Finance: Ratio Analysis and Investment Appraisal Techniques

This report discusses the importance of ratio analysis and investment appraisal techniques in finance. It analyzes the financial performance of Tesco plc and Sainsbury's plc using various ratios. It also provides recommendations for improving liquidity, profitability, and asset utilization. The report highlights the limitations of ratio analysis and the impact of inflation on financial analysis.

Finance

Table of Contents
INTRODUCTION...........................................................................................................................................3
PORTFOLIO 1...............................................................................................................................................3
Ratio analysis...........................................................................................................................................3
Interpretation .........................................................................................................................................4
Recommendations ..................................................................................................................................4
Limitation of ratio analysis.......................................................................................................................4
PORTFOLIO 2...............................................................................................................................................6
Investment appraisal techniques.............................................................................................................6
Limitation of using investment appraisal techniques in long term decision making................................7
CONCLUSION...............................................................................................................................................9
REFERENCES..............................................................................................................................................10

INTRODUCTION
Finance is the backbone of every business and to determine true and fair position of
financial situation of every business is as necessary as bread for a human being. In this context,
there are various tools and techniques those can be used as a way of determining the financial
position of a business (Agustina and Suprayitno, 2020). This action is necessary so that after
investigating into financial position of that firm, efficient strategic planning can be done for
future course of action. This report is divided into two portfolios. First part is concentrating on
analysis of financial position of Tesco plc and Sainsbury's plc through tool of ratio analysis.
Excess dependence of financial ratios is also not a good strategy in long run and it is also
explained in this report. Furthermore, second portfolio is talking about importance of investment
appraisal techniques which are used in order to determine and identify correct and appropriate
investment decision for a company.
PORTFOLIO 1
Ratio analysis
Tesco plc
Name of ratio Calculation Result
2018 2019
Current ratio Current assets/ current
liabilities
13,726 / 19,238
= 0.713484
12668/2
0680
=
0.61257
3
Quick ratio Quick assets/ current
liabilities
4379/ 19238
= 0.227622
3373/ 20680
= 0.163104

Net profit margin Net profit/ total sales (1206/57491)*100
=2.097%
(1322/63911)*100
= 2.068%
Gross profit margin Gross profit/ total sales (3350/57491)*100
= 5.827%
(4144/63911)*100
= 6.484%
Gearing ratio
(Debt to Equity Ratio)
Total debt/ total equity 44862/10480
= 4.280%
49047 / 14858
= 3.301%
P/E ratio Market value per share/
Earnings per share
229/ 9.35
=24.49
213.6/13.65
= 16.97
Earnings per share Income available/ total
number of shares
outstanding
9.35 13.65
Return on capital
employed
Operating profit/
capital employed
5.13 6.86
Average inventories
turnover period
Net sales/ average
inventory
57491/2282.5
= 25.91 days
63911/2240.5
= 28.52 days.
Dividend pay-out ratio Dividend paid/ net
income
82/1206
= 0.68.
357/1322
= 0.27
Sainsbury plc
Name of ratio Calculation Result
2018 2019
Current ratio Current assets/ current
liabilities
7857/10302
=0.73
7550/11849
=0.63
Quick ratio Quick assets/ current
liabilities
1933/10302
=0.19
1283/11849
=0.19
Net profit margin Net profit/ total sales 309/28456
=0.11%
186/29007
=0.006%
Gross profit margin Gross profit/ total sales 518/28456 601/29007

=0.018% =0.02%
Gearing ratio
(Debt to Equity Ratio)
Total debt/ total equity 34.44 97.75
P/E ratio Market value per share/
Earnings per share
238.80/0.22
=10.85
213.40/46
=4.64
Earnings per share Income available/ total
number of shares
outstanding
22 46
Return on capital
employed
Operating profit/
capital employed
4.65 3.84
Average inventories
turnover period
Net sales/ average
inventory
28456/1792.5
=15.87 days.
29007/1869.5
=15.51 days.
Dividend pay-out ratio Dividend paid/ net
income
235/309
=0.76
247/186
=1.33
Interpretation
1. Current ratio: It is a ratio that defines the liquidity position of the company and it
represents the capacity of firm to pay off its current liabilities with the help of current
assets (Bhardwaj and Gupta, 2018). This means that company will be able to pay off
those liabilities which are due in coming 1 year or so with almost liquid assets, such as,
cash, inventories, debtors, etc. Ideal ratio according to various theories and models is 2:1.
In the given case of Tesco and Sainsbury, analysis is done over a period of 2 years,
former has a ratio of 0.71 and 0.61 in 2018 and 2019, respectively. In case of sainsbury,
0.73 and 0.63 respectively in two span periods. Condition is almost same in both the
companies in both the time period. Therefore, it can be concluded that they both are
equally performing in their working capital. Ratio is not as per the ideal mark and
according to results, it is low and current assets are not enough to pay out current
liabilities.

2. Quick ratio: it is a type of ratio that basically acts as a true presentation of liquidity
position of firm, as it only takes actual liquid or quick assets into consideration. In other
words, it can be explained as that value which represents the capability of firm to pay off
its current liabilities from quick assets or cash and cash equivalents (Carini and Teodori,
2019). According to common theories and models, it is a known fact that 1:1 is the ideal
benchmark for the ratio. In the given case of tesco and sainsbury, their ideal ratios are not
up to the mark. The situation is better in tesco as compared to the other company.
Though, both the companies are performing very low as compared to the ideal
benchmark.

3. Net profit margin: it is basically an indicator of company's performance in terms of the
amount of profit that it generated in a specific period of time. This margin is created
based on the amount of sales (Carreras, Simó and Coenders, 2020). Higher the profit
margin, higher is the profitability of the firm. This profit measure is dependent upon
number of factors, such as, indirect expenses, taxation amount, etc. in the given case of
tesco and sainsbury, profitability is not encountering any significant increase over 2018
and 2019. instead the graph is slowing down. In comparison, tesco is performing better as
compared to other company.

4. Gross profit margin: it is the presentation of gross profitability of the firm. In other
words, it can be explained as the indicator of performance of company before incurring
indirect expenses. As the name suggests, it represents gross profitability of the company
and its root performance. The main factor that impacts this level of profitability is sales
volume and direct expenses in the firm. In given case of real companies, performance of
both companies is declining, but in comparison it can be stated that Tesco is performing
better than Sainsbury (Easton and et.al., 2018).
5. Gearing ratios: The gearing ratio is a financial ratio that compares some form of owner's
equity (or capital) to debt, or funds borrowed by the company. Gearing is a measurement
of the entity’s financial leverage, which demonstrates the degree to which a firm's
activities are funded by shareholders' funds versus creditor's funds. The gearing ratio is a
measure of financial leverage that demonstrates the degree to which a firm's operations
are funded by equity capital versus debt financing. In the given case of Tesco and
Sainsbury, tesco is having less burden of debt and on the other hand, sainsbury is having
a very heavy burden of debt. Tesco has reduced the burden over two years and sainsbury
has almost doubled it up (Gafli, 2019).

6. Price to Earning ratio: it is also known as price multiple or earnings multiple. This is
basically an indicator of comparison of current market price of share and per share
earnings. This is a ratio that is useful for investors and analysts and they use this ratios to
evaluate various investment options that are available for them. If one option is having
higher returns on relatively low market rate, than that option is considered to be more
profitable (Mukhametzyanov and Nugaev, 2016). In given situation of Tesco and
Sainsbury, price to earnings ratio is decreasing over the year. In comparison, it is very
clear that former is performing better that the latter.

7. Earnings per share: It is basically the indicator of profitability that is received by the
shareholder. It is calculated by dividing total company's profit by total number of
outstanding shares in the market. It is a common notion, that higher the EPS, higher will
be the profitability measure of the company. In given situation, the situation is
comparatively better in Sainsbury, as the EPS is higher in this company in comparison
with Tesco. Both companies are encountering a growth is EPS bar and thus, it can be
stated that both companies are performing well in terms of profitability ( Palepu and
et.al., 2020).
8. Return on capital employed: It is basically a financial ratio that is used to reflect
profitability and position of efficiency of usage of capital in the company. In simple
words, it can be explained as the indicator of the yardstick that presents the company's
performance in generating profits from its capital investment. It is useful tool for
financial managers, stakeholders and also potential investors and they use this ratio as a
tool for analyzing possible profitability after making investment into company. In given
situation, this condition is better in Tesco, rather than the other company. Also tesco is
visualizing growth in the ratio. On the other hand, Sainsbury is confronting decline.

9. Inventory turnover average period: this ratio is an indicator of the time period that
average inventory takes to sell off completely. This means it is the time period, which the
company is taking to sell off a set of inventory and bringing the new one. Shorter this
period, means the company is having a high sales volume. In the given case, sainsbury is
taking shorter time period, therefore, it can be stated that latter has higher sales volume.
10. Dividend payout ratio: it is the comparison between total amount of dividend paid to
shareholders and the net income of the company. It represents the percentage of earnings
paid to shareholders in terms of dividend out of net income of company (Romanyuk and

Ichkitidze, 2020). The amount that is not paid to shareholders is retained by the company
to pay off debt or to reinvest in core operations. It is sometimes simply referred to as the
'payout ratio.' In the given case of comparison between Tesco and Sainsbury, the situation
is better in latter as it is countering growth in the graph and also former is visualizing
decline in the ratio.
Recommendations
 From the about report it has been recommended that company should monitor and access
inventory level whether it is managed effectively or not. This will help in improving
Quick ratio.

 For improving liquidity ratio, company should run promotions and offer discounts on
their products to decrease inventory and generate profit.
 Company should conduct an analysis for the demand of the products and identify what
factors are responsible for creating low demand. This improves interest coverage ratio.
This also includes buying behavior of customers, competitors analysis, and companies
marketing strategies etc.
 To improve profitability ratio in finance then company needs to decrease its operating
expenses and work towards boosting profit margin. There can also be a detailed analysis
of cost and pricing structure. This will help the company in staring great.
 If company turns too high, then it is not likely that company could not carry enough
inventory to fulfill its customers’ needs. So for that, company should monitor its
inventory and always keeps right balance for their inventory.
 A low Assets turnover ratio indicates that company is not operating at its full capacity
and not utilizing its assets properly. So for this, company should analyze its assets
properly (Trofimova and et.al., 2018)
Limitation of ratio analysis
Similar to some other technique of financial analysis technique, ratio analysis is also
having certain limitations and they are as follows:
 Historical information: The main challenge with this tool of analysis is that it is
calculated on the basis of part results. Analyses are done with the purpose of gaining a
knowledge which can assist financial managers to plan for future course of actions.
Therefore, it can be stated that ratio analysis does not provide a clear picture of future
financial performance of company.
 Inflationary effects: Ratio analysis is done based on the data and information furnished
by financial statements of the company and these statements are released on fixed
periodical basis. Therefore, calculation part of ratio analysis also encounters time gap
between two specific release dates of financial statements. If economic condition of

country confronts some situation of inflation or deflation, than it may affect the numbers
in financial statement as well. This impact is reflected further in ratios and thus, makes
them incomparable. In long term period, if ratios are incomparable of two financial year,
than it may pose challenge in front of strategic planning process.
 Changes in accounting policies: If the company has changed its accounting policies and
procedures, this may significantly affect financial reporting. In this case, the key financial
metrics utilized in ratio analysis are altered and the financial results recorded after the
change are not comparable to the results recorded prior to the change. It is up to the
analyst to be up to date with changes to accounting policies. Changes made are generally
found in the notes to the financial statements section.
 Projects cannot be measured in cash terms: There are some projects which cannot be
calculated in terms of cash. Social, Political, Military projects are some projects which
cannot be measured in cash terms. Projects like charity funding for poor people to have
meal or building new flight for military purpose fall under this category. Net present
value model is not suitable for these types of projects. Some projects contains cash and
non-cash both. These projects may be approve with negative NPV provided they have
some extra non- cash benefits judged to be sufficient good value for cash to more than
make up difference (Willigers, Jones and Bratvold, 2017).
PORTFOLIO 2
Investment appraisal techniques
In the given situation, most suitable tool of evaluating available alternative is Net Present
Value method and accordingly, calculations are made as follows:
Project A
NET
PROFITS
DICOUNTING
RATE
PRESENT
VALUE
45000 0.862 38790

45000 0.743 33435
45000 0.641 28845
35000 0.552 19320
35000 0.476 16660
25000 0.41 10250
147300
Less: Initial investment 110000
Net present value 37300
Project B
NET
PROFITS
DICOUNTING
RATE
PRESENT
VALUE
10000 0.862 8620
15000 0.743 11145
25000 0.641 16025
55000 0.552 30360
65000 0.476 30940
58000 0.41 23780
120870
Less: Initial investment 110000

Net present value 10870
Interpretation: According to above calculations, net present value is the amount that is calculate
after determining all present value taking discounting rate into consideration and deducting
initial cash outflow. According to this concept, the project having higher net present value is
considered to be more profitable. In accordance with this principal, project A is more profitable
for the company and it is recommended for selection.
Limitation of using investment appraisal techniques in long term decision making
There are several investment appraisal techniques those can be used to evaluate
investment options available with management of a firm. To illustrate, payback period, internal
rate of return, net present value method, etc. In the given situation, suitable method is net present
value method. It also has certain limitations as explained below:
 Selection of suitable discounting rate: In this method, the most significant challenge is
in the form of calculating discounting rate. Discounting rate is basically that conversion
rate which is used to determine the present value of some future cash flows. This rate is
dependent upon number of factors, such as, risk associated with the option, arithmetical
accuracy, etc. These all factors if not considered accurately, than may lead to
identification of a wrong rate. This step may lead to complete failure of process and a
huge financial setback for the company.
 Determining cost of capital and cash flows: The cost of capital is the rate of return
required that makes an investment worthwhile. It helps determine whether the return on
an investment is worth the risk. When a company decides on whether or not to make an
investment, it has to set an appropriate cost of capital. If it aims too high then it may
determine an investment is not worth the risk and have a missed opportunity. Conversely,
if the cost of capital is too low, it may be making investment decisions that are not
worthwhile. When an investment doesn't have a guaranteed return it can be difficult to
determine the cash flows from that investment. This can sometimes be the case for

companies that invest in new equipment or decisions based on business expansion. A
company can estimate the kind of cash flows these investment decisions may have, but
there is a chance they could be off by a significant percentage.
 Investment size: it is a common notion that a higher NPV represents option that is better
investment. But this is not a true fact, as if there are two investment alternatives that are
available for making choice with the management of a company and one option is having
a larger outlay or scale, than it will obviously report a higher NPV, on the other hand a
small outlay option may have higher returns. Therefore, this technique is proved to be a
vague concept for evaluation of projects having unequal size. To gain an accurate picture
of profitability of an investment option, it is necessary to concentrate on calculation of
returns, rather that present value of cash flows (Нугуманова, 2016).
 Additional cost: NPV is a narrower concept as it includes only the cash flows that are
incurred during this project life cycle. This method fails to recognize those costs which
can be crucial for the profitability of a project. To illustrate, opportunity costs are one
type of costs that may be an important consideration in choosing an investment
alternative, but net present value method does not take these type of cost in consideration.
 Expressed in absolute terms: Result of net present value method is expressed in
absolute terms and hence, it becomes difficult to compare this result with some other
criterium of scale of investment. If management wants to evaluate more than one
alternatives of investment, than most important element is to compare future profitability
of all these options. If the result is in absolute terms, than comparison is not possible.
This is one of the most significant limitations of net present value method.
 Manipulation of financial statement: ratio analysis is based on the analysis which is
recorded in financial statement of the company. This analysis may be manipulated by the
company to record it better results then its actual performance in the financial statement.
Hence, ratio analysis did not reflect true performance of the business. As there might be
misrepresentation or mistake in any information because these mistakes are not detected
in simple analysis. It is very much important that the analyst should detect these mistakes
and must aware about possible manipulation and make conclusion accordingly.

 No common standards: this is the another limitation as it is difficult to calculate a
common standard of comparison because situations differ from concern to concern and
nature of each company is different from another. For example- a business having ratio
3:2 might not be in that condition to pay its liabilities on time because of an unfavorable
distribution of assess. Likewise, on other side another company having ratio 3:2 may not
face any problem to pay its liability on time because of its favorable distribution of
current assets. So, ratio analysis has no common standards to calculate a real comparison.
CONCLUSION
From the above report, it can be elucidated that mere analyzing financial position is not
important, to analyze and calculate about different investment options available with the
management is also necessary. As finance is most important part of every company, therefore, it
is necessary that company is taking care of their funds at every step and ensuring they are being
utilized in optimum manner.

REFERENCES
Books and Journals
Agustina, Y.N. and Suprayitno, H., 2020. ANALYSIS OF FINANCIAL STATEMENTS
USING LIQUIDITY RATIO TO MEASURE FINANCIAL PERFORMANCE IN 2017-
2019. JOSAR (Journal of Students Academic Research). 5(2). pp.32-39.
Bhardwaj, M.A. and Gupta, R., 2018, October. Qualitative analysis of financial statements for
fraud detection. In 2018 International Conference on Advances in Computing,
Communication Control and Networking (ICACCCN) (pp. 318-320). IEEE.
Carini, C. and Teodori, C., 2019. Making Financial Sustainability Measurement More Relevant:
An Analysis of Consolidated Financial Statements. In Financial Sustainability of Public
Sector Entities (pp. 103-121). Palgrave Macmillan, Cham.
Carreras Simó, M. and Coenders, G., 2020. Principal component analysis of financial statements:
a compositional approach= Análisis en componentes principales de los estados
financieros: un enfoque composicional. Revista de Métodos Cuantitativos para la
Economía y la Empresa, 2020, vol. 29. p. 18-37.
Easton, P.D. and et.al., 2018. Financial statement analysis & valuation. Boston, MA:
Cambridge Business Publishers.
Gafli, G.F.M., 2019. The Extent of Capital Budgeting Techniques In Evaluating Capital
Investment Decision Case Study: Development of Photovoltaic Power Plant
Project (Doctoral dissertation, Sekolah Tinggi Bisnis IPMI).
Mukhametzyanov, R.Z. and Nugaev, F.S., 2016. Financial statements as an information base for
the analysis and management decisions. Journal of Economics and Economic Education
Research. 17. p.47.
Palepu, K.G. and et.al., 2020. Business analysis and valuation: Using financial statements.
Cengage AU.
Romanyuk, K. and Ichkitidze, Y., 2020, July. Time Series Analysis of Financial Statements for
Default Modelling. In Science and Information Conference (pp. 281-286). Springer,
Cham.
Trofimova, L.B. and et.al., 2018. Institutional analysis of financial statements and improvement
of investment performance. Eurasian Journal of Analytical Chemistry. 13(4). pp.288-
295.
Willigers, B.J., Jones, B. and Bratvold, R.B., 2017. The net-present-value paradox: Criticized by
many, applied by all. SPE Economics & Management. 9(04). pp.90-102.
Нугуманова, Г.А., 2016. COMPARISON OF INVESTMENT APPRAISAL TECHNIQUES.
In НАЧАЛО В НАУКЕ (pp. 134-137).