Abstract
The analysis of financial data plays an important role in the management of organizations. This is because through analysis of various business sectors, competitors and performance a company can plan for the future. In an analysis of financial data, financial ratios play a crucial role in understanding the implications of such data. However, these ratios concentrate on different aspects of business and as such a combination of them is best for a better analysis of the business environment. This discussion will highlight a set of financial ratios and describe the information that can be obtained from their usage.
Introduction
The company that forms the basis of this analysis is among the leading retailers within the UK. Marks & Spencer is involved in the business of selling high-quality and great value clothing, home products, and outstanding quality food (M&S 1). Statistics indicate that the company has over 20 million customers visiting their stores every week. In addition to that, it has been reported that the company employs over 75,000 people in its stores across the UK as well as in 42 territories globally (M&S 1).
The company generates a turnover from sales within the UK of over 8.6 billion British pounds (M&S 1). This revenue is generated from the three main divisions within the company namely clothing and home, food and stores. In the UK, Marks & Spencer is the largest clothing retailer featuring something for everyone within its stores. The company sells high-quality stylish clothes for all ages. In the UK, the company is the market leader in women’s and men’s wear as well as lingerie (M&S 1). The company is also the largest provider of high-quality foods in the UK. The food products offered range from fresh produce and groceries to innovative part prepared meals and a range of award-winning wines (M&S 1).
The company has over 700 stores in various locations across the UK. The stores can be found on high streets, retail parks, stations, airports and several other locations (M&S 1). The company is currently undertaking a store modernization program that is aimed at enhancing the shopping environment and expanding the range of hospitality options. The company allows the customer an opportunity to either visit stores, shop online or over the phone (M&S 1).
In the international market Marks & Spencer has over 150 wholly or partially owned stores across the globe. In addition to that, the company also has over 200 franchises strategically positioned across Europe, the Middle East and Asia (M&S 1). The company also has built a commitment to dealing with issues related to environment. In this regard, the company has an ethical program in place that seeks to reduce impact on the environment, develop sustainable products, and improve the lives of employees, clients, suppliers and the local community (M&S 1). In this report, the data from the company’s financial report will be used to perform an analysis of the company over a period. After the discussion on financial performance, there will be some information on the limitations of the analysis approach. The report will also consider several major accounting principles that form the basis for the preparation of financial documents.
Company Performance and Ratio Analysis
It has been observed that although financial statements are essential in helping to analyze a company these reports are basically a starting point for successful financial management (Vasigh, Fleming and Mackay 168). For this reason therefore it is possible to assume that financial reports provide a good starting point for in-depth financial analysis. The financial statements provided by companies often provide raw figures which are only meaningful when compared with other firms within the industry. Various quantitative methods can be used in the comparison of financial statements to report on a firm’s financial condition. These methods used in the evaluation of the financial condition and performance of a company are commonly referred to as ratio analysis (Vasigh, Fleming and Mackay 168).
The process of ratio analysis encompasses a wide range of calculations and measures that enable a manager to quickly spot trends in the company performance highlight historical performance and provide projections for the future (Vasigh, Fleming and Mackay 168). There are two major comparisons that ratio analysis provides and these are comparisons of the firm across time and comparisons of the firm within industry. Through the use of ratio analysis management can standardize financial results across time to provide an analysis of company performance over various periods (Vasigh, Fleming and Mackay 168). Such an analysis would be useful in that it assists in understanding the evolution of a company over time within an industry. However, it has been noted that due to the effect of macroeconomic shocks it is not always suitable to compare company results from one year to the next.
To provide a more powerful ratio analysis it is better to compare company performance with other competing firms in the same industry. This is especially due to the fact that financial statements for all publicly traded companies are readily available. What remains is to carry out benchmarking of competing firms to understand the company position within the industry (Vasigh, Fleming and Mackay 168). This benchmarking is crucial in that it can help firms recognize their strengths and weaknesses in the industry. This is due to the fact since firms vary in size and composition a standardized benchmark can best provide insight into the true state of company performance.
The various measures used in ratio analysis can be broadly classified into four main categories namely profitability ratios, liquidity ratios, long-term risk ratios and stock market ratios (Vasigh, Fleming and Mackay 168). The profitability ratios are reported to help in the assessment of the efficiency or success of the business. On the other hand liquidity ratios assess a firm’s ability to meet specific short-term obligations. Long-term risk ratios are those that assess the capital structure of a company and utilize a macro-level approach to company analysis. The stock market ratios deal specifically with publicly traded companies and provide a description of the company’s position in the stock market (Vasigh, Fleming and Mackay 168).
It should be noted that regardless of the type of ratio used during analysis there is no single ratio that is used alone to provide an accurate financial description of a firm. For that reason it has been recommended that a combination of financial ratios is used to help provide a broader perspective on the company (Vasigh, Fleming and Mackay 168). This point is further complicated by the fact that the same part of a company can be analyzed using several ratios. For this reason there is no fixed criterion on which ratios to use and when more ratios are used it is possible to get a better understanding of the financial position (Vasigh, Fleming and Mackay 168).
For this report, the ratio analysis will focus on profitability ratios and long-term analysis ratios. As earlier mentioned profitability ratios can help in describing the success of a business by a comparison of the profits (or losses) generated against a variety of baselines (Vasigh, Fleming and Mackay 169). These ratios help in standardizing the profits of a company. Thus it becomes easier to assess the profitability of one company against the profitability of another. It has been reported that while the ratio helps to standardize small and large companies alike it may not be the most suitable for comparison across multiple industries. This is because industry dynamics can vastly distort how companies make profits (Vasigh, Fleming and Mackay 169). For the purposes of our discussion, five profitability ratios and one long-term risk ratio will be applied and discussed in the Marks & Spencer case.
The first ratio discussed is the gross profit margin ratio. This ratio compares the gross profit of a company with the total revenue generated from sales (See Appendix A). Through an analysis of this ratio, management can determine how much gross profit is generated for every pound of revenue. In the case of Marks & Spencer in the year 2010 the gross profit margin was 38.24% following a calculation based on the formula. The gross profit can be especially useful when analyzing a company as it excludes items such as interest expenses and taxes that are largely based on the macrostructure of the company (Vasigh, Fleming and Mackay 169). This exclusion generally allows for a greater in-depth analysis of company operations. It has been observed that due to these exclusions in the calculation the gross profit margin ratio tends to be more stable over time. Based on the calculation it is possible to understand that for every pound of revenue generated the company created approximately 38 cents of gross profit. The gross profit margin for the previous year indicated that the company generated 37.94% for every pound of revenue earned. Based on this trend it is possible to observe that Marks & Spencer noted a slight decrease in the gross profit margin over the period.
The next ratio that will be considered is the operating profit margin ratio which represents the operating profit as a percentage of share capital, reserves and noncurrent liabilities (See Appendix B). This ratio takes into account all facets of a company’s financial structure and standardizes the financial bottom line of a firm (Vasigh, Fleming and Mackay 170). Because of this standardized approach it becomes possible to compare the performance of million-pound companies with billion-pound companies. This is because it compares the amount of net income generated for every pound of revenue (Vasigh, Fleming and Mackay 170). In the year ending 2011 the operating profit margin ratio was 16.55% whereas for the period ending 2010 the ratio was reported as 15.01%. This trend can be taken to signify that the Marks & Spencer Company has continued to increase the amount of profit generated on every pound of revenue created over the period.
The next ratio to consider is the Return on Assets ratio (ROA). This ratio can also be used to standardize small and large companies. The ratio measures the net income of a company and compares this against the fixed assets of the company (Vasigh, Fleming and Mackay 170). The purpose of the comparison is to show the investment return that assets have provided. This is because a company will invest in fixed assets with the goal of generating some income. This ratio thus analyzes company performance at one very fundamental element of business (See Appendix C). For the year ending 2010, the ROA was 8.15% whereas for the year ending 2011 the ROA was 7.31%. This ratio indicates that for every 100 pounds spent on assets the company makes 8 cents of profit for the company. However, this ratio will vary considerably based on the industry since some industries are more capital intensive than others.
The next ratio considered is the Return on Equity (ROE). This ratio has a similar goal as the return on assets ratio. It compares the company performance against the total stockholder’s equity (Vasigh, Fleming and Mackay 171) (See Appendix D). In the year ending 2011 the company ROE was 22.390% while in the year ending 2010 the ROE was 24.12%. This ratio does not vary much between industries. Though there was an increase in net income for the period there was also a significant increase in stockholder equity and it can be said that this was the reason for the decline in ROE.
The next ratio discussed is the Current Ratio (CR). This ratio involves the measurement of the company’s current assets against current liability (See Appendix E). The CR for the year ending 2011 was 0.743 while the figure for the period ending 2010 was 0.804. This indicates that in 2011, 74.3% of Marks & Spencer’s current liabilities will be satisfied with current assets (Vasigh, Fleming and Mackay 174).
The last ratio that will be used to analyze the Marks & Spencer case is the Debt to Equity ratio (D/E) (See Appendix F). This is a classic long-term risk ratio that aims to determine what proportion of company capital structure is composed of equity. The ratio helps determine if funding for the company is available and the weight of the company with regard to debt or equity financing (Vasigh, Fleming and Mackay 178). Based on the company financial data it is observed that the company reported a D/E of 0.720 in the period ending 2011 whereas it reported a figure of 1.050 for the period ending 2010. This signifies that in 2011 for every 1 pound of stockholder equity the company has been able to leverage 0.720 pounds of debt finance. The decline in the figure is therefore positive as it signifies a reduction in the degree of debt.
Limitations of Ratio Analysis
In the above section, an analysis of Marks & Spencer’s financial performance was carried out using various measures of ratio analysis. The use of ratio analysis to assess company performance is common despite the inherent flaws associated with the approach. It has been observed that all financial ratios in ratio analysis exhibit one key fundamental flaw. This is the use of Generally Accepted Accounting Principles (GAAP) and the matching principle which can smooth the numbers (Taparia 92). Due to this flaw, a clever accountant can create misleading revenue and net income figures. An example of this flaw is the fact that matching allows the reporting of revenue and net income figures well before cash is collected (Taparia 92). In addition to this potential flaw is the fact that in many cases the revenue reflected may only be based on estimates.
In addition to the above-mentioned flaw is the fact that companies may be involved in different industries (Taparia 92). It has been established that even companies in the same industry are not always alike. For example within the newspaper industry it is possible to have two companies that are involved in various activities. An example is company A which produces newspapers and also owns radio stations while company B produces newspapers and also is involved in billboard advertising. The different business models will thus suggest different business risks and hence different profitability structures (Taparia 93). This is not often considered in the use of ratio analysis.
About the above point it is vital to keep in mind that ratios are best used in the analysis of similar competitors. This suggests that industry norms can only be derived from a group of similar companies. It is reported that this flaw makes it difficult for even professional financial analysts to compare company ratios with industry ratios (Taparia 93).
Another challenge about the use of ratio analysis is the fact that company size may vary (Taparia 93). This fact suggests that care should be taken when comparing large players with small players in the industry. It has been reported that the size of the company may affect the business strategy used in the company (Taparia 93). In addition to this is the fact inflation may distort the balance sheet. It should be noted that assets are recorded at cost on the balance sheet and not at market value. Though the balance sheet caters for depreciation it has been observed that the actual market value of assets may be much higher due to inflation (Taparia 93).
Main Accounting Principles
Accounting principles can be taken as guidelines adopted by the accounting profession that serves to guide the practice of accounting (Woelfel 10). The phrase generally accepted accounting principles or GAAP is a term that identifies accounting principles that are accepted at a particular time. This set of principles reflects a consensus of what is considered good accounting practice and procedure within the accounting profession (Woelfel 10).
An example of major accounting principles includes the historical (or acquisition) cost principle. This principle states that the acquisition cost is the proper amount at which transactions involving assets should be recorded in the accounting system (Woelfel 11). Another accounting principle used in the development of financial statements is the revenue realization principle. This principle determines when revenue is considered to be realized. This is given the fact that realization involves the conversion of non-cash resources into money (Woelfel 11). According to this principle it can be assumed that revenue is realized once a sale takes place. In returning to the discussion on limitations of ratio analysis it can be seen that this principle is potentially dangerous as sale and collection of monies are not one and the same thing.
Another accounting principle used in the preparation of accounting statements is the matching principle. This suggests that income generate and expenditure incurred in earning income must be reported in the same financial statement (Woelfel 12). Another principle is the full (or adequate) disclosure principle which requires that information in financial statements must be sufficiently complete to avoid misleading users of reports. This suggests revealing all information that may be useful or support in decision making (Woelfel 12). In addition, there is the principle of materiality which requires that anything which is material or significant to potential users of a report be revealed (Woelfel 13).
In addition to the above preparing financial statements requires adherence to the principle of conservatism. This principle requires reasonable anticipation is made in the case of potential losses in recorded assets or settlement of liabilities (Woelfel 13). In addition to conservatism financial statements are expected to adhere to the principle of consistency. This principle suggests that reporting practices are sustained from one year to the next within an organization (Woelfel 13).
Conclusion
In this report, the discussion focused on the analysis of the financial performance of Marks & Spencer. The company is a major player within the UK market with significant revenue collections in the UK and several other regions. In the analysis, it was observed that ratio analysis is a useful technique in analyzing a company’s financial performance. To perform ratio analysis an individual can use several different ratios. It has been observed that a combination of ratios provides a better overall picture of performance. It has also been established that ratio analysis has inherent flaws due to several factors. For this reason, it is advised that a comprehensive set of ratios be used to perform an analysis of financial statements.
Works Cited
M&S. marksandspenser.com. Annual report and financial statements 2011, 1-116.Web.
Taparia, Jay. Understanding Financial Statements: a journalist’s guide. Illinois: Marion Street Press Inc., 2004. Print.
Vasigh, Bijan, Ken Fleming, and Liam Mackay. Foundations of Airline Finance: Methodology and Practice. Surrey: Ashgate Publishing Limited, 2010. Print.
Woelfel, Charles J. Financial statement analysis: the investor’s self study guide to interpreting and analyzing financial statements. USA: McGraw-Hill Publishers, 1994. Print.
Appendix
Appendix A: Gross profit margin ratio
- Gross profit margin = Gross Profit / Sales x 100
- 2011 Gross profit margin = 3724.70/9,740.3 x 100 = 38.24%
- 2010 Gross profit margin = 3618.50/9536.6 x 100 = 37.94%
Appendix B: Operating Profit Margin Ratio
- Operating Profit Margin = Operating Profit/ (Share capital + Reserves + Noncurrent liabilities) x 100
- 2011 Operating Profit margin = 836.9/ (396.2+2202.6+2456.5) x 100 = 16.55%
- 2010 Operating Profit Margin = 852.0/ (395.5+2202.6+3076.8) x 100 = 15.01%
Appendix C: Return on Assets (ROA)
- Return on Assets = Earnings after Taxes/Total Assets x 100
- 2011 ROA = 599/7344 x 100 = 8.15%
- 2010 ROA = 523.0/7153 x 100 = 7.31%
Appendix D: Return on Equity (ROE)
- Return on Equity = Earnings after Taxes/Total Stockholder’s Equity x 100
- 2011 ROE = 599/2674 x 100 = 22.390%
- 2010 ROE = 523.0/2169 x 100 = 24.12%
Appendix E: Current Ratio (CR)
- Current Ratio = Current Assets/Current Liabilities
- 2011 CR = 1641.70/2210.2 = 0.743
- 2010 CR = 1520.20/1890.5 = 0.804
Appendix F: Long term Debt to Equity Ratio (D/E)
- Long term Debt to Equity = long term debt/equity
- 2011 D/E = 1924/2674 = 0.720
- 2010 D/E = 2278/2169 = 1.050