Why are financial ratios important in evaluating the performance of Primark? What are the limitations of financial ratios in evaluating the performance o

Discussion Questions:

Why are financial ratios important in evaluating the performance of Primark?

What are the limitations of financial ratios in evaluating the performance of Primark?

How can managers address the limitations of financial ratios when evaluating company financial performance?

4. Reflection – the students also should include a paragraph in the initial response in their own words reflecting on specifically what they learned from the assignment and how they think they could apply what they learned in the workplace or in everyday life.

The last few years have been challenging for clothing retailers in the United Kingdom. A number of struggling clothing retailers have experienced a decline in revenues as customers reined in their spending because of the uncertainty posed by Brexit and prioritization of wealth management to more fiscal conservative measures. Primark, however, seems to have bucked this trend. Primark’s owner, Associated British Food, reported revenues of GBP 7,477 million and adjusted operating profit of GBP 843 million for the fiscal year ending in 20X5. To evaluate Primark’s financial position in relation to its competitors, this case study is compiled using financial data from 20X1 to 20X5. This case study employs the latest financial performance and historical data to evaluate and critically analyze the financial performance of Primark in comparison to three of its competitors in the UK: Next, Marks & Spencer, and New Look. The case will focus on the key issues facing Primark in comparison to its competitors and use both financial ratios and distress models to evaluate performance. For comparative purposes, five years of data from the four retailers were chosen to identify trends and patterns in the industry. Students are asked to consider whether Primark is a good company to invest in and where the company will rank financially within its sector.

Primark is one of Ireland’s largest clothing and accessories retailer and has stores throughout the UK. It is the biggest retailer by volume and will likely challenge Next and Marks & Spencer, who are currently second and first place respectively, in terms of financial performance for first place. While other clothing retailers have seen a decline in revenues over the past five years, Primark seems to have bucked the trend. Furthermore, Primark reported revenues of GBP 7,477 million and adjusted operating profit of GBP 843 million for the fiscal year ending in 20X5.1 Primark does not sell online and its good showing defies the shift from in-store to online shopping. Primark’s main competitors Next, Marks & Spencer, and New Look have all moved into online shopping, but Primark continues to open a slew of stores across the UK. Low prices and tight stock controls have been credited for Primark’s continuing surge in revenues. Despite its success, Primark is still vulnerable to a decrease in sales, which brings into questions the premium multiple of the company. This case study will assess the risk, profitability, solvency, and efficiency of Primark in comparison to its competitors. To further this objective, the case will use financial performance and historical data to evaluate and critically analyse the performance of Primark in comparison to three of its competitors – Next, Marks & Spencer (M&S), and New Look. More specifically, the case will use financial ratios and models to evaluate Primark’s performance in comparison to its competitors with reference to the relevant literature.

An Analysis of the Current Business and Financial Situation of Primark

Table 1 presents the results of Primark’s financial position for 20X5. As of 20X5, Primark seems to be in a very strong profitability position. Primark’s profitability ratios signify that the company is in a very healthy position to generate revenues, fund operating costs, and generate value to shareholders. In particular, Primark’s return on asset (ROA) means that the company is using its assets efficiently to generate revenues. Primark’s return on equity (ROE) and return on invested capital (ROIC) is also very high, which mean that the company is using its equity financing to grow the business, while at the same time generating handsome returns to investors.

The efficiency ratios measure the company’s ability to use its assets to generate income and manage its liabilities. As can be seen in Table 1, Primark takes on average about two months to sell its inventory. Given that Primark is in the clothing retail sector, this is reasonable and signifies that the company is converting inventory into liquid cash in a relatively short time period. The value for days in inventory is not surprising, given that Primark turnover on cost of goods sold from inventory about 5.60 times per year and is doing a decent job controlling storage costs and merchandizing. Primark for the most part is not over-buying inventory and more importantly, management is working hard to sell the inventory that the company purchased. Primark is collecting its receivables on average about 15 (14.86) times per year. The high receivable ratio means that Primark is collecting credit sales more frequently and is a sign that the company has tight credit control policies.

Beneish M-Score

Unlike the Altman Z-score that focuses on predicting financial distress, the Beneish M-score (1997), more generally, is optimized to detect earnings manipulations. The Beneish M-score has two forms: an eight-variable model and a five-variable model. Relative to the eight-variable model, the Beneish M-Score five-variable model excludes depreciation, leverage, and the general sales and administrative expenses index. Each variable is constructed so that higher values are associated with a greater probability of manipulation (Beneish et al., 2013, p. 76).

The M-Score formulae are as follows:

Five-Variable Model:

Eight-Variable Model:

The variables are as follows:

DSRI: Days’ sales in receivable index

GMI: Gross margin index

AQI: Asset quality index

SGI: Sales growth index

DEPI: Depreciation index

SGAI: Sales and general and administrative expenses index

LVGI: Leverage index

TATA: Total accruals to total assets

Appraisal of the Financial Strengths and Weaknesses of Primark and Its Competitors

Primark’s strengths lie in its profitability ratios. As mentioned earlier, Primark’s return on capital employed (ROCE) was significantly above its competitors. Note that Primark’s ROCE was higher than the rate at which the company borrowed (as was evident from its low gearing and interest ratios). This is advantageous to Primark because an increase in borrowing would have reduced shareholder earnings (see Arnold, 2013; Pike & Neale, 2009). The increase in ROCE could have been the result of an increase in asset turnover and/or the operating profit percentage.

In comparison to its competitors, Primark will have problems with its ability to pay short-term debts that may suddenly arise. Primark’s liabilities to its trader creditors kept rising from 2009 and could potentially lead to a cash shortfall if these creditors call in the debt. On average, Primark only has about GBP 25 to cover every GBP 100 of current liabilities that it owes. The acid test position remains steady over the four-year period. For every GBP 100 owing to its current liabilities, Primark has about GBP 75 worth of coverage in terms of its liquid assets.

What is also very perplexing is that Primark’s inventory turnover was very low when compared to its main competitors Next and M&S. As alluded to earlier, there are a few reasons which can explain this disparity. However, Primark needs to be very wary of its inventory becoming obsolete. Low turnover may have been caused by overstocking, deficiencies in marketing the product and obsolescence – all of which are factors that can work to decrease the Primark market share in the UK.

A Critical Evaluation of the Finance Techniques Applied in the Analysis

The principal limitation of ratio analysis is the inadequacy of source data (i.e., from the income statement and balance sheet; Chadwick, 2001, p. 86). The use of accounting concepts and the manner in which professional judgements are applied can lead to inconsistencies in the calculation of the final figures (Bowen et al., 2005). It must be remembered that ratio calculations are based on “financial statements and that the results of the financial analysis are dependent on the quality of those underlying statements” (McLaney & Atrill, 2002, pp. 232–233). Subsequently, ratios will inherit the limitations of the financial statements they are based on (p. 223).

Inter-firm comparisons can be problematic and very often lead to inconsistencies in financial statement analysis (Kellogg & Kellogg, 1991). The four firms used for comparison “could be using different accounting policies, applying the concepts in different ways, and could be affected by off-balance-sheet financing, etc.” (Chadwick, 2001, p. 87). An important issue here is to consider the degree of conservatism that each business adopts in the reporting of profit (McLaney & Atrill, 2002, p. 232). To make meaningful comparison, any subsequent review of financial statements must entail an examination of the accounting policies that are being adopted (p. 233). Perhaps, adjustments may have to be made to allow for changes in accounting policies (Chadwick, 2001, p. 87).

In interpreting financial ratios, it is important to also keep in mind that the subsequent analyses are based on profit and loss account and balance sheets, which are subject to the limitations associated with historical cost accounting (Gillespie et al., 2004, p. 353). More specifically, inflation, specific price changes, and different bases of evaluation are all likely to distort comparison (p. 353). What happens through the period of the asset’s working life therefore appears to be irrelevant (Chadwick, 2001, p. 87). For instance, using different bases for depreciation and stock valuation can affect the final figures (Gillespie et al., 2004, p. 353).

In summary, financial indicators of performance tend to show what has happened rather than what is going to happen to drive the creation of wealth. The analysis evaluates what the companies are expected to achieve. This is particularly important in firms where management is concentrating on achieving short-term set targets. Traditional financial indicators using ratios or even net present value and internal rate of return can give misleading signals deliberately or by accident, particularly in the short-term (Brealey et al., 2009).

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