Financial Performance Analysis - Boral Limited - Case Study Example

Financial Performance Analysis Introduction Financial performance analysis refers to the process of analyzing the financial statements of a business from different perspectives in order to identify the financial strengths, weaknesses and viability of the business (Manisha B 9-10). There are different tools such as ratio analysis, identifying the capital structure and cost of capital, profitability analysis etc. to analyze the financial performance of a business. Therefore, the main purpose of this paper is to critically analyze two (02) academic articles on capital structure and cost of capital, and E-finance. The assumptions of findings of these articles will then be applied to analyze the financial performance of an organization (Boral Limited) in order to see how much of the theories and findings presented in the articles match the reality (i.e.: the financial performance of the chosen organization). E-finance The first article that was reviewed is called ‘E-finance: status, innovations, resources and future challenges’ by Manuchehr Shahrokhi (2008). This article gave a clear overview of e-finance, its implications, the challenges and issues related to e-finance, and recommendations how e-finance can be used to provide better financial services to the customers and businesses. It also showed how the adoption of e-finance can add value to the overall financial performance of an organization. Here, the author defined e-finance as the process of providing financial services by using internet based communication and computation. The author argues that the widespread use of e-finance will transform the role of finance and financing activities carried out by businesses. It was also said that technological developments have helped banks, and other financial and non-financial institutions provide an array of financial services in more convenient ways, which made it easier for small and medium businesses to acquire capital in a cost-effective way. According to the author, the widespread adaptation of e-finance the quicken the development in the financial sector by enabling organizations to implement, offer and use more and innovative financial products and services at a lower cost. The author also says that e-finance has the potential to have a significant global impacts, even in the developing countries by giving everyone the opportunity to access financial services (Shahrokhi). However, this will also create security issues as individual customers and business organizations will have to provide their personal and sensitive financial information on the Internet in order to avail the services offered by e-finance. Consequently, the author argues for proper policy creation and implementation in the following areas- global public policy, competition policy, safety and soundness, and consumer and investor protection. This will strengthen the infrastructure for the provision of e-finance services. It was argued that the adoption of e-finance will bring about easier, cheaper and faster financial and capital transactions. This will eventually revolutionize the banking sector and the capital market. According to Shahrokhi, “The e-finance sector can be divided into five broad categories: (1) Business-to-Business (B2B), (2) Business-to-Consumer (B2C), (3) Consumer-to-Consumer (C2C), (4) Technical infrastructure to support the e-finance platform, and (5) Global institutional and regulatory environment that facilitate the functioning and growth of e-commerce and e-finance.” As a result, any business can implement the practice of e-finance, but proper IT modifications are required to integrate traditional business processes with e-finance. In the capital market, e-finance reduces the cost of transactions, thereby enabling people from one part the world trade the stocks of a company located in another part of the world. This makes it easier for companies to obtain funds by selling both equity and debt over the internet. Moreover, the expansion of e-finance also gave rise to online investment banking systems and specialists that provide tailored investment planning, taxation and other services to business organizations at a cheaper cost. E-finance is also helping businesses outsource core business activities to third party specialists, thus helping businesses achieve better cost-effectiveness. Capital structure and cost of capital “An analysis of cost of capital, capital structure and capital budgeting practices: a survey of South African listed companies” is the second article by Correia and Cramer. A survey was used by these researchers for determining and analyzing different South African company’s corporate finance policies regarding capital budgeting, capital structure and cost of capital. The study then matched their findings with the results of other similar studies and the already existing financial theories. The findings of this study were in line with the other similar studies and the already existing financial theories. It was found by these researchers that most South African and American companies use discounted cash flow (DCF) like Internal Rate of Return (IRR) and Net Present Value (NPV) for evaluating projects. It was also found that most companies from these 2 countries use Capital Asset Pricing Model (CAPM) and Weighted Average Cost of Capital (WACC) for calculating the cost of different sources of financing in order to help them in their decisions regarding capital structure and capital budgeting. Correia and Cramer also suggested that flexible and strict debt-equity ratio are the two most widely used capital structure decisions employed by most companies. The authors also concluded that the corporate financing decision making process of the South African firms are very much similar to the corporate financing decision making process of the American companies. According to the authors, most companies are yet to use new and modified financial tools like real option analysis and Modified Internal Rate of Return (MIRR). Instead, most firms like to stick to the traditional tools mentioned above. In calculating WACC, most companies from the US and South Africa use a target debt-to-equity ratio. However, the use of a flexible debt-equity ratio is also there, but it is not as widespread as the previous one. Beta calculation is an integral part of calculating WACC. This study found that 83 percent of the companies surveyed use their own company-specific beta, while the rest use either different betas for different projects or they just use the beta of the industry where they operate in for the sake of simplicity. Testing the findings of the studies In order to test the findings of the 2 studies reviewed above, an Australian company, Boral Limited was chosen. Boral Limited is a leading multinational construction and building materials company based in Sydney, Australia, and is one of the largest 100 companies listed on the Australian Securities Exchange depending on market capitalization figures (Boral Limited). Boral’s weighted average cost of capital (WACC) It was mentioned in Boral Limited’s 2015 annual report that the company uses mostly WACC to calculate its cost of capital. Since CAPM and Beta calculation are 2 vital elementa in calculating CAPM, Boral uses both CAPM and a company-specific beta to calculate WACC. In general, every company finances the purchase of its assets by equity and debt. Simply put, WACC is the average after-tax cost the firm has to pay in order to obtain capital from different sources such as bonds or other types of long term debts, preferred stock, and common stock. According to Velez-Pareja & Tham (n.d.), a company’s overall value decreases and financial risk increases as its WACC increases. The formula to calculate WACC is as follows- WACC = (cost of common stock) (percentage of common stock) + (cost of preferred stock) (percentage of preferred stock) + (cost of debt after tax) (percentage of debt) As of August 2016, Boral’s market capitalisation was AUD 3950.37 Million ("Boral Limited - Quote and News", 2016). However, it is usually very hard to calculate the market value of a company’s debt. As a result, the book value of Boral’s debt was used in the calculation. To simplify the calculation, Boral’s 2014 and 2015’s average long term and short term debts were added. Therefore, the book value of Boral’s debt is AUD 1026 million approximately (in round figure). So, the weights of Boral’s equity and debt are calculated below- i) Weight of equity = Equity / (Equity + Debt) = 3950.37 / (3950.37 + 1026) = 0.79 ii) Weight of debt = Debt / (Equity + Debt) = 1026 / (3950.37 + 1026) = 0.21 Cost of Equity Here, CAPM (Capital Asset Pricing Model) will be used for calculating Boral’s required rate of return. CAPM will be calculated by using the formula shown below- Cost of Equity = Risk-free security’s rate of return + the company’s Beta * (the overall market’s expected rate of return - Risk-free security’s rate of return) i) The “10-Year Treasury Constant Maturity Rate” will be used here as the Risk-free security’s rate of return. This rate is daily updated. As of 21 August 2016, the rate of this security was 2.48 percent ("10-Year Treasury Constant Maturity Rate", 2016). ii) Beta indicates a company’s stock’s sensitivity to the return of the overall market. When the beta is less than 1, it means the company’s stock is less sensitive to the movement of the market. And if the beta is greater than 1, then it has the opposite effect (Nobanee & Al Hajjar, n.d.). According to Boral Limited - Quote and News (2016), Boral’s beta is 1.38. iii) Here, Boral’s market premium or (the overall market’s expected rate of return - Risk-free security’s rate of return) is 7.5 percent. Therefore, Boral’s cost of equity = 2.48% + 7.5% * 1.38 = 12.83 percent. Cost of Debt Here, Boral’s 2015 interest expense will be divided by its 2-year average debt for calculating its cost of debt in a simplified way. From Boral’s 2015 annual report, we can see that the company’s interest expense was AUD 59.03 Million and Boral’s total debt’s book value was $1026 Million. So Boral’s Cost of Debt is = 59.03 / 1026 = 5.75%. Average tax rate The average tax rate of 2014 and 2015 was 3.2 percent ("Boral Limited - Quote and News", 2016). Therefore, Boral’s WACC is = 0.79 * 12.83% + 0.21 * 5.75% * (1 - 3.2%) = 11.33 percent. Boral’s capital structure determination policy Determining the most suitable capital structure for the company is one of the major financial decisions made by a business. According to Cheng & Shiu (2007), it involves deciding the proportion of debt and equity in the capital structure in order to fund the company’s investment and operational activities at the minimal cost and risk. The main objective here is to find out the right capital structure, which will minimize the business’ weighted average cost of capital (WACC) that in turn will add financial value to the company. The various components of the capital structure include- external equity, retained earnings or internal equity, and different types of long and short term debts. The main consideration here is on the company’s financial and business risks. As a result, companies either have a targeted capital structure or they change it according to their changes objectives and business situation. When it comes to choosing the right capital structure, Boral limited has been quite flexible. In its 2015 annual report, the company stated that it does not have a targeted or fixed capital structure. Rather, Boral reviews its capital structure on an ongoing basis in order to make certain that all the components (debt and equity) of the capital structure are optimized so that the capital structure creates the maximum value for both the company and its shareholders (Boral Limited, 2015). Finally, Boral’s Total Debt to Total Capital ratio was obtained from Morningstar to see if there is any trend in the company’s capital structure. It was found that there is no trend in Boral’s capital structure. This finding is in line with the claims Boral made in its latest annual report. From 2006 to 2015, Boral’s Total Debt to Total Capital ratio ranged between 39% and 50% ("Growth, Profitability, and Financial Ratios for Boral Ltd (BLD)", 2016). It should be noted that the company’s total debt never exceeded 50% of its total capital. From this, it can be inferred that Boral always maintained a safe debt ratio without weakening its financial strength and stability. This is a positive sign for its investors. Conclusion From the above discussion, it is apparent that Boral Limited does not follow any fixed or rigid financial plan. Rather, the company is quite flexible in its financial decision making. It always changes its financial decisions according to the situation for making sure that its financial activities add value to both the firm and to its shareholders. This is done by ensuring that all its financial decisions lead to a better profitability of the entire group. For example, the company’s WACC is 11.33%, which is within the range of ‘good WACC’ according to financial specialists (Velez-Pareja & Tham, n.d.). In addition, in terms of capital structure policy, Boral has always maintained an acceptable debt to equity ratio. Considering all these, it can be said in some cases (the use of WACC, CAPM and Beta) Boral’s financial decision making processes are in line with the findings of the studies reviewed above. However, in some instances Boral’s financial practices and calculations differ from the findings of these studies. For instance, while most of the companies surveyed in 1 of the studies use a fixed target debt-equity ratio, Boral changes its debt-equity ratio and its capital structure based on the changing circumstances. And there was no mention about Boral implementing any e-finance practices. Works Cited "10-Year Treasury Constant Maturity Rate". Federal Reserve Bank of St. Louis. N.p., 2016. Web. 21 Aug. 2016. Boral Limited,. Boral Limited 2015 Annual Report. Sydney: Boral Limited, 2015. Web. 23 Aug. 2016. Annual Report. "Boral Limited - Quote And News". Morningstar.com.au. N.p., 2016. Web. 21 Aug. 2016. Cheng, Shuenn-Ren and Cheng-Yi Shiu. "Investor Protection And Capital Structure: International Evidence". Journal of Multinational Financial Management 17.1 (2007): 30-44. Web. Correia, C. and P. Cramer. "An Analysis Of Cost Of Capital, Capital Structure And Capital Budgeting Practices: A Survey Of South African Listed Companies". Meditari Accountancy Research 16.2 (2008): 31-52. Web. "Growth, Profitability, And Financial Ratios For Boral Ltd (BLD)". Morningstar. N.p., 2016. Web. 23 Aug. 2016. Manisha B, Rathod. "Financial Performance Analysis". GRA 3.5 (2012): 9-10. Web. Shahrokhi, Manuchehr. "E‐Finance: Status, Innovations, Resources And Future Challenges". Managerial Finance 34.6 (2008): 365-398. Web. Velez-Pareja, Ignacio and Joseph Tham. "A Note On The Weighted Average Cost Of Capital WACC". 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