Financial Management of General Electric Corporation - Case Study Example

General Electric: Financial Management 2009 Abstract General Electric (GE) is an old US multinational company with businesses in various fields including energy, electrical equipment, medical equipment, locomotives and aircrafts and financial services. This paper studies the financial management practices of GE with respect to its capital budgeting, shareholders’ value creation and dividend payout policy. For the purpose, I have first analyzed the company’s balance sheet and profit & loss statement and see its main profitability, liquidity, activity and market ratios. It is found that GE has traditionalized capitalized on its reputation so that with a moderate profitability, as seen from its profitability ratios compared to the industry ratios, the company has had very high share prices and turnovers. This has enabled it to create high shareholders’ value, which has been the high point of the company. Also because of the company’s reputation, it has been highly dependent on external borrowings for asset creation. Hence, with low levels of liquidity, the company’s capital budgeting practices have been adventurous, to say the least, so that its short and long term borrowings are much higher than its competitors. The company has also traditionally rewarded its shareholders with high dividend payouts and low retention rates. The shareholder focus got a battering when the company came to be negatively affected by the global financial crisis. The share price fell and the company’s earnings were reduced as a result of which it found debt servicing difficult. Fund crunch affected its capital budget planning and dividends had to be cut for the first time in 71 years. Introduction General Electric (GE) was formed in 1892 and has over the years, grown into one of the largest multinational companies in the world. GE has around 39,000 employees in its 215 manufacturing plants and offices in the United States and 80 plants in other countries. From lighting business, GE has grown into a diversified company with business interests in electricity generation, industrial automation, medical diagnostic equipment, locomotives, aircraft engines and capital services. Financial Analysis In the period ending December 2008, GE had total assets of $797,769 million, of which intangible assets were $14,977 million. The difference, that is book value of the company, is $782,792 million. GE is highly leveraged, with very high levels of debt in comparison to its equity. Being a highly diversified company, GE has adopted a strategy of high leverage to finance its capital projects in the United States and abroad. $ million 2008 2007 2006 2005 Short term debt as % of total liabilities 28% 29% 29% 28% Long term debt as % of total liabilities 48% 47% 45% 38% Debt to asset ratio 87% 85% 84% 84% The company had total debt-equity ratio of 4.58, implying that for $1 provided by investors, the company borrowed $4.58 from other sources in June 2009. The debt to common equity ratio was 3.03. As much as 48 percent of the debt is in long term borrowings, 28 percent in short term borrowings and the rest in current liabilities. The debt-to-asset ratio was 87 percent, implying that this amount of the company’s assets was financed by creditors. The main financial ratios for GE are given below. Latest 12 Months Data Items Latest Full Context Quarter Ending Date 2009/06 Gross Profit Margin 58.7% EBIT Margin 21.4% EBITDA Margin 25.4% Pre-Tax Profit Margin 7.9% Interest Coverage 1.6 Current Ratio 2.2 Quick Ratio 2.1 Leverage Ratio 6.9 Receivables Turnover 0.4 Inventory Turnover 5.0 Asset Turnover 0.2 Revenue to Assets 0.2 ROE from Total Operations 12.1% Return on Invested Capital 3.0% Return on Assets 1.7% Price/Book Ratio (Price/Equity) 1.55 Book Value per Share $10.55 SG&A as % of Revenue 33.3% R&D as % of Revenue 0.0% Receivables per Day Sales $811.47 Source: Forbes.com Compared to the industry, GE’s return on assets and return on equity is not very high which means that it is not competitive in terms of generation of income that would be sufficient for its asset build-up requirement. In terms of industry comparison, GE’s returns are one of the lowest (Business week, 2009). In terms of leverage ratios, the total liabilities/asset ratio, the current ratio and the quick ratio are the lowest for GE in the industry. However, it has to be noted that GE, being a diversified company, is also involved in financial services while the competitors like Philips, 3M, Wesco and Tyco are electrical equipment manufacturing companies that invest mostly on physical assets (Arola, et al 2007). Besides, being a large and mature company, GE’s revenue streams are fairly predictable so it is not necessary for the company to maintain high levels of liquidity. However, the financial services industry has been badly affected in the global financial meltdown since 2007 as a result of which the company has been in the brink of bankruptcy because of its low level of liquidity. In terms of profitability ratios, the company is moderately profitable and in terms of activity ratios, that is inventory turnover and accounts receivable turnover, GE is moderately efficient. The valuation ratios like the tangible book value and earnings per share of GE have been high compared to the industry but its market capitalization has been affected negatively by the financial crisis as a result of which its share price has fallen drastically (Los Angeles Times, 2009). Shareholder Value A company creates shareholder value when the market return to shareholders exceeds the return on equity, that is, the company outperforms shareholders’ expectations. The created shareholder value can be written as: equity market value X (shareholder return – Ke) where Ke is the required return on equity. This can also be written as Created shareholder value = shareholder value added – (equity market value – Ke). The equity market value of a listed firm is the company’s market value, that is, each share’s price times the number of shares. This value can increase if the share price rises or the company increases the number of equities floated. Shareholder value, on the other hand, increases if the wealth in the hands of the shareholders at the end of the year is higher than at the beginning of the year. This can increase if shareholders buy new shares of the company or if there is a conversion of convertible debentures. The equity market value can decrease, without a similar effect on shareholder value, if the company increases the dividend payout or buys back shares. So, the shareholder value may be calculated as: Increase in equity market value + Dividends paid during the year – outlays for capital increases + other payments to shareholders – conversion of convertible debentures. Over the years, shareholder value of GE has grown as dividends and other payouts to the shareholders have exceeded the amount of outlays that they have to make. Shareholder return is the ratio of shareholder value and the equity market value. The required return on equity is the return that shareholders expect to make on equity outlays to feel satisfied, depending on the interest rates of long term Treasury Bonds, which is risk-free, and the company’s risks. Hence, Ke, or the required return on equity, is the return on long term Treasury Bonds + risk premium. GE’s equity market value increased by $238.05bn from December 1992 to December 2003, shareholder value added by $289.89bn and shareholder value by $197.93bn (Fernandez, 2004). During this period, GE’s number of share outstanding increased from 854.04 million to 10063.12 million, with the price of each share falling from $85.49 to $30.98. Compared to the returns on 10-year Treasury Bonds, GE gave investors higher return on equity than risk-free return, assuming the risk premium to be 4 percent. As a result, GE created value for shareholders year after year for investors. However, with the global financial crisis, the market value of GE shares has fallen drastically, making GE investors poorer (Wall Street Journal, 2009). With the global financial meltdown and the resulting fall in share prices, companies have changed focus from that of quarterly shareholder value. Since shareholder value is essentially a short term ratio, comparing point to point values, it is considered insufficient for the purpose of long term strategy planning. Jack Welch, the legendary ex-chairman of GE, is quoted to have said that the policy to maximize shareholder value as a business strategy to be a “dumb idea” (Bogoslaw, 2009). GE no longer targets quarterly shareholder value. As the global financial crisis affected GE’s financials, it had to sell off $12 billion in common shares to raise funds (Seeking alpha, 2008). As has been seen from the financial analysis of the company, GE has traditionally kept very low levels of liquidity, depending on debt funds to add assets. However, with the financial crisis leading to credit crunch, GE’s ability to raise debt resources has been limited. Besides, the high interest costs in the face of dwindling business has meant that it went close to a debt trap. Capital Budgeting Capital budgeting is the process of allocating funds to generate cash flows beyond one financial year. An effective capital budgeting process enables the company to grow fast. Typically, the process enables budgeting for expenditures towards capital outlays that include expenditure for land, building, plant and equipment, additions to working capital (including inventories and receivables) required for the company’s expansion projects, new advertising campaigns and research & development, all of which have long term implications for the firm. Although the financial managers are primarily responsible for the function of capital budgeting, they require inputs from all departments since each of the other functions have important ramifications for the company’s future cash flows. Hence, each project needs to be classified according to its category, that is, whether it is a replacement project, cost-saving project or expansion project as each of the categories will have different cash flows (Hirschey, 2009). Typically, the financial crisis of 2008 made capital budgeting for most multinational companies difficult. With cash constraints, most companies had to postpone budget outlays (Campello, 2008). Besides, GE has been a major player in the financial services that, through the asset-backed securities investment, resulted in the sub-prime crisis and the global financial meltdown. Over the years, GE’s earnings growth has been more from its financial services industry than the physical industries. GE has for about a decade been operating more like a bank and has got itself engulfed in risky investments by lending to sub-prime borrowers. The finance division of GE, which was initially set up to boost sales of its products, over the years has grown to be independent profit centers. This has led to the situation in which GE has very low levels of liquidity as it invests most of its earnings to earn returns from the financial services. Such reckless investing, an indication to poor financial management, has resulted in near bankruptcy of the company when the global financial meltdown came about. Dividend payout A company is committed to its shareholders in terms of increasing the shareholders’ value, which has already been discussed in the case of GE, as well as dividend payouts. In the theoretical literature, there is controversy over this, that is whether shareholders prefer to earn high dividends or want the company to plough it back so that shareholders’ value can be increased in the long run. While some researchers postulate an inverse relationship between a firm’s dividend outflows and shareholders’ value (Litzenberger and Ramaswamy, 1979), others have found a positive relationship (Gordon, 1959). Some scholars have also found no relationship between the two parameters (Miller and Scholes, 1978, cited in Holder, et al 1998). Modigliani and Miller (1961) postulated the dividend irrelevance theory, stating that dividend payouts simply alter the allocation of funds between the shareholders’ income and capital gains without affecting the net value. This, of course, assumes perfect capital markets where there are no transaction costs (Holder et al, 1998). But, Titman (1984) shows that stakeholders other than equity holders have incentives to maximize shareholders’ wealth in order to reduce transaction costs, e.g that of job searches by employees or maintenance costs by customers (Holder et al, 1998). It has however been found empirically that shareholders expect higher dividends, especially indicated by the favorable sentiments in the share market immediately after a dividend declaration. Dividend payouts have a signaling effect on the firm’s value as a higher dividend is seen as an indication that the company is committed towards long term growth and sustenance of the growing dividend payouts. Besides, higher dividend also indicates that the company’s cash flows would be reduced, which means that managers of the firm is seen to be accommodative towards investors. If there is free cash flow with the company, investors see it as an indication of financial slackness on the part of the managers (Natti, 2006). In early 2009, GE reduced dividend rate by 68 percent in the face of the global meltdown (Wall Street, 2009). This was the first time since the Great Depression that GE’s dividend was cut as much as this. The first dividend cut in 71 years was required by the company in order to save costs by $9 billion annually. Because of the fall in the share price, which fell by 85 percent earlier this year, the low levels of liquidity forced to company to take this step. Similar dividend cuts were announced around the same time by most large US multinational companies. However, because of the historically good dividend payouts by the company, dividend yields for GE investors have been relatively high despite the dividend cut this year. Conclusion Thus, GE is a mature and diversified multinational company with businesses in physical and financial arena. However, the financial management of the company has not been spectacular, with low liquidity, high leverage and moderate financial activity ratios. However, the company has traditionally high market valuation because of its reputation, as a result of which shareholders’ values had been high. Only when the severe financial crisis hit it last year, the company reversed its policy of targeting shareholders’ value and high dividend payouts. GE’s capital budgeting has also traditionally depended on the share market as it raises external resources for the purpose of long term capital acquisition. This, too, has been affected by the global financial crisis. Works Cited Hirschey, Mark, Fundamentals of Managerial Economics, Cengage Learning, 2009 Bogoslaw, David, Shareholder Value: Time for a Longer View? Business Week, march 17, 2009 Fernandez, Pablo, Shareholder Value Creation of Microsoft and GE, Working Paper Series 564, August 2004, IESE Business School University of Navarra, Madrid Business Week, Profitability, GE, http://investing.businessweek.com/research/stocks/financials/ratios.asp?ric=GE Arola, Anthony, et al, General Electric: Financial analysis, www.plu.edu/~arolaal/doc/general-electric.doc Miller, M.H. and F. Modigliani, "Dividend Policy, Growth, and the Valuation of Shares," Journal of Business, October, 1961, 411-433. Natti, Keisuke, Does Dividend Policy Enhance Shareholders’ Value, 2006, http://www.nli-research.co.jp/eng/resea/econo/eco060309.pdf Holder, Mark E., et al., 1998, Dividend policy determinants: an investigation of the influences of stakeholder theory - Special Issue: Dividends, Financial Management, Autumn Los Angeles Times, GE hacks dividend by 68% to preserve cash, Los Angeles Blog, February 27, 2009, http://latimesblogs.latimes.com/money_co/2009/02/general-electri.html Wall Street Journal, GE Joins Parade of Deep Dividend Cuts, February 28, 2009 Seeking Alpha, GE finally joins victims of financial crisis, October 22, 2008, http://seekingalpha.com/article/98144-ge-finally-joins-victims-of-financial-crisis Campello, Murillo et al, The Real Effects of Financial Constraints: Evidence from a Financial Crisis, Duke University, 2008, http://www.fuqua.duke.edu/alumni/connect/pdfs/harvey_graham_1208.pdf MSN Money, How GE Dug Itself Deep into Crisis, March 18, 2009, http://articles.moneycentral.msn.com/Investing/CompanyFocus/how-ge-dug-itself-deep-into-crisis.aspx Read More