Financial Statement of Sainsbury PLC

Financial statements are produced in order to help stakeholders understand the financial condition of the entity in question. Different types of entities, however, have different reporting requirements. A self-employed individual has very different needs from a limited company, and these are different from not-for-profit organisations as well. This paper will examine some of these differences.

The first class of business is the self-employed individual. There are no reporting standards for self-employed individuals. Such individuals, when engaged in business for themselves, need only report to Her Majesty's Revenue and Customs their revenues and expenses for the year. A self-employed individual has no other stakeholder besides himself/herself and Her Majesty, so there is no need for complex standardized reporting. The self-employed individual can choose what method of accounting they want to follow -- accrual or cash basis. Cash basis accounting is accepted for the self-assessment tax return, whereas it would not be for a limited company. Cash basis can only be used for self-employed individuals earning up to £81,000 in the year. Having standardized accounting requirements would be burdensome for self-employed individuals, hence why there is no such requirement and even cash basis is accepted. A self-employed individual, therefore, might not have financial statements at all, just a simple ledger of cash incomes and disbursals.

Limited companies, by contrast, are prescribed to use standards outlined by law. The rules are in a state of flux at the moment, with some entities using generally accepted accounting principles (GAAP) and some entities using the International Financial Reporting Standards (IFRS). The system is comprised of tiers, such that IFRS are required of Tier 1 companies -- those considered to be publicly accountable. Tier 2 companies - those that are neither publicly accountable nor small, may opt to use IFRS should they choose, but are not obligated to do so. Alternately, they may choose to use the Financial Reporting Standard for Small- and Medium-Sized Entities (FRSME), a UK standard but based on IFRS for companies of a similar size. Tier 3 companies are small, and report based on the Financial Reporting Standards for Smaller Entities (FRSSE). A tier 3 company may also apply FRSME or IFRS, should it choose (BDO, 2011).

Regardless of the methodology, limited companies must create financial statements and reports according to an accepted system, and there are mechanisms in place for the enforcement of these standards. Limited companies that are publicly accountable must also make regular reports to the public, in particular quarterly and annual reports. These reports are in standard format, and this allows external stakeholders like investors and regulatory agencies to evaluate the content of the reports in order to understand the financial condition of the reporting entity. Limited companies are also typically subject to audit.

Not-for-profit organisations are also seeing changes in their reporting standards as the result of the move towards IFRS. IFRS standards for public benefit organisations are different from the ones for limited companies, but the principle of using specific reporting standards remains. Public benefit entities requires such standards because they receive taxation benefit, and it is essential that Her Majesty is able to determine the financial health of not-for-profit entities, and that they are truly operating as NFP entities. With the new IFRS requirements going into place, NFPs are all but required to have specialized accounting abilities to meet these requirements, as they apply even to smaller NFPs (BDO, 2010). A key difference of course between the way that NFPs report their performance is with the matter of profit -- and by extension the matter of taxation. Their reports show a balance sheet, and outline their incomes and expenditures, but not as a profit statement per se. The unique nature of NFPs in this grouping highlights the need for a slightly different set of objectives in financial reporting.

Thus, the level of sophistication in financial reporting for entities is dependent on the public interest of the organisation. Whereas there is no real public interest in self-employed individuals, both limited companies and not-for-profit entities have a higher level of public interest, and the result is that they are required to produce standardized statements according to a regular timetable, and to make these available for public and regulatory scrutiny. The self-employed individual needs only to produce a basic ledger and their financial reporting is between them and Her Majesty, with no public reporting requirement.

Part II. A) My chosen company is Sainsbury's. The following table illustrates the company's key financial ratios for the past three years.

Sainsbury's Key Ratios

2013

2012

2011

Gross Margin

5.48%

5.43%

5.50%

Net Margin

2.63%

2.68%

3.03%

ROCE

10.71%

10.62%

11.80%

ROA

0.048365

0.04846

0.056145

Current Ratio

0.58

0.65

0.58

Acid Test Ratio

0.26

0.35

0.30

Total Asset Turn

1.84

1.81

1.85

Stock Turnover

22.32

22.48

24.56

Debtors' Turnover

90.32

77.95

61.52

Gearing ratio

1.21

1.19

1.10

As these numbers indicate, the financial performance of Sainsbury's over the past three years has been fairly stable. The company operates in a stable industry, mainly groceries, and the British economy has been basically flatlined over the same period of time. Thus, it would not be expected that there would be a major swing in Sainsbury's performance, and there was not. Revenues have steadily increased over the past three years, increasing 5.6% in 2012 and 4.5% in 2013. Net income declined by 6.4% in 2012 then increased by 2.6% in 2012.

One of the reasons or the lower net margin is that Sainsbury's experienced a lower gross margin. There are a number of possible explanations for the decrease in the gross margin, but it typically reflects a decrease in pricing power over either buyers or suppliers. Competition often is the cause of this, especially as a firm like Sainsbury's is for the most part a price-setter with suppliers and with customers. Increased competition in its space, however, will result in the company having to lower its prices to customers in order either to move inventory or to increase market share. It is possible that Sainsbury's', whose revenue outpaced the growth in the British economy the past two years, sought to lower its prices in certain areas to win more market year, and the increase revenues are reflective of that. Whatever the case, the fact that the company saw a restoration -- somewhat anyway -- of its gross margin in 2013 is encouraging. What is less encouraging is that the net margin continues to decline. Net margin losses in this case reflect operating expenses, which grew faster than revenues. For Sainsbury's, it is essential to control costs in order to continue to see margin growth. Where costs outpace revenues, there may be extenuating circumstance but in general this reflects slightly weaker managerial control over costs.

The company's returns are fairly stable, however. The overall size of the company means that the return on assets in particular did not change much the past two years. However, it did drop in 2012 to 4.8% from 5.6% in 2011. This decline also occurred with the return on capital employed. These figures indicate that the apparent decline in pricing power with Sainsbury's has affected the returns that the company earns as well, something that is detriment to shareholders.

However, it should be noted that such minor deviations in performance may simply be cyclical or happenstance. Changes do occur from year to year, and it is only when they form a trend that management truly needs to be worried. However, management can take this as a sign that it might want to control its costs and start to undertake steps to improve its pricing power, as these trends have been occurring for the past two years.

Another ratio that can be used to analyse the performance of Sainsbury's For example, the company's liquidity and gearing can be analysed. With respect to liquidity, two good ratios are the current ratio and the acid test ratio. The first is a measure of financial health of the company in terms of its ability to meet its pending obligations for the next year. In this, the current ratio is today at 0.58, down from 0.65 last year, but on par with the level of 0.58 in 2011. This indicates that there might have been an outlier result in 2012. The level of 0.58 itself is not particularly stellar, as 1.0 is more of a normal benchmark for this ratio. However, there might be extenuating circumstances to be taken into consideration. One is that the company has maintained a stable current ratio. It is clearly able to handle this ratio, and there is no major downward trend based on the past three years. Indeed, further research indicates that this level is healthy because the company has strong inventory turnover.

The acid test ratio is similar to the current ratio, but using the current assets less the inventory. The reason for taking out the inventory is that inventory may need to be marked down in order to be sold, or it might be unsellable, therefore it is good to understand the company's financial position without the inventory. This ratio is at 0.26, its lowest level of the past three years, and well down from the 0.35 of the year before. This might be of some concern to an analyst if there are other factors at play, and other warning signs. The acid test ratio is not as important for Sainsbury's as it might be for other companies because most of its inventory will be sold, it can be safely assumed. Much of the goods are not especially perishable, and most of the items can be sold even if a discount is needed. Sainsbury's therefore cannot be viewed in the same light as a company whose inventory might be worthless if unsold. If Sainsbury's need to sell more cans of beans, it just needs to knock 10p off the price.

Overall, then, the company appears have relatively healthy liquidity. For investors, Sainsbury's represents low overall right, despite having a fairly low current ratio, because of the nature of its business, and because of the nature of its inventories. The company has held its current level stable, something that indicates that this level is something that can be maintained over the long run, and is therefore not indicative that the company has a genuine solvency issue.

With respect to gearing, it is up to the directors of each company to determine the optimal gearing ratio. This depends on a number of factors, including the nature of the industry, in particular with respect to the fixed asset base and the nature of the cash flows. One of the major considerations is that the company might want to align its cash flows with its financing. With much of the fixed investment going into real estate, that might be aligned by using equity, while other investments are more short-term in nature and therefore financed with liabilities.

The gearing ratio for Sainsbury's is 1.21, up from 1.19 in 2012 and 1.10 in 2011. Trends are important with respect to gearing ratios because they indicate whether a poor ratio is the company moving towards bankruptcy or whether management is pulling the company out of the situation. In this case, Sainsbury's does have a negative trend with respect to its gearing ratio. The ratio as it stands is not unusual for a firm in its industry, especially given the high level of fixed assets required to compete in the grocery business (usually real estate). The company therefore can afford to have this gearing ratio. Another consideration is that the company might specifically be taking on more debt because the cost of debt is so low at present. The level of long-term debt, however, has not increased that much, and certainly not to indicate that the company is having financial trouble and is adding to its debt load in order to keep the cash flowing. Some of the increase is also in current liabilities, which will always tend to increase when a company's operations become larger. Indeed, the company might see an increase in all forms of debt if it is growing faster than profits. Given that profits have declined in the past couple of years, this is a reasonable suspicion. No matter what the reason for the increase in debt, it should still be explained that the gearing level of Sainsbury's is well within reason for a firm in its industry.

The non-financial ratios are the turnover ratios, which highlight the movement of goods and credit through the organisation. The turnover ratio reflects how fast inventory moves through the organisation, in this case between 22-24 times per year, so roughly fortnightly. This means that Sainsbury's is highly efficient with respect to how well goods move through its stores. It has a good sense of what people purchase and when. Sainsbury's probably uses sophisticated analytical techniques in order to understand consumer buying patterns, with the result being that it is able to purchase the right amount of each item at the right time. While its efficiency in this regard has slipped, that slippage could also be attributed to growth, especially where new stores are concerned. New stores often underperform, because they have to win customers from other, pre-existing stores in the area. So if Sainsbury's has grown by adding stores then that might explain the slight decrease in its ability to move goods through its stores.

The other related ratio is the debtors' ratio, which reflects how fast Sainsbury's collects on its debts. In the retail industry, these debts are usually with credit card companies, or cheques written on bank accounts to pay for groceries. In both cases, a company the size of Sainsbury's can be expected to have good relationsihps with creditors, and collect quickly. There is significant economic advantage to rapid collections, as that money can be reinvested faster. The rate in 2013 of debtors' turnover is 90 times, compared with 78 times in 2012 and 61 times in 2011. These figures reflect that Sainsbury's is improving rapidly in this area. It now collects of its revenues in just four days. This is good for its financial performance overall, and the rapid improvement from six days two years ago to the current level indicates that Sainsbury's is taking the issue more seriously and working with creditors for more rapidly settling of accounts.