Analysis of British Petroleum Company - Assignment Example

Analysis of British Petroleum Company (BP) Analysis of British Petroleum Company (BP) Introduction The report provides a detailedanalysis various financial management theories that are applied by numerous companies today. Financial decision-making is a crucial aspect of management that determines companies’ success rates. Various financial and accounting theories are analyzed in the paper to project knowledge on managing decision module. To relate the utilization of these postulates in real-life situations, an analysis of the theories is conducted with regard to financial management of the British Petroleum Plc. (BP). Financial Management of British Petroleum Company (BP) Question I Companies need to be sufficiently financed in order to attain its goals and smoothly conduct its operations. Long-term financing of companies are those that are required over a long period, usually over a year. The reasons companies need long-term finance is different to the intents of seeking short-term finance. The long-term earnings for companies can be categorized into two: internal sources such as shares and return earnings; external sources such as bank loans and government grants (Graham et al., 2010). BP Plc. is a Public Limited Company and applies the following long-term finance sources to maintain optimal capital structure: i. Shares – shares are parts of company ownerships. If a company requires sources of finance, for instance, to expand its expansion plans, it can engage in ‘floating the shares’, which is the activity of selling company shares to the general public to raise the necessary funds. The provisions of these shares are accompanied by a prospectus, which informs of the company details on the parameters of management and structure (Megginson et al., 2008). It is achievable by enlightening the prospective investors of the company’s information before committing to purchasing the shares. ii. Bank Loan – BP Plc. has faced management issues that have resulted in loss of important infrastructure, adverse legal concerns, and issuing compensation. It, therefore, needed long-term sources of finance. To settle these issues in a long-term, BP resorted to lending money from the banks. iii. Government Grants – companies like BP Plc. are eligible to obtaining funds from the ruling bodies in order to meet their long-term goals. These bodies could be the local authorities, the European Union, or the British government. iv. Venture Capital – venture capitalists refer to very wealthy groups of individuals or companies that have set aside funds for financing promising companies. In return, they are given some authority within the companies as well as profit-share (Graham et al., 2010). Other sources include selling assets, owner’s capital and retained profit. The theories that explain how these sources can contribute to the optimum capital structure include the Pecking Order Theory, which declares that a company’s management can decide on how to finance its expansion or long-term goals. The process is normally influenced by feasibility analysis, complexity of the process and issue cost (Megginson et al., 2008). Because there are numerous risks associated with external financing sources such as high interests on loans, internal financing sources is usually preferred. However, at times a company can lack the financial advantage to obtain funds from the internal sources to execute its long-term investments. The capital structure’s trade-off theory observes an idea that a company chooses the amount of debt finance and that of equity finance to use by balancing benefits and costs. This version of hypothesis emanates from Kraus and Litzenberg who recognized a balance between dead-weight bankruptcy costs saving tax benefits of debt; agency costs are often included in this balance (Ferrier et al., 2002). The trade-off theory if set up as a competitor to the other capital structure pecking order theory. BP part receives funding by equity through debts. In view of the theory, there is an advantage to funding with debt: the financing cost with debt, the tax debt benefits, non-bankruptcy debt costs and bankruptcy debt costs. The marginal benefits of persistent debt increases declines as debt increase (Graham et al., 2010). At the same time, there are increase in marginal costs in a manner that a company optimizing in general value focuses on a trade-off when deciding the amount of debt and equity to utilize for financing. The agency theory observes the relationship between the agency (management) and the company’s stakeholders. It notes that the management can use their position in influence changes and make decisions that may be untowardly adverse to the maximization of the principal wealth. A major explanation of this scenario is where an agency invests in low-risk ventures using equity finance in order to reduce a company’s risks. Firms in equilibrium are usually affected by the financial structure. For instance, when the corporate income tax is proportional, there is adequate economic incentive that enables such firms to soar their utilization of debt financing (Palepu, 2007).  It has been confusing to establish which theory would best support capital structure. Various economists have and finance experts have supported different theories. However, the only logical explanation is that companies from different industries perform well under the theory they are best suited. From recent BP’s recordings by James Bamberg, it is possible to infer that it conducted pecking order. Following the changes in which oil companies made payments to oil-producing countries, BP experienced tremendous increase in capital expenditure and a drop in profits (Ferrier et al. 2002). It could not cover the expenditure with the finances accruing from its operations. It had to turn to the capital markets through raising new long-term debt. It later increased production to settle the demands of the countries producing oil. It began planning its operations based on attaining volume rather that targeting profits. Every major oil company suffered the hit but BP was affected the worst since it lacked presence in the US market, where quotas had been applied. The company that was once the most profitable became the least profitable. The company performed very poorly that influenced its financing behavior. BP, that was once least reliant on debt became the most debt-reliant company. The debt ration became very high, pin pointing the risks associated with pecking order theory. Gearing Ratio The gearing ratio refers to the proportion between a company’s equities to its debts. It is calculated by dividing all the debts by the shareholder equity, and can be presented in percentage (multiplied by 100). Fig 1: BP Plc. Gearing Net Ratios from 2007 – 2011 Fig 2: BP Plc. from 2010 to 2014 financial years The gearing net rations are calculated by the equation: (Total debt/ total shareholders equity) x 100 Chapter II Working Capital Management Theories Working capital management observes the problems that emanates from managing the current liabilities, current assets and the relationships between them. The current assets are the assets that can be converted into cash within a year without depreciating or disrupting a company’s operations such as marketable securities, cash, inventory, and accounts receivable. Current liabilities can be paid within a year out of current assets and earnings of the concern at their inception such as bills payable, outstanding expenses, bank overdraft, and accounts payable. Working capital management’s goal is to oversee a company’s current assets and liabilities in a manner that maintains the level of the working capital (Graham et al., 2010). Therefore, it depends entirely on the balancing and relationship between current assets and liabilities. Working capital management theories are overseen by various theories outlined below: Aggressive working capital management theory or policy involves minimizing investments of short-term assets and extensive application of short-term credit. For instance, it is an efficient management theory that advocates for utilizing as much resources as possible in order to decrease the time taken in the production process, delivery of services and turn over inventory. It entails speeding up the business cycles that maximizes sales and revenue. Some money should be held at hand to care for bill payments while cutting slow-moving inventory and less important supplies (Ryan, 2004). It is not advisable to delay avoid taxes and interest when the company is practicing aggressive working capital techniques as creditors can sue, liquidate assets and force a company into bankruptcy. BP applies this policy in order to attain its long-term profitability unlike other seasonal companies that applies conservative policy since excess, but kept resources register no returns. Conservative working capital policy works best in companies in seasonal or volatile industries like farming, tourism or construction as it buffers them against risks. The policy ensures that the company’s money in the bank is full, payables are up to date, and inventories are full in the warehouses. It is conservative to an extent that employees are encouraged to use the resources economically; they do not just turn in their old provisions like pens before the time set for them to have new ones. This theory can yield a ration above 2.0 upon computing the working capital ratio (current assets/current liabilities). This policy, however, can make a company compromise its long-term profitability as it helps avoid short-term cash shortages (Palepu, 2007).  Fig 2: The Comparisons of Current Assets to Sales Ratios in the Three Policies The moderate working capital management policy involves either high levels of current assets compared to total current assets; high levels of current liabilities compared to total current liabilities or low levels of assets based on the percentage of total assets; low levels of current liabilities based on total current liabilities. It is sort of a resolution of both aggressive and conservative management and graphically cuts in the middle of aggressive and conservative graphical presentations. Fig 3: BP Current Ratio Analysis BP Plc. as shown in the above diagrams is operating on moderate working capital policy. This is an effective policy to follow given it minimizes the disadvantages of aggressive and conservative policies while at the same time, enjoys the benefits associated with them. BP Plc. being a company in the oil and gas industry, it is unlikely that it would be challenged by the issues or risks common with seasonal companies, which are most likely to adopt conservative capital management policy. Chapter III Dividend policy refers to the company’s decision to pay out earnings against retaining and reinvesting them. Dividend policy entails various elements such as high or low pay out, stable or irregular dividends, the frequency, and its announcement. Various investors or managers prefer different policies; therefore, there are theories that explain the preferences of the investors in policy selection. Theories Governing the Dividend Policies Dividend Irrelevance Theory shows how investors vary between retention- generated capital gains and the dividends. For instance, when the investors want cash, they can sell stock or inventories. However, when the investors do not require cash, they can use the dividends to buy current assets or stock. Therefore, Dividend irrelevance theory justifies how a company can easily acquire liquid cash in emergency cases and how it can dispose the dividends to acquire an important asset to the company. The theory proves that earnings of the company should be used to fund profitable programs, purchase goods such as stock and the rest be shared among equity shareholders as a dividends. Modigiliani-Milner supports this theory as it enables acquisition of stock and cash during relevant situations (Graham et al., 2010). However, the theory has unrealistic assumptions such as there are brokerage costs or no taxes. Investors or companies do not care about the payout. Therefore, the companies need to undertake the empirical test to articulate the dividend policy effectively and efficiently. The company’s finances accrue from the limitation of oil. From the law of demand and supply and elasticity ratio; relativity; GULF as being the key competitor, controls 19% of market share; the French ‘Total’ following the incident at Mexico: BP oil spill. The company suffered from oil spill, in an economic manner that conditioned competitors such as Shell to develop adverse strategies against it. Bird-in-the hand Theory entails the comparison of dividends and future capital gains. It supports that dividends are more important and not very risky as compared to the capital gains. Therefore, investors like dividends since they think dividends are not so much risky as compared to the likely future gains of the company. Due to the Bird-in-the –Hand, the investors would highly value high payout firms more greatly. For instance, a company would generate high profits due to the high payout. Finally, The Tax reference theory. It illustrates that investors prefer low pay thus company growth. Like illustrated and affirmed by Keynesian theory, consumption meets expenditure, income inclusive. BP Plc. contributes to 1.09% of the world’s economy. Future anticipation in consideration of fossil fuel depletion, solar energy companies like Vivint Solar and AMEC imply second competitors of the company. Oil consumption will drastically drop by 2030 as foreshowed; an increase with an increment vividly demonstrates the success of BP. BP Plc. earnings per share represent its profit allocated to every outstanding share within then union stock. The net income for the time divided by the aggregate number of shares outstanding at the time elaborates the positive outcomes that the company attains from the industry. Range of Dividend Policies and their Preference to Companies and Investors Empirical analysis of these theories enables the companies to select the best dividend policy. The first range of dividend policy is the residual dividend model. The British Petroleum Company finds the retained earnings required for the capital budget. The total earnings enable the company to plan effectively. For instance, the BP Company uses the earnings to purchase relevant stock and the residuals or leftover earnings is paid out. Therefore, the policy enables the company directors to minimize flotation and equity signaling costs. Signaling effect or information content enables the directors to signal shareholders and investors on the relevant information of the company. British Petroleum mangers do not cut dividends hence they do not raise dividends unless they find out raise is so unsustainable. Therefore, dividend policies in the BP Company signal other companies or management on the productivity or profitability in the future (Palepu, 2007). For this reason, an increase of stock price of a dividend increase reflects higher reflection for the future. Clientele Effect illustrates that different clienteles or investors prefer different dividend policies. Due to clientele effect, company investors suffer from taxes and brokerage costs as they switch to companies. Therefore, the past dividend policy of the British |Petroleum Company determines its current clientele of investors. Therefore, companies choose various policies that suit them to achieve their goals and objectives efficiently and effectively. Chapter IV A company’s profitability is measured in many forms, mainly by the financial ratios. The ratios project the successfulness of a company including how the management conducts its operations. To attract investors, the company must release its prospectus that reveals all the performance rations to equip them with the necessary information to enable them make informed decisions. When the company’s profitability, which symbolizes the levels of success, is high, investors will feel free investing in the company. Current rations are important calculations to this aspect as they portray relevant balances that determine company’s stability. For instance, high working current ratios depict that the company in question has enough assets to cater for its liabilities through the next fiscal or financial year. BP Plc.’s Current Ratio stands at 1.32, which is fairly better. This implies that the company operates on moderate working capital management policy, given that companies operating on conservative working capital management policy report very high ratios that can jump above 2.0 (Ryan, 2004). Investors observe potential risks a company suffers in the future. Therefore, risk assessment is a usual activity investors practice. The Capital Asset Pricing Model (CAPM) is a sure way of measuring share risk in perspective to the systematic risk, and return to the market. Actually, it is the ration between expected risk and expected return following Security Marking Line (SML). The pricing is normally low if the perceived risks is low, which in turn attract investors. There are aggressive, moderate, and conservative investors as well, but most importantly, the types of investors with this regard are categorized in high-risk and low-risk extremes. The high-risk investors are also high-goaled (Ryan, 2004). Low-risk investors on the other hand do not normally have high goals, and they invest with immense vigilance. Knowledge of the type of investors helps the company sets its target audience for the sale of shares. References BP Plc. (2015). Our key performance indicators. Retrieved May 1, 2015 from http://www.bp.com/en/global/corporate/about-bp/our-strategy/key-performance-indicators.html#three Ferrier, R. W., & Bamberg, J. H. (2002). The history of the British Petroleum Company: Ill., Kt. Cambridge: Cambridge Univ. Pr. Graham, J. R., Smart, S. B., & Megginson, W. L. (2010). Corporate Finance: [Linking Theory To What Companies Do]. Mason, OH: South-Western Cengage Learning. Megginson, W. L., Smart, S. B., & Lucey, B. M. (2008). Introduction to Corporate finance. London: Cengage Learning EMEA. Palepu, K. G. (2007). Business analysis and valuation: IFRS edition, text only. London: Thomson Learning. Ryan, B. (2004). Finance and Accounting for Business. London: Thomson Learning. Read More