2011 2010 2011 2010 Profit Margin 4.19% 4.33% 4.58% 4.59% 3.60% Asset Turnover 1.52 1.49 1.32 1.30 2.6 Return on Assets 6.48% 6.62% 6.03% 5.96% 5.2% Return on Equity 18.71% 18.94% 17.18% 17.74% 11.01% Earnings Per Share $ 4.31 $ 4.03 $ 0.37 $ 0.34 NA P-E Ratio 11.6 13.5 860.54 1,154.85 16.3 Payout Ratio 25.6% 20.9% 40.03% 39.15% 31.55% Dividend Yield 2.21% 1.55% 0.05% 0.03% 2.3% Table 1: Profitability Ratios For the first 3 ratios, three factors are considered to have major effects to their comparability: PP&E impairment reversal, development cost capitalization, and inventory accounting. To compare the ratios, the profits from continuing operations are used to replace net income. Ratio

The first factor is the impairment of Property, Plant and Equipment. To simplify comparison, it is assumed that the two companies recorded impairment using the difference between carrying value and fair value (i.e., selling cost is immaterial, and fair value equals discounted cash flows). The difference now lies on the recognition of impairment reversal. Because IFRS allows the reversal of impairment, the profit and PP&E book value in an IFRS-prepared financial statement may be higher than in a US GAAP financial statement. The second factor is the capitalization of development costs by Tesco. According to its disclosures, there is an increase of $154 million or a total of $ 1,454 million in its 2011 assets, because of internally generated development costs. In contrast, Target has been classifying all development costs as expense. An adjustment to net income arising from the non-expensed development costs and gains from reversal should reduce the profit margin of Tesco. Also, adjusting the total assets amount as affected by capitalizing development costs and revaluating PP&E, should increase the asset turnover of Tesco. The third factor that could potentially change the profit ratios is inventory cost flow assumption and write-down. This, however, was found with no material effect in comparing Tesco and Target (see Liquidity, par. 1-3). As a result of these, profit margin and asset turnover cannot provide enough information to decide which is more profitable. The profitability of each dollar invested in assets (ROA) of Target and Tesco compares favorably with the industry average of 5.2% (see Table 1). These high ROAs are probably a result of the companys effective leveraging. Despite the high Debt-to Assets ratio (see Table 3), the companies managed to use the money borrowed from creditors to increase the returns to shareholders. This effective use of leveraging is a good indicator of profitability to shareholders. Compared to Target, Tesco has lower ROAs for the last two years. This could be dragged even lower if the effects of the two accounting differences discussed before were integrated. For the remaining profitability ratios, the standard formulae were altered to accommodate some other differences in financial reporting standards. This is because the complexity of the two businesses varies from one another. First, Tesco reported discontinued operations for 2011 and 2010, whereas Target had no discontinued operations for the same years. These losses and gains could substantially affect the comparability of profitability, because such transaction is not done in the ordinary course of business. Second, all material subsidiaries of Target are wholly-owned, whereas in Tescos subsidiaries, minority interest exists. The financial statements are thus reported differently. While the consolidated income of Target is wholly attributable to the parent, Tesco has to report all income, allocated between the parent and non-controlling interest. As a result, the net income (or profits for the year) reported by Tesco is not representative of the real income of the parent. Therefore, for Tesco, net income in the ratios should mean profit from continuing operations attributable to parent, cash dividends should refer to dividends paid to equity owners, and stockholders equity should refer to equity attributable to the owners of the parent (see Appendix I). In terms of stock ownership, Target is less profitable with its 25.6% payout ratio compared to Tescos 40.03% and the industrys 31.55% (see Table 1). However, the dividend relative to the stock price (dividend yield) of Target is close to the industry average and is more than 40 times Tescos. The high P-E ratio of Tesco means that a stock earns less than it is priced. It may indicate that Tescos stockholders have a bullish outlook for the company, or the stocks are simply overpriced. The basic EPS are not compared, because Target and Tesco do not have the same number of shares outstanding. Target is more profitable than Tesco to a shareholders point of view. In addition, Targets ratios seem to be acceptable based on industry average. If the effects of impairment reversal and

development costs are adjusted, Tescos ratios would get even worse. Overall, Target is more profitable than Tesco. Liquidity A very critical factor in determining profitability and liquidity of retailers is their policy for inventory accounting. As evident in the common-size financial statements, the Cost of Goods Sold accounts for more than 50% (more than 90% in Tesco) of Sales Revenue. Therefore, the choice of costflow assumption method and the financial reporting standard is of significant influence to the financial position and results of operations. Target uses LIFO method, while Tesco uses weighted average cost method. Assuming similar inflation rate existed for inventories in both companies, Target must be reporting higher cost of goods sold and lower inventory. This would need an adjustment to reflect the difference. However, based on the disclosures of Target, no LIFO provision/reserve was reported because of its immateriality. This means that there is small difference between using the LIFO method and FIFO method, and it follows that the difference between average method and the two is not significant.

Ratio Current Ratio Receivables Turnover Average Collection Period Inventory Turnover Days Sales on Hand Table 2: Liquidity Ratios

Target 2011 1.71 11.57 31.56 6.17 59.16 2010 1.63 10.27 35.53 6.19 58.97 2011 0.67 25.88 14.1 17.54 20.81

Tesco 2010 0.68 28.67 12.73 18.78 19.43

Industry 1.8 153.7 2.37 3.3 110.61

Target reports inventory at the LCM, while Tesco reports inventory at the LCNRV. Having lack of information about how the write-down is done, it is assumed that both companies use the same method (e.g., item-by-item basis). It is also assumed that the market value used in Target is close to or equals the net realizable value. A reason to support this is the presence of Inflation in the countries these companies operate in. As long as manufacturing costs follow the inflation trend, replacement cost should be expected to be higher than the original cost. Moreover, the nature of the business (i.e., bigbox discount stores) has high inventory turnover (see Table 2). It is less likely that an inventory remains unsold for one year, entailing possible write-down. Under the inventory turnover, Target has a better performance than the industry. Tesco, however, has more liquid inventory because it sells and replaces inventory 17.54 times a year or every 21 days. The liquidity of receivables of Target and Tesco is below the 153.7 of the industry. This could be the result of Targets credit card segment and Tescos banking segment, which are not available in most retailers of the industry. Tescos ability to pay currently maturing obligations is also affected by foreign exchange fluctuations. The risk of liquidity, however, is being mitigated by Tesco through its cash flow, fair value and net investment hedging instruments. In contrast, Target only has interest rate swaps, because it considers fluctuation gains and losses to be insignificant.

Although Tesco has more liquid inventory and receivables, it has lower current ratio than Target. Also, unlike Target, Tesco compares less favorably to the industry average. In addition, Tesco has less than 1.0 current ratio (see Table 2) and a negative net current asset (see Appendix F). This would ordinarily indicate that the company has a working capital deficiency and is short of $ 6,386 million current assets to pay current liabilities and upcoming operational expenses. This is attributable to Tesco Bank segment in which all customer deposits are current liabilities. This current ratio is not an effective comparative measure, because Target doesnt have a banking segment, and the banks contribution to the consolidated statements is hardly identifiable and separable. The receivables and inventory turnovers seem to be better representations of their liquidity. The ratios were calculated using receivables and inventories related to the retailing segments of the two companies. Based on these ratios, Tesco is more liquid.

Solvency Because Tescos income statement is presented differently, the EBIT used in Times Interest Earned Ratio was adjusted to refer to Tescos Operating profit plus Share of post-tax profits of joint ventures and associates (see Appendix G). Tesco outperforms Target in its ability to pay interest from long-term obligations. Targets profits can pay 6.15 times the amount of interest, which however, is better than the industrys 3.0.

Ratio Debt to Assets Ratio Times Interest Earned Table 3: Solvency Ratios

Target 2011 0.66 6.15 2010 0.65 6.94 2011 0.65 16.91

Tesco 2010 0.65 11.93

Industry 0.67 3.0

The debt to assets ratio shows that around two-thirds of the assets of Tesco and Target are from creditors. This is normal for the industry which has 67% (see Table 3). Targets non-current liabilities went down in 2011. This means that it was either paid or reclassified as current debt. The unsecured debt and other borrowing account classified as current liabilities, however, increased for the year (see Appendix F). Because the cash account also decreased, it appears that the short-term unsecured debt was used as source of funding its investments in property, plant and equipment. Its increased amount of loans must have caused the lower times interest earned ratio, because more interest had to be paid. In contrast, Tesco provides more income and pays lesser finance costs. Therefore, Tesco is in a more solvent position than Target.

Conclusion In conclusion, the differences between U.S. GAAP and U.K. GAAP reporting are not very significant to deter comparability. Adjusting the differences (e.g., presentation, accounting for PP&E

impairment), and avoiding ratios that are affected by irreconcilable differences (e.g., current ratio) made it possible to analyze the two companies. As a result, it was identified that Target is more profitable, but less liquid and solvent than Tesco for the year 2011 and 2010.

References RMA Financial Benchmark Ratios 2011: 452990 - All Other General Merchandise Stores . (2012). RMA Financial Benchmark Ratios. Retrieved from RIA Checkpoint database. Target Annual Report 2010. (2011). In SEC. Retrieved April 25, 2013, from
http://www.sec.gov/Archives/edgar/data/27419/000104746911002032/a2201861z10-k.htm

Target Annual Report 2011. (2012). In SEC. Retrieved April 25, 2013, from http://www.sec.gov/Archives/edgar/data/27419/000104746912002714/a2207838z10-k.htm Target Corp. Historical Prices. (n.d.). In Yahoo! Finance. Retrieved April 25, 2013, from http://finance.yahoo.com/q/hp?s=TGT+Historical+Prices
Tesco Annual Report and Financial Statements 2011 (2011). In Tesco PLC. Retrieved April 25, 2013, from http://www.tescoplc.com/files/pdf/reports/tesco_annual_report_2011.pdf

Tesco Annual Report and Financial Statements 2012 (2012). In Tesco PLC. Retrieved April 25, 2013, from http://www.tescoplc.com/files/reports/ar2012/files/pdf/tesco_annual_report_2012.pdf Tesco PLC Historical Prices. (n.d.). In Yahoo! Finance UK & Ireland. Retrieved April 25, 2013, from http://uk.finance.yahoo.com/q/hp?s=TSCO.

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