Module 4: Case study the Income Statement

Transcription

1 Module 4: Case study the Income Statement Watch the Income Statement video > In this module we will use Debenhams plc as a case study to analyse the aspects of a company s income statement. Debenhams plc is a suitable case study for this series as it is: a public listed company that is a familiar name and one that has an interesting history; a simple organisation to understand. Its annual report and accounts contain most of the material needed for the glossary of terms ; and like many retailers, Debenhams is also a property company. Debenhams - A brief history Debenhams was founded in 1778 by Thomas Clark, who began trading at 44 Wigmore Street in London as a drapers store. In 1813, William Debenham became a partner and the business changed its name to Clark & Debenham. The company incorporated in 1905 as Debenhams Limited and grew through the acquisition of department stores, including Harvey Nichols in 1920, before listing on the London Stock Exchange in In 1985 it was bought by the Burton Group, demerging and relisting in It was then bought by a private consortium, returning to a listing once more in In 2009, it bought Magasin du Nord, a leading Danish department store group. At it s 2015 year end, it owned and operates from 178 stores. The Debenhams brand also operated under licence in 26 other countries from Armenia to Vietnam, and it has plans to increase the number of international franchise partners to 150. The primary source of information referenced will be the annual report and accounts that were issued for the reporting period 52 weeks ended 29th August Debenhams Annual reports -

2 The accounting period Retailers, whether food, fashion, homeware or variety businesses, traditionally use a weekly or a four weekly period to monitor sales. It is important they have a consistent reporting period to enable comparability between sales periods as performance is expressed in terms of progress against the previous week, and against the equivalent week or cluster of weeks for the previous year. Reporting on a weekly or a four weekly period results in an accounting period of 364 days (13 periods x 4 weeks x 7 days per week) and there are 365 days in a year. So retailers periodically need to report on 53 weeks to catch up on that missing day each year and then adjust the results over 53 weeks to 52 weeks in order to get comparability with the previously reported 52 weeks. It is also typical for retailers to report at the end of August after the summer sales are all over when inventories or stocks are run down, cash has been collected and the balance sheet is in best shape. Financial reporting today The Debenhams 2015 Report & Accounts is 158 pages long. This is by no means unusual for public companies and is due to the detail required by financial reporting rules. As the gap between the owners and the managers of businesses has grown owners include future generations of pensioners who rely on their employer and the investment managers that they retain to look after their interests so there has been a growing demand for more disclosure about the way that managers run these businesses and the reward that they get for their efforts. Reasons for the length of disclosures? Readers and commentators are looking for comparability between organisations and require more detail to make informed comparison. The fiduciary duties of directors to shareholders/stakeholders demands proper accountability and accountability means giving a full and fair account.

3 Turnover: Revenue and Gross Transaction Value (GTV) The first line on the face of the statement is Revenue which was ahead by about 0.4% when compared with the previous period. Revenue is strictly defined and what s interesting is that it is formally reported in the published financial statements differently to the way that the management of Debenhams refer to sales for their own internal management purposes. They call it Gross Transaction Value (GTV) and the difference reflects some of the little nuances that characterise department store chains. Debenhams grants concessions within its stores in exchange for a fee. Sales within these concessions are not sales by Debenhams but are recorded within GTV as they have an interest in how their concessions are performing and they believe that readers of the accounts will as well. Similarly, consignment sales to overseas franchisees are treated differently as are sales to Debenhams staff at a discount. So there are two definitions of turnover but for reporting purposes and to enable comparability with other businesses, revenue is clearly defined differently to GTV. Note that VAT is always excluded from reported revenue figures and GTV data.

4 In the CFO s report, there is an analysis of GTV which shows that whilst sales in the UK on a likefor-like basis were down about 0.3% there was progress in UK online sales (up 11.4%) and the international businesses in Ireland and Denmark despite adverse currency fluctuations. New space added in the UK also gave sales a boost. On balance, this is a positive result given the difficult trading environment in the UK. The pressures of a strengthening currency over the year to August 2015 also made the overseas franchise business more challenging and meant that their sales would have been worth less in sterling terms. Gross profit Revenues may have been reasonably flat but gross profit, which is calculated after deducting the cost of sales from revenue, at million has increased by nearly 20 million which is not far short of 7.0%. What are the levers for this difference? - Improved stock control. Retailers are sometimes referred to as buying businesses as well as selling businesses. Being able to buy in the right quantities is as important as buying at the right price as this means having to mark down less when the sales are on. Reduced sales stock is good for protecting gross profit margins and margin protection really matters, sometimes more than protecting market share, in a difficult economic environment. - The continuing trend towards online sales in the UK (now 14% overall after returns) also helps gross margin although online sales do also add to distribution costs and increase systems costs. - Finally, product mix has a bearing because the gross profit margins of different product lines can vary significantly.

5 Operating profit (after distribution costs and administrative expenses) Gross profit identifies the profit achieved after direct cost of sales i.e. those costs that can be directly attributed to achieving sales. Operating profit is measured after deducting distribution costs and administrative expenses, which are generally quite fixed e.g. the head office costs that happen regardless. At million, Debenhams achieved an increase in operating profit of 5.5 million, or 4.3% on the year. Fixed and variable costing; marginal costing One of the challenges for a retailer like Debenhams is that it has to: - price its merchandise competitively whilst ensuring; - sales contribute enough profit to pay for its estate and its employee costs. As a department store, like Selfridges, John Lewis, Fenwicks, House of Fraser, and to a lesser extent Marks & Spencer, part of its attraction to shoppers is the breadth of its catalogue. But different departments contribute very differently to profits. So traditionally clothing is higher margin than homeware. To give a specific example, the carpet department at John Lewis has operated at very low margins and certainly takes up its fair share of space that could otherwise be used for more profitable merchandise. But that is a conscious decision to attract and retain customer loyalty. Other chains feel differently and mix their own sourced merchandise between those: - Brands that they design themselves - They commission from well-known designers - They buy directly from international suppliers - That take concessions within stores in order to take advantage of nesting alongside other brands. They all do it differently but they are all aiming for the same thing. Profit margin, profit contribution, marginal profitability of ranges, density of product profitability (DPP), these are all some of the measures that retailers will consider in order to try and squeeze extra value out of the space available to them. Retailers do not disclose a lot of information about particular product lines and their profitability as they do not want to give away information that might be useful to competitors or might be ammunition for analysts. They will tell you about the performance of homeware, or clothing in total but not much more. And, by way of example, the Debenhams disclosures are quite limited on the margins achieved from concessions, which now form 25% of total GTV.

6 EBIT and EBITDA Like GTV these do not appear on the face of a published Income Statement as there are very strict rules about what you can and cannot include in the Primary Statements. So any reference to them will be elsewhere in the financial statements, for example in the notes. What is the value in these two variations on a theme of profit? They are an attempt once again to achieve comparability between businesses that are competitors or operate in a similar sector. And this comparability is one of the ways in which investors and commentators try and answer questions such as: - Is that a good or a bad result? - How does performance compare with the competition? - Has management done a good job? - Is the business strategy the right one? - Is this the right team to deliver the strategy? The management team that is reporting may find some of these a little awkward from time to time and may reasonably argue that delivering consistently good financial performance from pursuing the right strategy takes time and that observers should not take a short term view of performance. This tension is healthy as it obliges management to take the necessary time to explain the progress that has been made against previously stated objectives and the reasons for any variation from those objectives. Profit before tax (PBT) and Profit for the financial year attributable to owners of the parent company (otherwise Profit after tax or PAT) These two take as their starting point the operating profit and then show the impact of financing costs and tax respectively. In the case of Debenhams there is symmetry between the share of operating profits taken by providers of finance and the tax authorities for the year about 15% each - leaving 70% for shareholders. It is clear from Debenhams cash flow statement, the group is a net repayer of debt after paying for capital investment and dividends which should mean that in the absence of very sharp interest rate increases it should see less paid away to its financiers in future years. This should be an encouraging sign for shareholders. This aspect of Debenhams financial management will be explored in more detail in Module 7: The Cash Flow Statement and explain the structure of the company s finances.

7 EPS and earnings: basic and diluted The last section of the Income Statement deals with how the value created for shareholders is expressed. The profit attributable to shareholders has gone up by 7.2% to 93.5 million and one can assume that this is a good result. However, one way of increasing shareholders profits is to repay debt and thereby save interest costs. The easiest way to do this in the short term is to raise money by selling shares whether to existing shareholders or to new shareholders. In this way the profit may go up but it gets shared out amongst a larger number of shares so this increase is illusory. In addition, the issue of shares to new shareholders dilutes the share of the company owned or controlled by the existing shareholders. The test is to calculate the profit by the weighted average number of shares in issue to see the real increase in earnings the alternative expression to profit. If there has been no change in the number of shares issued during the last two years the rate of increase in basic earnings per share should be the same as the percentage increase in profit. But shares are often issued in dribs and drabs, sometimes as part of executive remuneration, or may indeed be bought back from the market. So we see in the case of Debenhams that while PAT increased by 7.2% year-on-year, basic earning per share increased by 7.0%. There is also another calculation of earnings per share that recognises shares which have not yet been issued but could be issued at some stage in the future under the terms of some contractual agreement. This calculation is referred to as the diluted earnings per share and, again, it will tend to erode the impression given by the underlying profit performance comparison. The Consolidated Statement of Comprehensive Income So that deals with the Income Statement. On the following page within the financial statements is the Consolidated Statement of Comprehensive Income which is the second Primary Statement.

8 Accounting and reporting has become more complicated in the pursuit of consistency and clarity, so there are an increasing number of areas of measurement that need to be dealt with. This statement, therefore, deals with other events and developments during the period which are important but which are separated so as not to distract from an understanding of profitability. Often they are outside the immediate control of management but are dependent on the movement of financial market places, e.g.: - the revaluation of pension schemes has added additional value to Debenhams of 17.8 million based on changes in the actuarial assessment of future pension liabilities, and - gains of 39.2 million in the mark-to-market valuation of cash flow hedges (or derivative instruments) arranged to control currency, interest rate and other risks. The majority of these items are valuation movements that are unrealised i.e. they may disappear in future periods as the markets used to value them change, and they do not reflect receipt or payment of cash. They are included within the Consolidated Statement of Comprehensive Income but, importantly, they are excluded from the calculation of Earnings per Share. To access related learning and development practice notes for in-house lawyers, sign up for a free trial of LexisPSL and discover the full portfolio of bespoke resources that LexisNexis has to offer for in-house lawyers