Tesco Company’s Capital Structure and Finance

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Table of Contents

Introduction
Overview
Justification of Choice
Current Position
Analysis
Discussion
Theories of Capital Structure
Conclusion
References

Introduction

Financial analysts recognize that the evaluation of a company’s capital structure is a key step to understanding its financial prospects over the long term (Arnold, 2013). The strength of a company’s balance sheet is determined to a great extent by the composition of its capital structure. A firm’s capital structure refers to the composition of investor-supplied capital that is used to fund overall operations and growth (Brigham & Houston, 2015). A capital structure or capitalization is a mix of an organization’s debt and equity (Brigham & Houston, 2015). Taking into consideration the fact that no company functions in the perfect market in which its long-term capital has no bearing on its success, it is extremely important to understand the effects of capital structure decisions.

This paper aims to analyze the capital structure of Tesco PLC (henceforth Tesco). The paper will discuss the strengths and weaknesses of the company’s current position and provide comments on the firm’s long-term financing decisions based on several theories of capital structure.

Overview

Tesco is a multinational food retailer headquartered in Welwyn Garden City, England (“Annual report,” 2017). The company was founded in 1919 by Jack Cohen who opened the first grocery stall in the East End of London (“History,” n.d.). Tesco built the first supermarket in 1950, which allowed it to increase the number of its outlets to more than 500 in less than five years (“History,” n.d.). Currently, the company has 27.6 percent of the grocery market share in the UK, which makes it the largest food retailer in the country (“Market share,” 2017). The fresh produce retailer has 6, 902 outlets in the following countries: the UK, the Republic of Ireland, the Czech Republic, Poland, Malaysia, Thailand, and Slovakia (“Company overview,” 2017). Tesco employs more than 464, 500 specialists around the world (“Company overview,” 2017). In 2016, the group revenue of the company amounted to £55, 917M, which represented a 3.7 percent growth from the result of the previous year—£53, 933M (“Annual report,” 2017).

In addition to selling fresh produce, the company provides banking and insurance services. Tesco Bank has more than 7.6 million accounts and reports a high level of customer growth (“Annual report,” 2017). In 2016, the bank’s total revenue was £1,012M, which constituted a 6 percent increase from the previous year’s figure—£955M (“Annual report,” 2017). Furthermore, financial income from joint ventures and associates of Tesco grew to £109M in 2016 (“Annual report,” 2017).

Justification of Choice

Tesco has been chosen for the analysis because it is a company with the highest debt-to-equity ratio in the industry—1.1 (“Tesco PLC (OTCPK: TSCDY),” 2017). Its closest competitors Morrison Supermarkets PLC, Sainsbury PLC, Ocado Group PLC, Greggs, PLC, Conviviality PLC, and Crawshaw Group PLC have substantially lower ratios—0.37, 0.32, 0.91, 0.00, 0.49, and 0.00, respectively (“Tesco PLC (OTCPK: TSCDY),” 2017). Furthermore, until recently, the company’s debt-to-equity ratio was 1.86 (“Tesco PLC (OTCPK: TSCDY),” 2017). Tesco has been steadily increasing its debt-to-equity rate since 2013 (“Tesco PLC (OTCPK: TSCDY),” 2017). The elevation of debt levels is not the soundest long-term financing decision if one’s EBITDA generation capacity is diminished. In the first quarter of 2015, Tesco’s debt/EBITDA ratio increased to 5.4x, which is a substantial increase in comparison with the 2014 level of 4.1x (“Moody’s downgrades,” 2015). For this reason, the company’s credit rating was downgraded by Moody’s in 2015 (“Moody’s downgrades,” 2015). Taking into consideration the reduction of the retailer’s sustainable debt capacity and the rating agency’s action, it would be educational to critically analyze the company’s capital structure. By evaluating the constituents of the company’s capital, it is possible to understand the company’s financial strength.

Current Position

The company funds its current operations and expansion endeavors with the help of 16 percent of senior debt, 24 percent of junior debt, and 60 percent of equity (“Tesco (UK),” 2017). Senior debt accounts for a relatively small share of the company’s funding and represents the cheapest form of long-term financing. The junior debt of Tesco has maturity dates that exceed ten years (“Annual report,” 2017). Equity capital accounts for the largest share of the company’s founding. In 2016, the company substantially reduced a share of debt in its capital structure (“Annual report,” 2016). The long-term financial decision is associated with the disadvantage of the high cost of equity financing. However, by reducing its debt, Tesco diminished its ongoing financial liabilities, which is a significant benefit of the action. Moreover, the company safeguarded itself from the potential bankruptcy risk. It is extremely important because, during recent years, the company experienced substantial financial difficulties. For example, half-year operating profits of the retailer fell by 55 percent from £779M in 2014 to £354M in 2015 (“Tesco half-year,” 2015).

Analysis

Equity Capital

Equity is the element of the capital structure of the company that is sourced through the issuance of shares or profits claimed by stockholders (Arnold, 2013). As of February 2017, the total shareholder’s equity of Tesco was £6.414B (“Annual report,” 2017). The total equity consisted of the following items: £409M of share capital, £5, 096M of share premium, £601M of total other reserves, and £332M of retained earnings (“Annual report,” 2017). In 2017, the capital value of Tesco’s equity was lower than that in the previous year—£8.616B (“Annual report,” 2016). However, the value of total equity in 2015 was £7.071B, which represented a substantial decrease from the previous year’s level (“Annual report,” 2015).

It is clear from the company’s statement of changes in equity that variations in accounting policies of Tesco contributed to £80M adjustments in reserves of stockholders (“Annual report,” 2017). Differences in currency translation resulted in £764M worth of changes in equity from 2016 (“Annual report,” 2017). Other equity variations during the accounting period were due to transactions with owners, taxes, and gains on cash flow hedges. The closing balance shows that in February 2017, shareholder equity was substantially lower than that in the previous year (“Annual report,” 2017).

Debt Capital

Debt is a portion of the capital structure that is sourced by entities that do not have an ownership stake in the company (Arnold, 2013). As of August 2017, Tesco’s short-term debt was £3.8B (“Tesco PLC,” 2017). The liabilities of the retailer came in the forms of trade and other payables, borrowings, derivative financial instruments, customer and bank deposits, tax liabilities, and provisions (“Annual report,” 2017). The company managed to substantially reduce its short-term debt in comparison with the previous year’s level of £5.1B (“Annual report,” 2017). The marked improvement of the company’s indebtedness can be attributed to the increase in operating cash flows for the accounting period. Proceeds from retail operations amounted to £2.3bn, which represented a 9.1 percent increase from the previous year’s level (“Annual report,” 2017). Tesco’s long-term financing goal is to smooth its debt maturity profile while simultaneously strengthening the continuity of financing (“Annual report,” 2017). Therefore, in 2016, the company redeemed £1.9B worth of bonds and issued new ones (“Annual report,” 2017).

Financial Leverage

Financial leverage refers to “the degree to which a company uses fixed-income securities such as debt and preferred equity” (“Financial leverage,” n.d., para. 1). To assess the capital structure of Tesco, the debt-to-equity ratio will be used. As of February 2017, the company had a total debt-to-equity ratio of 1.86 (“Tesco PLC (OTCPK: TSCDY),” 2017). The figure was slightly above the 2015 value of 1.79 and the 2016 value of 1.57 (“Tesco PLC (OTCPK: TSCDY),” 2017). However, these ratios were markedly higher than the 2014 value of 0.76 and the 2013 value of 0.65 (“Tesco PLC (OTCPK: TSCDY),”) 2017). When compared to its top competitors, it is clear that the company tries to finance its growth by borrowing. Current debt-to-equity ratios of Morrison Supermarkets PLC, Sainsbury PLC, Ocado Group PLC, and Greggs PLC are 0.37, 0.32, 0.91, and 0.00, respectively (“Tesco PLC (OTCPK: TSCDY),” 2017).

Enterprise Value

Enterprise value is a concept that refers to “the sum of all debt and equity in the capital structure” (Bagaria, 2016, p. 21). Enterprise value is used by financial analysts to compare different organizations at various growth stages. As of August 2017, the company’s enterprise value was £27,48B (“Tesco PLC Enterprise,” 2017). Tesco’s enterprise value was extremely volatile in recent years. A downward trend from £57,29B in February 2013 to £30,18B in February 2016 shows that over these years the company became cheaper to buy (“Tesco PLC Enterprise,” 2017).

Discussion

Tesco relies more on equity financing than debt financing—40 percent debt and 60 percent equity (“Tesco (UK),” 2017). The current debt to equity (D/E) ratio of the company is 1.86 (“Tesco PLC (OTCPK: TSCDY),” 2017). According to the trade-off theory, a company can have an optimal structure of capital that maximizes its value by making a balance between the costs and benefits of increasing debt (Ghazouani, 2013). Such a structure of capital has a direct influence on Tesco’s weighted average cost of capital (WACC). A WACC calculation helps to determine how much capital costs for a company by proportionately weighing its categories. It follows that whenever a firm changes the proportion of its debt to equity its WACC also invariably fluctuates (Hirschey, 2016). It has to be born in mind that the market value of a firm is calculated as its future cash flows divided by its WACC (Hirschey, 2016). Therefore, to increase the market value of a company, it is necessary to reduce its WACC.

If one were to look at fluctuations in the Tesco’s WACC for the last three years, they would discover a downward trend. In February 2015, the company’s WACC was equal to 7.77 percent (“Tesco PLC WACC,” 2017). In February 2016, the WACC was lowered to 5.58 percent, which was followed by a further reduction to 4.51 percent (“Tesco PLC WACC,” 2017). The reason for this reduction is a substantial change in the company’s capital structure. In 2015, Tesco announced its intention to sold its joint venture with Samsung—Homeplus (Butler, 2015). The sale allowed the company to reduce its total debt from £21.7B in 2015 to 15.5B in 2016 (“Annual report,” 2016). Thus, with the reduction of the level of total indebtedness the company’s WACC was also substantially lowered.

The decrease in the WACC may seem counterintuitive because equity is more expensive than debt. It follows that the lowest WACC can be achieved by issuing more debt (“Optimum capital,” n.d.). However, by increasing a share of debt in its capital structure, a company raises the amount of interest it has to pay out of its profits, thereby putting its ability to pay dividends at risk. The increase in the financial risk to a company’s shareholders translates into a higher cost of equity (“Optimum capital,” n.d.). Therefore, a company has to achieve a balance between the amount of its equity and debt, to lower its WACC. The reduction of the company’s WACC points to the fact that Tesco was able to strike such balance.

Theories of Capital Structure

To understand the company’s recent financial decisions and their impact on its long-term financial health, it is necessary to review several capital structure theories. Under the traditional theory of capital structure, an organization “should aim to minimize its weighted average cost of capital and maximize the value of its marketable assets” (Ross, 2015, para. 2). From this vantage point, it is clear that Tesco made a sound decision when it decided to reduce its net debt, thereby strengthening its balance sheet. Two major credit rating agencies commented on the company’s action by arguing that it was “a step in the right direction” (Butler, 2015, para. 4). It has to be borne in mind that after measuring the company’s ability to repay its debt, Moody’s downgraded Tesco from Baa3 to Ba1 in 2015 (“Moody’s downgrades,” 2015). Following the net debt reduction, the retailer’s debt to EBITDA ratio fell from 2.8 to 2.4 (“Tesco (TSCO),” 2017). However, this year, the company has increased the share of its debt, which is, arguably, not the soundest long-term financing decision (“Tesco (TSCO),” 2017). Modigliani and Miller’s trade-off theory suggests that a company’s capital composition has a bearing on its WACC (Miglo, 2016). Changes in Tesco’s WACC that were preceded by the reduction of the share of its debt confirm the theory’s key proposition.

Another approach to capital structure decisions is based on the pecking order theory. According to the theory, a company should fund its current operations and growth through retained earnings. However, if for some reason, retained earnings cannot be used for financing, a firm has to increase its debt level. Equity should be issued when other sources of external financing are not available. The long-term financing decisions of Tesco are not informed by the pecking order theory. The company’s debt-to-equity ratio is the highest in the industry, which translates into high volatility of earnings (“Tesco PLC (OTCPK: TSCDY),” 2017).

Conclusion

The paper has critically evaluated the capital structure of the largest retailer of fresh produce in the UK—Tesco. The analysis has included the discussion of the strengths and weaknesses of the company’s current proportions of debt and equity. The paper has also commented on Tesco’s long-term financing decisions. It has been argued that the company pursues optimal debt-equity relationships, which is evidenced by the marked reduction of its WACC in recent years. However, the current debt-to-equity ratio of Tesco, which is the highest in the industry, suggests that it might be hobbled by the high level of debt in the long term. Given that food retail is a highly competitive industry, the long-term financing decision may provide its rivals with an advantage in the future.

References

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Annual report and financial statements 2017. (2017). Web.

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Butler, S. (2015). Tesco to reduce net debt by as much as £3.35bn after Homeplus sale.The Guardian, Web.

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Financial leverage. (n.d.). Web.

Ghazouani, T. (2013). The capital structure through the trade-off theory: Evidence from Tunisian firm. International Journal of Economics and Financial Issues, 3(3), 625-636.

Hirschey, M. (2016). Managerial economics. Boston, MA: Cengage Learning.

History. (n.d.). Web.

Market share of grocery stores in Great Britain from January 2015 to March 2017.(2017). Web.

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Ross, S. (2015). What is capital structure theory? Web.

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Tesco half-year profits fall 55% to £354m. (2015). Web.

Tesco PLC (OTCPK: TSCDY) Debt-to-equity: 1.10 (As of Aug. 2017).(2017). Web.

Tesco PLC (OTCPK: TSCDY) WACC %: 2.63 % as of today.(2017). Web.