Financial Distress - REA Group Limited and BHP Billiton Limited - Case Study Example

FINANCIAL DISTRESS Student’s Name Course Professor’s Name University City (State) Date FINANCIAL DISTRESS Introduction The business environment around keep changing by the minute. Companies compete each other as others enter and exit the market. It is a common phenomenon to find companies, mature or growth, competing each other in a given line of market operation. Analysts acknowledge that no matter the stage of the company, financial distress affect each firm and stock differently and this determines whether they will be profitable, will exit the market or have an attractive stock and dividend that investors will prefer (Romer & Romer, 2015). A mature firm is a firm that is considered and perceived to be well established in the industry it operates in. The mature firm always has a big and loyal customer base and a distinct and unique known product that it is identified with. Its growth is also considered to be at an average rate as that of the whole industry. Generally, a mature firm is one that has passed the rapid growth stage and use price competition as a profitability factor to compete with other companies. Due to the fact that mature companies have passed the rapid growth stage, their stock usually pay dividend (Altavilla, Carboni, & Motto, 2015). A growth stock, also known as a glamor stock, is a share of a firm that is still in the startup up phase or growth phase or expansion phase. The earnings of growth stock firms usually grow at a rate that is above average with respect to the industry. Growth stock companies reinvests their retained earnings mostly in capital projects and as results do not pay dividends or pay smaller dividends. Technology companies are mostly growth stock (Altman & Hotchkiss, 2006). This paper will analyze growth stock and mature firm stock of two companies that is REA Group Limited and BHP Billiton Limited respectively and report how one of them behave in a financial distress situation. 1. Stock selection criteria REA Group Limited is an Australian public online real estate advertising company that was founded in 1995. It is headquartered in Melbourne and is listed on Australian Stock Exchange (ASX). As of 16th May 2016, REA Group Limited stock traded at 55.09 Australian dollars which depicted a 0.13 percent decrease in daily value and a 0.24 percent decrease in stock yield (REA Group Limited Website, 2016). This performance show that REA Group Limited has the ability to take more market share from other mature firms. REA Group Limited has a brand of several real estate listing websites and launched a price estimate search engine segment for properties listed on its websites. The price estimate search engine attracted so many home owners, real estate researcher, real estate consultants and home buyers to its websites. REA Group Limited performance is outstanding and it is currently estimated that for every ten Australian real estate agents, nine of them use REA Group website. With innovations such as the price estimate search engine, REA Group Limited has had improved value proposition which is believe to be the result of its business reinvesting strategy. In the 2015 fiscal year, REA Group Limited had a 24 percent increase in its earnings. Its revenue also increased organically while that of the real estate listings in Australia decreased by 4 percent on average. REA Group Limited aims to expand to international markets that is Asia and United States of America. From the description above, REA Group Limited clearly fits as the growth stock for this paper. BHP Billiton Limited was founded in 2001 and is an Anglo-Australian petroleum, metal and mining company. It is headquartered in Melbourne. Anglo-Dutch Billiton plc and Australian Broken Hill Proprietary Company Limited merged to form BHP Billiton which was considered as a new company but with over a hundred years in operation experience (BHP Billiton Limited Website, 2016). This made BHP Billiton Limited to be the largest mining company in the world in the year 2013. BHP Billiton Limited is publicly traded in the New York Stock Exchange (NYSE). As of 16th May 2016, BHP Billiton Limited stock traded at 18.56 Australian dollars which depicted a 0.36 percent increase in daily value and a 1.98 percent increase in stock yield. At 1.98 percent stock yield, BHP Billiton Limited stock performed better than the world minerals and metals industry average stock yield of 0.83 percent. BHP Billiton Limited is the largest company in Australia with a market capitalization of 73.52 billion US dollars. It issued a dividend of 0.32 US dollars which reflected a dividend yield of 2.29 percent. These characteristics enabled BHP Billiton Limited to be considered as a mature firm for analysis in this paper. 2. Balance date and leverage ratios Balance date In accounting, the balance date is the date when the accounting year of a firm ends. Most companies in Australia have 30th of June each year as their balance date. BHP Billiton Limited has its balance date as 30th June while REA Group Limited also has its balance date as 30th June. Leverage ratios Leverage ratios refers to the ratios used to measure a company’s ability to meet its financial obligations. The paper will calculate the following leverage ratios; debt ratio, debt to equity ratio and equity ratio. The formulas are; Debt Ratio = Total Debt / Total Assets Debt to Equity Ratio = Total Debt / Total Equity Equity ratio = Total Equity / Total Assets Figure 1: Financial results as at 30th June 2013 (In millions of AUD) BHP Billiton Limited REA Group Limited Book value Market value Book value Market value Total Assets 1100 385 670 201 Total Debt 0 0 0 0 Total Equity 870 225 558 111 Source: Author Leverage ratios in book value REA Group Limited Debt ratio = 0 / 670,000,000 = 0 Debt to Equity ratio = 0 / 558,000,000 = 0 Equity ratio = 558 / 670 = 0.8328 BHP Billiton Limited Debt ratio = 0 / 1,100,000,000 = 0 Debt to Equity ratio = 0 / 870,000,000 = 0 Equity ratio = 870 / 1,100 = 0.7909 Leverage ratios in market value REA Group Limited Debt ratio = 0 / 670,000,000 = 0 Debt to Equity ratio = 0 / 111,000,000 = 0 Equity ratio = 111 / 201 = 0.5522 BHP Billiton Limited Debt ratio = 0 / 385,000,000 = 0 Debt to Equity ratio = 0 / 225,000,000 = 0 Equity ratio = 225 / 385 = 0.5844 3. Explanation of market value and book value leverage ratios There is difference between the market value and book value leverage ratios of both REA Groups Limited and BHP Billiton Limited. The ratios are a standardization of two values that are affected by similar business conditions (Information Resource Management Association, 2015). Market value equity ratios shows that the companies are slightly more risky to creditors while book value equity ratios shows that the companies are less risky to creditors. The debt ratio shows that on both book value and market value, the two companies have no debt (Jostarndt & Rudolph, 2007). On the other hand, the debt to equity ratio at both book value and market value of both companies show that for every Australian dollar each of the companies owe their shareholders, there is no amount owed to creditors (Hillman & Loewenstein, 2015). The change in one estimate that is assets, debt or equity with respect to the other estimate is almost the same in both book value and market value. However the performance of the ratios depend on the particular industry benchmarks and standards (Finch, 2012). 4. Variations of leverage ratios between the two firms BHP Billiton Limited has low leverage than REA Group Limited. The leverage ratio for BHP Billiton Limited are similar for both book value and market value expect for the equity ratio. The leverage ratio for REA Group Limited are also similar for both book value and market value except for the equity ratio. The low level of leverage in BHP Billiton Limited can be attributed to the fact that the company is a big and mature firm that has spread its risk over large area and has accumulated high revenues and assets to cushion it (Dewatripont, Rochet, Tirole, & Tribe, 2015). However, REA Group Limited has a slightly higher leverage because it still needs investments capital such as loans in order to carry out innovations and for expansion of the business (Claessens, Djankov, & Mody, 2001). 5. Effect of financial distress on BHP Billiton Limited I believe that BHP Billiton is a very big multinational company that has diverse portfolio and has a lot of financial resource such that severe financial distress will not affect it so much. Severe financial distress would make the company to start borrowing and this would affect its leverage ratios (Beaver, Correia, & Mcnichols, 2010). Financial distress would increase the debt level of BHP Billiton Limited by 10,000,000 and decrease the value of the firm by 0.001 percent. This would affect the leverage ratios as follows; Debt ratio = 10 / 1,100 = 0.009 Debt to Equity ratio = 10 / 870 = 0.0115 Equity ratio = 870 / 1,100 = 0.7909 At book value, the equity ratio remains the same while the debt ratio and debt to equity ratio shows that the company owes creditors. Although the levels of debt have increased slightly, the company is still a low risk venture to creditors. The effect of severe financial distress is mainly low because BHP Billiton Limited has liquid assets and low fixed costs. Its revenues are also not sensitive to economic distress. BHP Billiton Limited operations are also mostly capital intensive meaning that financial distress is unlikely to stall most of its operations because the few employees will still be paid on time and will have high morale (Altavilla, Carboni, & Motto, 2015). 6. BHP Billiton Limited BHP Billiton Limited had zero debt and a dividend per share of 0.44 US dollars (equivalent to approximately 0.44 Australian dollar as at 16th May 2016) as at the balance date of 30th June 2015. Given that the company is not in debt, I don’t think that there is or will be a conflict of interest between shareholders and non-existent debtholders. In case the company decides to have some debt, its financial performance will still be above the industry level. This will ensure that shareholders still get more positive dividend per share (Altman & Hotchkiss, 2006). References Altman, E. I., & Hotchkiss, E. (2006). Corporate financial distress and bankruptcy: predict and avoid bankruptcy, analyze and invest in distressed debt. Hoboken, N.J., Wiley. Altavilla, C., Carboni, G., & Motto, R. (2015). Asset purchase programmes and financial markets lessons from the euro area. Luxembourg, Publications Office.  Beaver, W. H., Correia, M., & Mcnichols, M. (2010). Financial statement analysis and the prediction of financial distress. Hanover, Mass, Now Publishers. BHP Billiton Limited Website. Accessed on 16th May 2016. http://www.bhpbilliton.com/ Claessens, S., Djankov, S., & Mody, A. (2001). Resolution of financial distress: an international perspective on the design of bankruptcy laws. Washington, D.C., World Bank. Dewatripont, M., Rochet, J.-C., Tirole, J., & Tribe, K. (2015). Balancing the banks: global lessons from the financial crisis. Princeton: Princeton University Press. Finch, B. (2012). Insolvency and financial distress how to avoid it and survive it. London, Bloomsbury Pub. Hillman, R. W., & Loewenstein, M. J. (2015). Research handbook on partnerships, LLCs and alternative forms of business organizations. Cheltenham, UK: Edward Elgar Publishing. Information Resources Management Association. (2015). Banking, finance, and accounting: concepts, methodologies, tools, and applications. Hershey, Pennsylvania: Business Science Reference. Jostarndt, P., & Rudolph, B. (2007). Financial distress, corporate restructuring and firm survival an empirical analysis of German panel data. Wiesbaden, Deutscher Universitäts-Verlag. REA Group Limited Website. Accessed on 16th May 2016. http://www.rea-group.com/ Romer, C., & Romer, D. (2015). New evidence on the impact of financial crises in advanced countries. Cambridge, National Bureau of Economic Research. Read More