Updated: Jun 8th, 2024

J Sainsbury Plc’s Financial Management Policies Report

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Table of Contents

Introduction
Investment Appraisal
Working Capital Management
Source of Capital
Conclusion
References

Introduction

‘J. Sainsbury Plc consists of Sainsbury’s- a chain of 504 supermarkets and 319 convenience stores, and a bank. (Annual report 2008, Page 3)[1]. With such large establishments, the financial analysis of the J.Sainsbury Plc group of companies requires a detailed research study of its financial statement and other available information. In this write up an effort has been to make a study under three different parameters, namely an investment appraisal of the firm, secondly a critical study of its working capital management, and a study of its sources of capital funding. Though in this study, mostly reliance is placed on ratio analysis, the other available information like information at yahoo.com about market prices of its equity shares at different dates have also been used.

Calculations of ratios have been depicted in each section wherever those have been used to interpret the financial figures stated in the financial statements of J.Sainsbury Plc.

Investment Appraisal

Investment appraisal involves how the capital and debt funds raised by J.Sainsbury PLC have affected the company’s profitability, efficiency, and liquidity of the company over a period of five years. As appraisal of liquidity has been taken up in the next section of working capital management, the profitability and efficiency effects of investments of

J.Sainsbury PLC in various assets, fixed and currents are as under:

The profitability status of any entity can be reviewed by its Gross profit ratio, Operating profit ratio, Return on Total assets (ROA), and Return on Equity. All these ratios for J.Sainsbury PLC have been calculated for the last five years as under:

Gross Profit Margin ‘indicates the percentage of each sales dollar remaining after a business has paid for its goods.’(Linda Pinson, 109)[2]. J.Sainsbury PLC has had a mixed performance over the years. From mighty 8.65% in 2004 to low of 4.33% in 2005 speaks a lot about the company’s sales policy. The heavy fluctuations of Gross margin over the period of time indicate that the company is not having a stable sales long-term policy. The fact the company reached 6.83 % in 2007 from 4.33% in 2005 provides ample proof that company investment in fixed assets is the right direction, but slipping to 5.62% again reflect some lacunas in policy matter, which the company should sort out to attain stability.

The operating profit ratio ‘shows the profitability of the business relative to sales after deducting the cost of goods sold and all operating expenses but excluding interest and taxation. It is a general indicator of the overall profitability of the business though it does not reflect the full impact of the capital structure of the business on profitability.’(Peter J. Clarke, 91)[3]. Though expenses have largely being managed by the company as is clear from 3.03% of operating profits in 2007 and 2.97% in 2008 from the operating loss of 0.99% in 2005, the company’s risky investments in current assets might have caused a delay in payment of expenses that has increased the cost of overheads to cope up with the loss of interest on delay payments.

‘Return on assets reflects the effects of operating decisions. It is influenced by two interdependent factors- net profit margin and asset turnover. It represents the combined effect of pricing, the effectiveness of the marketing mix in creating sales, and the control of costs incurred in the process of doing business. It measures the efficiency of the assets in generating sales.’(John W. English, 292)[4].

J.Sainsbury Plc’s returns on total assets have been encouraging during the period except for 2005 and 2006 when the indifferent sales policies affected the operating results. But the company managed to achieve reasonable net profits available to shareholders due to some positive results from the discontinued business. Leaving aside this period of 2005 and 2006, the company has been very effectively using its assets to bring encouraging results as reflected by 3.38% and 3.25% returns on assets in 2007 and 2008 respectively.

The pattern for return on equities is similar to return on assets, but the returns are higher than the return on assets. This is because equities have not effected by further issues but are affected by resultant retained earnings. In fact, total equity employed has come down from $5104m in 2004 to $4935m in 2008.

In order to judge the efficiency of investments of J.Sainsbury Plc. in fixed and current assets, earning per share (EPS) and Price Earning (P/E) ratio reflect the performance of investments in a true sense.

Both EPS and P/E ratios are calculated as under:

‘Investors and analysts place great emphasis on earning per share and particularly on the trend of earning per share in evaluating common stocks’ (Hallman and Rosenbloom, page 152)[5]. Therefore any company’s investment results are reflected through its earnings per common share. J.Sainsbury Plc. had remarkable EPS of 20.7 pence in 2004 and that went down badly to 4.1p in 2005 and 3.8p in 2006. It has again gained respectability when its EPS rose to 19.2 pins in 2007 and 19.1 in 2008. This shows that the company has fluctuating results on its investments in fixed and current assets. This again has been confirmed by the P/E ratio commanded by the company over the year.

‘The Price Earning Ratio is a measure of how the market prices a common stock’ (Faerber, 146)[6]. In other, it is a reflection of how the company’s performance on its investment is being valued by the market. In fact, the P/E ratio measures the amount that investors are willing to for each dollar of a firm’s earnings per share through its investments on various assets. For J.Sainsbury Plc, the investors paid as high as $87.04 per dollar of its earnings per share in 2006. That happened when the company was at a low ebb, but the investors were hopeful about the company’s investment policies. But the downfall P/E ratio in 2007 and 2008 has brought the actual reaction of investors’ expectations from the investments made by the company.

Working Capital Management

Therefore, there is a need for working capital in the form of current assets to deal with the problem arising out of the lack of immediate realization of cash against goods sold. Thus need for working capital and its management is very crucial in any business, and in this section, the management of J.Sainsbury Plc’s working capital has been critically analyzed…

Working capital management is concerned with the problems that arise in attempting to manage the current assets and the current liabilities. The objective is to manage current assets and current liabilities in such a way that a satisfactory level of working capital is maintained. This is so because if the entity cannot maintain a satisfactory level of working capital, it is likely to be insolvent and may even be forced into bankruptcy. The current assets should always be enough to meet current obligations when they arise.

The main task of the financial manager is managing working capital efficiently to ensure sufficient liquidity in the normal working of the entity. The three main measures of a firm’s liquidity are the current ratio, acid-test ratio, and networking capital. Accordingly, for assessing the working capital management of J.Sainsbury Plc., the first step is to assess its liquidity during the last five years by calculating its current ratio, acid-test ratio, and networking capital as under:

The need for working capital in an entity cannot be overemphasized. Given the financial objective of maximizing shareholders’ wealth, it is necessary to generate sufficient profits. The extent o which the profits can be earned will depend, among other things, on the magnitude of turnover or sales. However, sales do not convert into cash instantly. There is invariably a time lag between the sale of goods and receipt of cash unless goods have been sold on a cash basis, which is not possible in every business. Therefore, there is a need for working capital in the form of current assets to deal with the problem arising out of the lack of immediate realization of cash against goods sold. Thus need for working capital and its management is very crucial in any business, and in this section, the management of J.Sainsbury Plc’s working capital has been critically analyzed…

“Current ratio measures the firm’s ability to meet its short term obligations’ (Lawrence J. Gitman, 58)[7]. Generally, the current ratio of 2:1 is considered optimum for any type of industry of business. Compared with the current standard ratio of J. Sainsbury PLC is very poor, and that is less than even 1:1 in all five years. That means J.Sainsbury PLC has remained uncomfortable liquidity-wise in all five years. That again is confirmed by its acid-test ratio, which “is similar to the current ratio except that it excludes inventory, which is generally least liquid current asset.”(Lawrence J. Gitman, 59)[8]

Acid test ratio of 1:1 is believed to be generally efficient, but J. Sainsbury PLC has carried acid test ratio much lower than that in the last five years. The company has been struggling to meet its current obligations. That is the reason NWC has always been negative in the sense the current liabilities always exceeded current assets during the five years under consideration. The company possessed a delicate liquidity position and was not in a position to meet current dues timely. It is always difficult to predict the cash inflow, which is the conversion of current assets to cash. When such conversion is predictable, the company requires less working capital. When such conversion is difficult to predict, which the case of J.Sainsbury PLC is during the last five years as it had negative NWS in all the years, the company requires more working capital.

For any company, the management of Net working capital (NWC) can be better analyzed through its trade policy between profitability and risk. Profitability can be increased only by taking extra risks of not being able to meet short-term obligations. When NWC is greater, there is less risk of becoming insolvent as the company has more liquid powers; and conversely, when NWC is lower, the risk involved is higher. The basic rule is that for increasing profitability, the company has to take more risk.

The best measurement of this trade-off between profitability and risk is amicably reflected by the ratio of current assets to total assets, and for J. Sainsbury PLC, this ratio for five years is calculated as under:

“Current ratio measures the firm’s ability to meet its short term obligations’ (Lawrence J. Gitman, 58)¹. Generally current ratio of 2:1 is considered optimum for any type of industry of business. Compared with standard current ratio of J. Sainsbury PLC is very poor and that is less than even 1:1 in all the five years. That means J.Sainsbury PLC has remained uncomfortable liquidity wise in all the five years. That again is confirmed by its acid test ratio which “is similar to the current ratio except that it excludes inventory, which is generally least liquid current asset.”(Lawrence J. Gitman, 59)² Acid test ratio of 1:1 is believed to be generally efficient, but J. Sainsbury PLC has carried acid test ratio much lower than that in the last five years. The company has been struggling to meet its current obligations.

That is the reason NWC has always been negative in the sense the current liabilities always exceeded current assets during five years under consideration. The company possessed a delicate liquidity position and was not in a position to meet current dues timely. It is always difficult to predict the cash inflow, which is conversion of current assets to cash. When such conversion is predictable, the company requires less working capital. When such conversion is difficult to predict, which the case of J.Sainsbury PLC is during last five years as it had negative NWS in all the years, the company requires more working capital.

For any company the management of Net working capital (NWC) can be better analyzed through its trade policy between profitability and risk. Profitability can be increased only by taking extra risks of not being able to meet short term obligations. When NWC is greater there is less risk of becoming insolvent as the company has more liquid powers; and conversely when NWC is lower, the risk involvement is higher. The basic rule is that for increasing profitability the company has to take more risk

The best measurement of this trade-off between profitability and risk is amicably reflected by the ratio of current assets to total assets, and for J. Sainsbury PLC this ratio for five years is calculated as under:

The rule is that increase in ratio capacity to profitability get reduced as current are considered to be less profitable than fixed assets. Conversely when ratio is declining the firm will have increased capacity to earn more. This can also be stated that on decreasing ratio, the firm is taking more risk and then chances to earn profits are more than in increasing ratio. J. Sainsbury PLC ratio is fluctuating since 2004. The ratio reduced from 32.2% in 2004 to 25.72% in 2005.

That means company’s capacity to earn better profits increased in 2005 as compared to 2004 as it has fewer current assets as compared to 2004. This capacity to earn again reduced in 2006 when company chooses to keep more current assets as compared to 2005. Thereafter ratio declined to 20.26% in 2007 and 17.02% in 2008, and thus its earning powers increased as the company took more risks by keeping low NWC.

The earning powers or trade off between profitability and risks can be estimated by taking into consideration the effect of changes into current assets and current liabilities on NWC as reflected in first table reflecting NWC. Though NWC of J. Sainsbury PLC has always been negative, but the company took more risk in 2005 and 2008 when negative NWC increased showing that current assets decreased as compared to earlier years but that enhanced the company’s earning capacity by its risk taking abilities.

However, it must be kept in mind that ‘the risk- return trade off does not apply to 100% of all cases, but in a free enterprises system it probably comes close.’ (Seung Hee Kim, 14)³ In nut shall it can be said that the company always maintained a very low current and acid test ratios than required and therefore liquidity the company has been struggling through during the last five years. However the company has shown some sparks of increasing profitability when it took risks in some years by keeping lowering current assets so that increased fixed assets could add more to profitability. But the company need to improve its liquidity otherwise it may face the problem of not meeting its current obligations as and when those become due.

Source of Capital

J.Sainsbury Plc has raised funds mainly by raising equity capital and funding on the basis of non- current and current liabilities in the business. According sources of capital invested in the company during the last five years are as under:

The single most important source of capital of J.Sainsbury Plc for long term funding is equity capital. It is a permanent source of funding without repayment liability and does not involve obligatory dividend payments. The main advantage of equity funding is that it forms the basis of further long term funding in the form of borrowings related to creditworthiness. J.Sainsbury Plc from equities has come down from $5185m in 2004 to $4935m in 2008.

There were fluctuations of equity funding during this period of five years and that was caused by ups and downs of retained earnings during thee years. But such funding by J.Sainsbury Plc has some limitations. First the shareholders with limited liability exercise control and also share other ownership rights in the income assets of the company. That is to say there is danger of dilution of control whenever more funding are raised through equities. Moreover equity funding involves high cost of funding and high floatation cost for the firm.

Large term borrowings of J.Sainsbury Plc also include preference capital as a source of some permanent funding. Like equities preference capital also involves high costs of raising the funds. But preference capital funding does not dilute control of equity shareholders. Further it has negligible risk and puts no restrain on managerial freedom.

Other long term borrowings of J.Sainsbury Plc generally have low costs of raising funding as compared to equity and preference capital funding. But such borrowings do not dilute control. However it involves high risk and many a times put restrain on managerial freedom.

Short term funding has been raised by J.Sainsbury Plc through current liabilities like trade and other payables, short term borrowings, derivative financial instruments and certain statutory liabilities. This type of funding is in the regular course of business and affect the working capital of the business. Trade creditors are in fact creditors that arise on accounts payable created by supplier of goods and services in the normal course of business.

Costs for raising short term funding are almost negligible. However interest and regular costs are payable on bank credits, commercial papers and other such liabilities. However short term funding is effective only when there is efficient working capital management. In case of J.Sainsbury Plc working is being ineffectively managed as has reflected in its current ratio calculated above, which is much lower than the norms for normal business entity.

While analyzing the sourcing of funding of J.Sainsbury Plc, particularly long term funding, it is important to analyze its long term solvency. There are two aspects of long term solvency of firm. First, its ability to repay the principal when due; and secondly, the ability to meet regular interest payments. These positions can be analyzed through leverage ratios and interest coverage ratio. Leverage of capital structure can be judged through debt equity ratio of J.Sainsbury Plc which is calculated for the five years as under:

‘Debt Equity Ratio is used to indicate the extent to which a firm is using financial leverage. The debt equity ratio is the ratio of total liabilities to total owners’ equities. (Marshall, Manger and others, page 386)⁴. The capital leverage is also called capital gearing. When this ratio is more than 1 the entity is considered having high geared capital structure and vice versa.

J.Sainsbury Plc has high geared capital structure during the years from 2004 to 2006. In fact debt equity ratio was 2.21 in 2006. In the remaining two years of 2007 and 2008 the company has more or less normal geared capital structure as it is certainly not a low geared capital structure.

High geared capital structure has an advantage to equity holders that they can play with the leverage of the capital structure. The equity holders are entitled to residual earnings. In the period of high earnings equity holders has the benefit of claiming large chunks of residual earnings after meeting the fixed liabilities of interests on borrowed capital.

Unfortunately in case of J.Sainsbury Plc except for 2004, rest of the two years were not good years earning wise, and therefore equity holders of J.Sainsbury Plc could not take the benefit of high geared capital structure during these years. In fact equity holders were the losers because of high geared capital structure as EPS during 2005 and 2006 was at the lowest ebb of 4.1 pence and 3.8 pence per share as compared to 20.1 pence, 19.2 pence, and 19.1 pence respectively in 2004, 2007, and 2008.

This is technically also called ‘trading on equity’ that expression describes the practice of using borrowed funds carrying a fixed charge in the expectation of obtaining higher return on equity holders.

On the other hand if debt equity ratio is high, the shareholders are putting up less money of their own. This is a clear danger signal for the creditors of the firm and that is case for J.Sainsbury Plc during the years from 2004 to 2006. The reason is that when there are heavy losses or fewer profits as was the case during 2005 and 2006 of J.Sainsbury Plc, the creditors would loose heavily. Moreover with small financial stake in the firm, the equity shareholders may behave irresponsibly and even indulge in speculative activities. In short, the greater the debt equity ratio, the greater is the risk to the creditors of not only not receiving interests on due dates but also of loosing their principal investments.

A low debt equity ratio has the opposite effects. To Creditors with relatively low stake than equity holders, it implies sufficient safety margin and substantial protection against shrinkage of assets.

Thus J.Sainsbury Plc has raised long term and short tern funds, and also during three of last five years it had a high geared capital structure. But during two of those years the company was having low or negative operational profits and the equity holders of the company could not take advantage of the high geared structure of the company. In other two years the company carried more or less a normal capital structure.

Conclusion

The study of five years performances of J.Sainsbury Plc has revealed that during 2004 the performance on account of its profitability and efficient working during 2004 was suddenly came to a halt during 2005 and 2006. Its share prices dropped due its lower EPS and P/E ratio during those years. But the company picked the threads during 2007 and continued to improve in 2008 though not as effectively as in 2007.

Working capital management of the company has been inefficient during al the five years as its current and acid test ratios were much below the required standards. With the result the company was struggling to meet its current obligations when those became due. Sources of capital funding of the company showed that the company was highly geared during 2004, 2005 and 2006, but in later two years the capital structure was almost normal. Bit during the years high geared capital structure the company could cash on trading in equities because of low performances in 2005 and 2006.

References

Lawrence J. Gitman, Introduction to Managerial Finance, Eleventh edition, Chapter 2, page 58, 2006.
Ibid, page 59.
Seung Hee Kim, Global Corporate Finance, sixth edition, page 14, 2006.
Marshall, Manger and others, Accounting, 6^th edition, page 386, 2003,.

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