Chapter 5 Financial Analysis

Problem 1. ROE Decomposition

Tesco plc is one of the world's largest food retailers. Fiscal year 2014 (the year ending on February 28,
2015) was a rocky year for the retailer. The company's sales and margins had come under pressure as
a result of strong competition in the industry. Further, in September 2014 company management
announced that it had overstated earnings in previous fiscal years through the accelerated
recognition of supplier rebates. The events led to a management change in which Dave Lewis took
over as Chief Executive and John Allen took over as Chairman. In April 2015 Dave Lewis announced a
record (pretax) loss of £6.4 billion - one of the largest losses in UK history.

The following tables show the standardized and adjusted income statements and balance sheets of
Tesco, for the years ended February 28, 2013, 2014, and 2015. Operating lease obligations have been
capitalized and the operating lease expense has been replaced with depreciation and interest
expense, following the procedure described in Chapter 4. Further, to help you better analyze the retail
activities of Tesco, the net assets of Tesco Bank have been included as one separate balance sheet
item, labeled 'Other non-operating investments - net assets Tesco Bank'; Tesco Bank's pretax profit is
included in investment income. Other expense (net of other income) includes, amongst other items:
(a) a £4.7 billion impairment of property, plant, and equipment; (b) a restructuring charge of £0.4
billion; (c) a £0.7 billion impairment of (non-operating) investment assets; and (d) a £0.2 billion
reversal of commercial income overstated in prior years. Tesco's statutory tax rate was 24 percent in
2012, 23.1 percent in 2013, and 21.2 percent in 2014.

1. Calculate Tesco’s net operating profit after tax, net investment profit after tax, interest after
tax, operating working capital, net non-current operating assets, investment assets, business
assets, debt, and capital in 2012, 2013, and 2014. (Assume that the cash balance needed for
operations equals to 3% of revenue.)
2. Decompose Tesco’s return on equity in 2012, 2013, and 2014 using the traditional approach.
3. Decompose Tesco’s return on equity in 2012, 2013, and 2014 using the alternative approach.
What explains the difference between Tesco’s return on assets and its return on net operating
assets?
4. Analyze the underlying drivers of the change in Tesco’s return on equity. Which factors explain
the decrease in return on equity?

[See spreadsheet ‘CH5 P1.xlsx’ for the statements]

1 Copyright © Cengage Learning EMEA ltd. All

rights reserved.