BPs Financial Strategy - Case Study Example

BP’s Financial Strategy Name: Course: Instructor’s Name: Date: Table of Contents Introduction 3 The basis of the analysis 3 Sources of finance 4 Boston Matrix 11 Dividend Policy 12 Recommendations 16 References 17 BP Financial Strategy Introduction The purpose of this report is to analyze and evaluate the financial strategy adopted by BP group and hence make appropriate recommendations with regard to its future financial strategy in the medium term of 3 -5 years. The analysis is carried out through evaluation of BP’s current sources of financing while analyzing their financial implications for the group. The Group’s past financial strategy in conjunction with its long-term dividend policy will be useful in making the recommendations. The basis of the analysis As at 31st December 2016, the company’s total liabilities had increased by 3,028 million dollars which was a 1.85% increase. This increase was caused by an increase in current liabilities amounting to 3,727 million dollars or 6.81% increase. However, the long-term liabilities slightly declined by 0.55% or 602 million dollars. There was a significant increase in both long-term and short term payables amounting to 17,002 million dollars or 48.79% increase. The increase can be explained by the losses made by the group over the years. Consequently, the company’s equity declined by 1,544 million dollars which was a 1.57% decline (Bp.com, 2017). As indicated in the above analysis, BP group’s use of debt grew faster than the company’s use of equity which actually declined. As a consequence, the group’s gearing rose to 172% in 2016 from 166% in 2015. The increasing debt levels is attributed to increasing group expenses as well as increased investment in plant, property and equipment as well as other assets aimed at generating income. The increase gearing ratio is also attributed to the company accumulating losses which has led to declining shareholders equity. This explains the reason why the company’s debt forms 81.12% of capital employed compared to 78.92% in 2015. Sources of finance Long-term vs. Short-term debt Long-term debt plays an important role in the group’s financing strategy. In 2012, the company’s long-term debt constituted 57.03% of its total debts. This has however increased to 64.95% in 2016. The increase in debt has been necessary to fund the company’s operations as well as various assets given the declining revenues and hence profitability. The company’s long-term financial strategy is aimed at providing BP with more time as well as flexibility of repaying the debt which is aimed at reducing the company’s financial risk. Such a policy goes a long way in promoting the company’s long-term stability while helping minimize the company’s long-term costs of capital. The company’s increased use of long-term debt has the aim of cushioning the company against cash flow problems arising from lack of profitability while facilitating the company’s growth both in terms of assets and revenues. The strategy is also important in promoting the business’ long term stability while minimizing business risk. Trade payables (Unstable) The company’s trade payables significantly increased by 18.67% over the last two years. This corresponds well with the 17.89 decline in the group’s revenues over the two years meaning that the trade payables have accumulated due to lack of funds to pay trade creditors. However, the group’s trade payables had declined by 20.36% in 2015 in comparison with 2014. This does not compare well with BP’s close competitors such as Shell Global which had its payables increase only by 5% in 2016 while those of Exxon Mobil actually declined by 14.20% over the same period. This might be an indication that the company has serious financial challenges and hence the need for a change of strategy. In 2016, the group’s trade payable days were 96.31 which was a great increase from the previous year’s 79.87 payable days. This increase is not desirable as it means greater financial inflexibility for the company given that the market growth is declining while trading conditions are more difficult. In fact, this might be an indication of financial difficulties. This policy ought to be changed as it might result in future financial difficulties for the company and might not promote growth and long-term financial flexibility. Policies need to put in place to reduce this level of trade payables while increasing revenues in a bid to guard against the resultant finance risk. Debt vs. Equity This section analyses the Group’s use of debt as a proportion of equity as part of the company’s finance strategy. In addition, the Group’s net debt including deductions such as interest bearing assets and cash will also be analyzed. The group’s debt as a proportion of equity has increased over the years. It was lowest in 2013 when it was 1.34 times the company’s equity and highest in 2016 at 1.71 times the equity. The company’s debt has also been increasing over the years and was lowest in 2013 when it was 1.2 times the equity while it was the highest in 2016 when it was 1.5 times the equity. The increasing debts over the period have been necessitated by reducing revenues as well as investment in production assets. Gearing The company’s gearing stood at 151% in 2012 in comparison to 172% in 2016. This is an indication that the company’s gearing has been increasing over the years and hence it cannot be considered to have been stable having risen by 21% over the five years period. Thus, a corrective action is needed in a bid to bring the ratio down as a measure to shield the group from increased financial risk associated with such a high level of gearing ratio. This is because the company might soon find itself unable to repay its interest obligations to the lenders and this might expose it to solvency problems. ROCE The Group’s return on capital employed has greatly declined to the current level of -0.21% from the 2012 level of 8.86%. This kind of performance does not inspire confidence to long term investors who would want to get high dividends while being assured of their capital. The decline in ROCE is also in line with the relative increase in liabilities and the decline in the owner’s equity. The decline in ROCE does also imply that the company’s debts have not been effective in generating revenue (Head and Watson, 2010). Thus, there is need for change of strategy to ensure an increase in returns to inspire long-term investor confidence. Cash and Cash Equivalents The company’s cash and cash equivalent levels have observed a general declining trend for the last five years. Cash and cash equivalents were 19.89% of liabilities in 2012 before significantly declining to 12.84% in 2013 and improved to 17.34% in 2014. The current level of cash and cash equivalents is 14.11% of the group’s liabilities implying that they have not been stable. The decline observed in the company’s cash and cash equivalents is not a desirable strategy as it is not sustainable in the long-term and has the potential of increasing the company’s finance risk given that the company’s revenue generating activities have generally declined and hence the safety barrier should not be declining. As such, BP needs to review its cash strategy to ensure that adequate cash reserves are maintained at all times in a bid to safeguard the company against the potential finance risk especially with the challenges in the operating environment. Without adequate cash, the company will be unable to take advantage of new investment and growth opportunities. Boston Matrix The company’s Boston matrix is shown below; As can be seen above, the company’s current markets are declining and hence the company needs to use the money it generates from the cash cow to invest in other energy areas that will help the company improve revenues which would enable the company have a stronger financial strategy. Dividend Policy The cost of capital The company’s long term cost of equity has had mixed reactions over the past few years. For instance, the company’s cost of debt was 0.87% in 2013 as compared to the current year at1.13%. The company’s weighted cost of capital on the other hand stood at 10.25% in 2013 in comparison to the 2016 level of 7.89%. This state of affairs can be attributed to the fact that although the company has significant debt levels, this is offset by the low cost of debt hence bringing some level of stability on the company’s weighted cost of capital. However, the costs may not remain stable in the long run unless an alternative strategy is adopted to stabilize the company’s gearing ratio while lowering its debt levels (Johnson and Whittington, 2008). This is because increasing levels of debt increases the company’s bankruptcy and financial risk and consequently the cost of equity. However, the fact that most of the company’s debt is long-term does give the company more time to adopt an alternative strategy since interest rates are relatively stable. The changes in the company’s cost of equity are in line with the company’s gearing and this is in line with the Miler and Modigliani’s 1st theorem. This is despite the fact that the rise in gearing has caused in the cost of capital rising as opposed to falling while the cost of debt has almost remained flat implying the effect of gearing on the cost of debt. Interest cover The group’s interest cover has declined significantly over the five years period from 21.36 times to -0.23 times in 2016. This decline is not desirable since it puts the company in a major financial risk as the ability to pay interest obligations declines. Action must thus must be taken to return the company to profitability thus improving the Group’s interest cover. Shareholders returns As depicted in the above graphs, the Group’s short term cost of equity or dividend yield increased significantly from 4.56% in 2012 to 7.89% in 2016. The increase in dividend yield is higher than that achieved by the company’s competitors including Shell Global and Mobil Exxon (Baker, 2011). The company’s share price. The company’s share price has also had mixed fortunes with the highest prices of 53.15 being recorded in 2014 while the lowest price of 29.81 was recorded in 2016. Though the company’s returns are generally stable, the share price and hence capital has declined over the five years hence giving an indication of a company in financial difficulties as the shareholders’ investment has not been stable. However, this kind of dividend policy is still desirable for long-term investors since they desire high returns on their investment with no intention of cashing out on their investments and hence the changes in the share prices may not have a significant effect on their decision making. For short term investors however, this is not a good dividend policy as they are majorly interested in growth of capital as opposed to high dividends. As such, it is important for the Group to bear in mind the kind of investors it wants to attract in raising the finances it needs most at the lowest cost possible. In line with Lintner’s theorem, the Group’s dividend policy does reflect the company’s earning potential. However, the company also seems to increase increases in dividends even when there are no increases in earnings and hence the sustainability of such a policy is questionable. However, the dividend policy does to a great extent conform to the theorem and is seen as appropriate for attracting long-term investors to the Group given the stage it is in its lifecycle. Recommendations The Group’s overall financial outlook does not appear stable and thus it is recommended that the Group adopts some changes to its financial strategy in the short run in a bid to ensure long-term financial stability for the company thus mitigating against resultant long-term financial and business risk. These recommendations are made on assumption that the market conditions remain unchanged in the short run. Thus, there may be need to alter the recommendations depending on whether the market conditions do improve or deteriorate. Recommendations on debt financing It has been noted that the Group’s cost of debt is increasing and hence the company should consider replacing most of the short term debt with long-term debt in a bid to reduce the volatility or ensure stability in the company’s cost of debt in the long run. The company should also consider reducing the amount of debt in its books in to more safe levels in a bid to reduce the company’s financial risk given the current declining levels of revenues and hence profitability. Recommendations on Equity financing It is recommended that the company takes steps to improve its gearing ratio. However, any increase in equity should be done such that it does not impede the Group’s current dividend policy in the long run (Shell.com, 2017). This means that changes in equity should be pegged on the Group’s profitability to ensure sustainability in the company’s overall cost of equity as well as rate of dividend. However, the current dividend policy needs to be altered so as to ensure that dividends are only pegged on profitability in a bid to ensure long-term sustainability. Recommendations on cash reserves strategy Given the industry in which the Group operates, the company needs to alter its cash reserves strategy so that it retains cash in levels proportionate to the level of liabilities. This will give the company adequate cash for normal operations as well as meeting its interest operations. In this regard, it is recommended that cash reserves be maintained at least 20% of the company’s total liabilities in a bid to provide a safety barrier against potential business risk. References Bp.com, 2017, Investors, Retrieved on 30th March 2017, from; http://www.bp.com/en/global/corporate/investors.html Head, A&, Watson, D2010, Corporate finance: Principles and practice, Harlow: Pearson. amigobulls.com, 2017, Exxon Mobil Annual Income Statement (NYSE: XOM), Retrieved on 30th March 2017, from; http://amigobulls.com/stocks/XOM/income-statement/annualj Johnson, S&, Whittington, R2008, Eploring corporate strategy, Harlow, Pearson. Baker, H2011, Capital structure and corporate financing decisions: Theory, evidence and practice, New York, Willey. Shell.com, 2017, Annual reports and publications, Retrieved on 30th March 2017, from; http://www.shell.com/media/annual-reports-and-publications.html#iframe=L21lZGlhL2FubnVhbC1yZXBvcnRzLWFuZC1wdWJsaWNhdGlvbnMvamNyOmNvbnRlbnQvcGFyL2lmcmFtZWRhcHBfY2FkOS5zdGF0aWMvaW5kZXguaHRtbA== Read More