Capital Structure Policy for BARWA Real Estate Company - Case Study Example

Capital Structure (leverage/Gearing) policy for BARWA Real E Company Table of Contents Table of Contents 2 Introduction 3 Definition of Capital Structure- 3 Importance of Capital Structure- 3 Financial Ratios- 4 Analysis 4 Analysis of Barwa Real Estate- 4 Views on the company’s future- 5 Comparison with peers- 6 Recommendations 8 Investopedia-d. 2009. Return on Asset. Available at: http://www.investopedia.com/terms/r/returnonassets.asp 14 Introduction Definition of Capital Structure- A company finances its activities from various sources like debt and equity. Capital structure is the combination of the various sources of financing that the company employs in its operations. Capital structure changes, significantly impact the pricing as well as entry and exit of market participants. It can be used to influence the behaviour of the market participants. A reputed firm can take the advantage of its powerful position in negotiating favourable terms of credit from the suppliers. (Matsa, 2006). Capital is a strategic tool influencing the long term growth prospects of the company. The company must allocate an ideal weight to the various sources of funding. Any kind of over or underutilization of any source must be avoided. It is important to have a healthy mix of debt and equity in the capital structure. Importance of Capital Structure- The company must design its capital structure with the aim of maximum utilization of resources and generating a return higher than the cost of procuring capital. In other words, the Return on invested capital (ROIC) must exceed the Weighted average cost of capital (WACC). The higher the ROIC, the more is the value generated by the company. The efficient management of available resources maximizes the value of the company. In order to improve the efficiency of the capital employed every company must aim at achieving an ideal capital base (Putrajaya Committee on GLC High Performance, n.d.). An optimal capital base helps the company to strengthen its growth prospects by seizing the opportunities. This helps the company in acquiring a competitive position in the market. In designing an optimal capital structure the company has to decide upon a right mix of debt and equity. Financial Ratios- Financial ratios help in assessing the financial health of the company (University of Washington, 1998-2000). Ratio analysis is a tool for making a quantitative analysis of the company’s financial performance. It is calculated using the current year figures and then it is compared with the previous years. It also facilitates intercompany comparison between firms belonging to the same industry. The important ratios include debt/equity ratio, current ratio, inventory turnover ratio, asset turnover ratio etc. The current ratio is an important indicator of the firm’s liquidity position. Asset turnover ratio helps in determining the amount of sales generated from the total asset. A high asset turnover ratio indicates that the company is making a good use of its asset structure. But, the ratios of companies belonging to different industries cannot be compared. Also, the ratios must be carefully interpreted as a high current ratio may indicate a good liquidity position for the company but this can also be interpreted as the company is keeping its cash idle (Investopedia-a, 2009). Analysis Analysis of Barwa Real Estate- Barwa Real Estate is a growing real estate company. The company has significantly increased its capital base in comparison to 2007. This is evident from the company’s Balance Sheet that shows an increase in Total Equity from QR 3,224 million in 2007 to QR 4772 million in 2008. This is an increase of more than 40 percent. It signifies that the company has increased its equity base significantly. On the other hand, the debt position of the company has also increased significantly from QR 12,470 million to QR 19,544 million in 2008 which is a rise of more than 50 percent. This shows that the company has sufficient liquidity to finance its expansion plans. The debt/equity ratio has increased from 3.86 in 2007 to 4.09 in the year 2008 (Investopedia-b, 2009). This indicates that the company has increased its debt exposure considerably in 2008. The funds thus raised have been used in making acquisitions of associates and joint venture. The debt ratio of the company has also moved up from 0.79 in 2007 to 0.80 in 2008 (Investopedia-c, 2009; Qatar Exchange, 2009). This signifies that the company is relying on debt for financing its activities. It shows that the company gives preference to debt financing over the equity mode of financing. A high debt/equity ratio can weaken the financial strength of the company which is evident from the Interest coverage ratio of the company which has moved down from 1.55 in the previous year to 0.59 in 2008. A decline in this ratio is not a good sign. It highlights that the company has overburdened itself with debt. This can lead to serious liquidity problems in the future. It can even endanger the company’s solvency position. It can be detrimental for the financial health of the company and can even lead to bankruptcy. The result of this overexposure to debt can be felt in the financials of 2008. The amount of Expenses and losses in the Consolidated Statement of Income has risen from QR 340 million to QR 1135 million in 2008. This can be attributed to the sharp rise in the finance expense that has increased by more than 25 percent in comparison to the last year. The equity ratio of the company has gone down from 0.20 to 0.19 in the year 2008. This means that the company is relying more on the long term liabilities. The Return on asset ratio of the company has also declined to 0.0125 in 2008 (Investopedia-d, 2009). Views on the company’s future- An analysis of the financial statements reveals that the company is overexposed to debt. This has burdened the company with financial obligations which in turn has deteriorated its debt servicing capacity. The interest coverage ratio has moved from the favourable position of 1.55 in the previous year to less than one in 2008. This means that the company’s earnings are not sufficient to take care of its obligations. The rising financial obligations also make it very risky from the investment point of view. It is the shareholders who suffer the most in this kind of a situation. The rising debt expenses put a pressure on the company’s earnings which thus reduces the return on equity. This is also evident from the Return on equity which has fallen from 17.42 percent in the previous year to 6.40 percent in 2008 (Investopedia-e, 2009). All these are not favourable for the investors. If the return on equity falls the impact of this can also be felt on the entry and exit of investors. The shareholders may become wary of their investment in the company. This could lead to decline in the share prices of the company. If the proportion of debt in the company is high the creditors, financial institutions etc become very cautious of extending credit. They view the company to be highly risky and demand for higher returns. Barwa Real Estate is expected to face the same fate in the future. Its overdependence on debt mode of financing can have serious implications for the company. The rising debt will put a burden on the company’s earnings. As most of the company’s earnings will go towards honouring its debt it will not be able to make use of the growth opportunities. The stagnation in the earnings will make the company unattractive to the investors. Comparison with peers- An analysis of the competitors of Barwa real estate reveals that its competitors are better placed in the business. The financials of Ezdan Real Estate shows that the company does not rely much on debt for financing its operations. This is evident from its debt/equity ratio of 0.067. Ezdan Real Estate has also significantly increased its exposure to the debt mode of financing in comparison to the previous year. The figure is much less in comparison to Barwa Real Estate which has a debt/equity ratio of 4.09. This limited exposure has kept the finance charges minimal for the company. Unlike Barwa Real Estate the company is not overburdened with financial obligations. It has succeeded in achieving an optimal capital structure. The finance charges resulting from the new debt does not drain the earnings rather the earnings have moved up to higher levels as evident from the raised profits for the year. This is in contrast to Barwa Real Estate, which seems to have overused its debt capacity, as a result of which the earnings have moved downward. As a result of the higher earnings, the finance cost can be paid comfortably. This is evident from the interest coverage ratio of the company which is 126.92. This means that the company’s earnings are sufficient for meeting 126 times its interest obligations. Ezdan has also issued fresh equity in addition to raising debt. But this new equity has not diluted its Earning Per share (EPS) which has moved up from QR 1.23 to QR 2.97 in 2008. In this regard also, it has outperformed its rival Barwa Real Estate which too had changed its capital structure, but this did not make any positive contribution to the shareholders wealth. In the case of the latter the return generated on equity dipped from 17 percent to 6.42 percent in 2008 and the EPS also slipped to QR 1.46 in 2008 (Ezdan Real Estate, 2008). Qatar Real Estate Investment another major competitor of Barwa Real Estate has a significant exposure to debt which is visible from the debt/equity ratio of 1.86. But this is much reasonable in comparison to Barwa’s ratio of 4.09. This company too has increased its liabilities position in comparison to the last year. The debt component in its capital structure has increased by nearly 48 percent. This again is in line with Barwa’s increase of 50 percent. But, unlike Barwa, this did not have any adverse impact on earnings, which has moved up to QR 311 million in 2008 rising by nearly 4 percent. So the finance expense incurred does not prove to be a burden for the company as it is capable of meeting roughly 5 times its existing interest costs. This is evident from the interest coverage ratio of the company which stands at 5.16. The company has maintained a healthy mix of equity in its capital structure. The equity ratio of the company is 0.34 which is nearly double the equity ratio of Barwa. The optimal composition of debt and equity has enabled the company to increase its EPS from QR 3.47 to QR 3.60 in 2008. This has been possible because unlike Barwa it has efficiently managed its capital structure and has not overused its debt capacity. The debt ratio of the company is 0.65 in comparison to 0.80 of Barwa. So, the company seems to have made good adjustments in its capital base which can be proved from the growth in its earnings (Qatar Real Estate Investment Company, 2008). Recommendations An analysis of the financial statements of Barwa Real Estate and its peer group reveals that the company has a very high debt ratio which is adversely affecting its earnings growth potential. It is recommended that the company must make necessary adjustments in its capital structure. The increased debt has overburdened the company financially as a result of which its net profit has dipped nearly 45 percent to QR 309 million. It is important that the company carefully plans its capital structure. The company must reach the desired level of debt like its peers. For financing the firm’s activities ideal weights must be allocated to both equity and debt. Any kind of overdependence on any one source of financing is harmful. Any undue reliance on equity can dilute the company’s earnings and the shareholders might interfere in the decision-making of the company. Similarly, any overexposure to debt can drain the financial resources of the company. Further, it makes the business very risky and makes it unworthy of investment. (Bauer, n.d.). Thus, the Board members must make suitable adjustments in the capital composition of the company such that neither an investment opportunity is lost nor is the company burdened with debt repayment. Annexure- BARWA REAL ESTATE (In thousand Qatari Riyals) 2008 2007 Total Debt 19,554,626 12,470,712 Total Equity 4,772,517 3,224,891 Debt/Equity Ratio 4.09734025 3.8670181 EBIT 271,370 561,824 Interest 457,092 361,788 Interest Coverage ratio 0.593687923 1.5529094 Net Profit 305,874 561,824 Total Equity 4,772,517 3,224,891 Return on equity 0.064090709 0.1742149 Net Profit 305,874 561,824 Total Assets 24,317,143 15,695,603 Return on assets 0.012578534 0.035795 Total Debt 19,554,626 12,470,712 Total Assets 24,317,143 15,695,603 Debt ratio 0.804149813 0.7945354 Total Equity 4,772,517 3,224,891 Total Assets 24,317,143 15,695,603 Equity ratio 0.196261419 0.2054646 EZDAN REAL ESTATE 2008 Total Debt 434,035,545 Total Equity 6,487,067,319 Debt/Equity Ratio 0.066907822 EBIT 1,357,020,475 Interest 10,692,105 Interest Coverage ratio 126.91799 Total Debt 434,035,545 Total Assets 6,921,102,864 Debt ratio 0.062711905 Total Equity 6,487,067,319 Total Assets 6,921,102,864 Equity ratio 0.937288095 QATAR REAL ESTATE INVESTMENT COMPANY (In thousand Qatari Riyals) 2008 Total Debt 3,790,677 Total Equity 2,036,204 Debt/Equity Ratio 1.861639109 EBIT 311,433 Interest 60,269 Interest Coverage ratio 5.1673829 Total Debt 3,790,677 Total Assets 5,826,881 Debt ratio 0.650549925 Total Equity 2,036,204 Total Assets 5,826,881 Equity ratio 0.349450075 References Bauer, K. No Date. Financial Risk. Capital Structure. Available at: www2.cob.ilstu.edu/kjbaue2/fil341/capstruct.ppt [Accessed on November 16, 2009]. Ezdan Real Estate. 2008 Consolidated Financial Statements. Available at: http://www2.dsm.com.qa/pps/dsm/publish/Pages/System+Pages/Document+View+Page?com.tibco.ps.pagesvc.renderParams.sub2d4fe3b_110da998b3a_-79810a000118=rp.currentDocumentID%3D1cb8e0f_11fb31436d7_2dea0a000118%26&com.tibco.ps.pagesvc.action=updateRenderState&rp.currentDocumentID=1cb8e0f_11fb31436d7_2dea0a000118&rp.attachmentPropertyName=Attachment&rp.revisionNumber=1&com.tibco.ps.pagesvc.mode=resource&rp.redirectPage=2d4fe3b_110da998b3a_-79880a000118&com.tibco.ps.pagesvc.targetPage=2d4fe3b_110da998b3a_-797f0a000118 [Accessed on November 16, 2009]. Matsa, D. 2006. Capital Structure as a Strategic Variable: Evidence from Collective Bargaining. Available at: http://www.gsb.stanford.edu/facseminars/pdfs/matsa-capitalstructure.pdf [Accessed on November 16, 2009]. 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Financial statements and independent Auditors report for the year Ended December 31, 2008. Available at: http://www2.dsm.com.qa/pps/dsm/publish/Pages/System+Pages/Document+View+Page?com.tibco.ps.pagesvc.renderParams.sub2d4fe3b_110da998b3a_-79810a000118=rp.currentDocumentID%3Db6b2a5_11f41f047c0_-59a70a000118%26&com.tibco.ps.pagesvc.action=updateRenderState&rp.currentDocumentID=b6b2a5_11f41f047c0_-59a70a000118&rp.attachmentPropertyName=Attachment&rp.revisionNumber=1&com.tibco.ps.pagesvc.mode=resource&rp.redirectPage=2d4fe3b_110da998b3a_-79880a000118&com.tibco.ps.pagesvc.targetPage=2d4fe3b_110da998b3a_-797f0a000118 [Accessed on November 16, 2009]. Qatar Exchange. 2009. Barwa Real Estate Company. Available at: http://www2.dsm.com.qa/pps/dsm/portal/Pages/DSM_FS2008 [Accessed on November 16, 2009]. University of Washington. 1998-2000. What are financial ratios?. Explanation. Available at: http://www.lib.washington.edu/business/Ratios/ratios_exp.html [Accessed on November 16, 2009]. Read More