How Safe Is Your Money In Tesco PLC?

Tesco (LSE: TSCO) (NASDAQOTH: TSCDY.US) shares took another battering this week, after the latest Kantar Worldpanel market research showed that Tesco’s sales fell by 3% during the first quarter of this year, reducing its share of the UK market to 28.6%.

Tesco has also reportedly suffered two high-level management departures in two weeks — the resignation of finance director Laurie McIlwee was confirmed last week, while an FT report suggested that the head of the Clubcard programme, Janet Smith is also leaving — raising fears that next week’s final results could be worse than expected.

For shareholders, the big fear is that Tesco’s dividend — which has not been cut for 29 years — could be under threat. I’ve taken a look at three key financial ratios to see if I can spot any warning signs of a cut.

1. Interest cover

What we’re looking for here is an operating profit/interest ratio of at least 2, to show that Tesco’s earnings have covered its interest payments with room to spare, over the last 12months:

Operating profit / net interest paid

£1,750m / £458m = 3.8 times cover

Tesco’s operating profits continue to provide adequate cover for its debt costs, but the firm’s interest payments have risen considerably this year, thanks to an increase in net debt. If this trend continues, Tesco’s dividend payments could come under pressure.

tesco2. Gearing

Gearing is simply the ratio of debt to shareholder equity, or book value (total assets – total liabilities). I tend to use net debt, as companies often maintain large cash balances, which can be used to reduce debt if necessary.

In its most recent published accounts, Tesco reported net debt of £8.3bn and equity of £15.7bn, giving net gearing of 53%. This is a little higher than I’d like to see, although it’s not an immediate cause for concern.

3. Operating margin

This ratio is usually known as operating margin and is useful measure of a company’s profitability. Tesco’s margins have been falling, but by how much?

Using Tesco’s most recent reported figures, which span the second half of 2012/13 and the first half of 2013/14, the firm’s operating margin has fallen to just 2.7% — nearly 60% lower than the 6.5% operating margin it reported in 2012.

Given that the firm’s sales have continued to fall during the second half of this year, I expect next Wednesday’s results to show that Tesco’s full-year operating margin dropped below 3% last year.

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Both Roland and The Motley Fool own shares in Tesco.