I warned in August about Tesco’s high debt levels and that it risked losing its investment grade credit rating (see “Aggressive accounting hides financial weakness”). At the interim results, the new management identified “strengthening the balance sheet” as one of their three priorities. As part of its post-Christmas trading update on 8 January, the company has said it will give more details on its future strategy. It is widely expected to announce the disposal of a number of non-core assets, and possibly some or all of its operations in Asia. However, the problem facing Tesco is that its debt is so high and its profits are currently so low that whatever it decides to do, even spinning off its Asian business, will not completely resolve its balance sheet issues and is unlikely to prevent a downgrade in its debt to below investment grade.
In an earlier note, I highlighted the nearly £4bn of off-balance-sheet property bonds that are not fully disclosed in Tesco’s financial statements (see Tesco’s hidden debt). In the earlier note, I discussed in detail how the transactions were structured. In this note, I focus on the relevant accounting issues; in particular, whether the underlying leases were correctly accounted for as operating leases. In my view, it is clear that they should have been treated as finance leases and capitalised on Tesco’s balance sheet, which would increase on-balance-sheet net debt by around £3.5bn to £11bn.
I have just published a detailed research article on Tesco (TSCO), which examines in detail some of the financial issues facing the company. Its high levels of debt, which do not appear to be fully understood by the market, gives it limited financial flexibility. The article is available at Seeking Alpha.