International Financial Management of Rio Tinto Australia - Case Study Example

International financial management Table of contents: Page number 0 Introduction………………………………………………………………………………….3 2.0 Overview of Rio Tinto Australia (RIO)……………………………………………………..3 2.1 multinational aspects and effects on business operations, profits, cash flows and balance sheet…………………………………………………………………………………………………………………………………………4 3.0 Analysis and interpretation of financial ratios………………………………….…………....4 3.1 Profitability ratios…………………………………………………………………….4 3.2 Asset utilisation ratios………………………………………………………………..6 3.3 Liquidity ratios……………………………………………………………………….6 3.4 Debt utilisation ratios………………………………………………………………....7 4.0 Strengths and weaknesses…………………………………………………………………...10 4.1 Strengths……………………………………………………………………………..10 4.2 weaknesses…………………………………………………………………………..10 4.3 Opportunities………………………………………………………………………...11 4.4 Threats………………………………………………………………………….…....11 4.5 Significant regulations affecting control of interest in RIO………………………...11 5.0 Significant operating and financial issues ………………………………………………….12 5.1 Currency management and performance evaluation of Rio Tinto…………………..12 5.2 Management of risk related to currency……………………………………………..13 6.0 Evaluation of Rio Tinto performance (2011-2013)………………………………………….13 7.0 Recommendations to an investor…………………………………………………………....14 8.0 Reference list:………………………………………………………………………………..15 9.0 List of figures………………………………………………………………………………… Figure 1: profitability ratios…………………………………………………………...... 4 Figure 2: Asset utilisation ratios…………………………………………………………6 Figure 3: liquidity ratios………………………………………………………………....6 Figure 4: Debt utilisation ratios…………………………………………………………..7 10.0 List of tables ……………………………………………………………………………………………………………………… Table 1: Dividend growth potential…………………………………………………………………………..….7 Table 1: Profitability growth potential………………………………………………………………………..…8 Table 2: Book value per share and cash flow per share trend……………………………………….9 Table 4: Critical ratios…………………………………………………………………………………………………..9 Investment research report-Rio Tinto Australia (RIO) 1.0 Introduction Leighton Holdings is a Hong-Kong based multinational company that has significant investments in mainland China and is considering making strategic investment in Rio Tinto Australia (RIO) with the intention of becoming a major shareholder. The Hong-Kong headquartered Leighton Asia is wholly owned by Australia’s Leighton Holdings, but the company functions independently within the financial, health and safety and environmental standards set by Leighton Holdings (Fridson & Alvarez, 2002). 2.0 Overview of Rio Tinto Australia (RIO) Rio Tinto Australia is a leading metals and mining company that is focused on exploration, mining and processing the earth’s mineral resources in order to maximise the value of its shareholders (Rio Tinto 2014). The company has a long-term approach to its business activities since it is currently developing Tier 1 orebodies in to low-cost and life-long operations that will deliver competitive returns. The main products offered by the company include Aluminum, copper, minerals and diamonds, energy and iron ore and exploration activities (Rio Tinto 2014). The current business environment in Australia favours Rio Tinto operations since the economy is currently on growth path and metal prices have remained stable. Australia is experiencing stable political environment and advancements in oil and metal exploration technologies that will enable Rio Tinto to cut down costs and ensure efficiency in its operations. Accordingly, the social environment is characterised by rural-urban migration thus metallic materials will experience high demand due to the need to build infrastructure in the cities and houses for the increasing urban population (Geddes, 2002). Rio Tinto must remain committed to reduction of the workplace accidents in the exploration sites and minimise the greenhouse gas emissions. 2.1 multinational aspects and effects on business operations, profits, cash flows and balance sheet The current growth of the global economy will enhance RIO operations, but unforeseen financial and economic shocks may adversely affect the business operations, decrease the profits and cash flows of the operations. Accordingly, foreign currency exchange rate movements may negatively affect the balance sheet of the company. The global population will increase by 30 percent in next forty years thus leading to high urbanisation and increased demand for metal product that will ultimately result to higher profits. The advancements in technology will lead to decline in exploration costs and improved cash flows for Rio Tinto. However, political and legal risks are imminent in the industry and this may result to failure to obtain leases, exploration permits, stringent foreign investment restrictions and increased regulation on greenhouse gas emissions. 3.0 Analysis and interpretation of financial ratios 3.1 Profitability The profitability ratios indicate the operational and financial performance of a company and the ability of the firm to generate sufficient returns for the shareholders. The ratios will indicate the company’s efficiency and performance in its operations (Drake & Fabozzi, 2012). Ratio Formula 2011(US$ M) 2012 (US$ M) 2013 (US$ M) Gross profit margin Gross profit / net sales (24, 374/ 60,529)* 100 = 40.3 % (13,408/50,942)* 100 = 26.3 % (15,067/51,171)* 100 = 29.4 % Net Profit margin Net profit/ net sales (5,835/60,529) * 100 = 9.62 % (-3,028/50,942) * 100 = - 5. 87 % (3,665 /51, 171) * 100 = 7.10 % Operating income margin Operating income/Net sales (14,039/ 60,529)* 100 = 23.19 % (-1,925/50,942)* 100 = - 5.94 % (7,430/51,171)* 100 = 14.5 % Return on equity Net income/ Average shareholder equity N/A (- 3,028/((57, 740+ 58, 884)/2) * 100 = - 5.19 % (3,665/((53, 502+57, 740) / 2) * 100 = 6.58 % Return on capital employed Net operating profit/ capital employed (total assets- current liabilities) 14, 039/ (120,152- 15, 162) * 100= 13.37 % -1,925/ (118, 437- 13, 980) * 100 =- 1.84 % 7,430/ (111, 025-15, 190) = 7.78 % The return on equity (ROE) measures the rate of return invested by the common shareholders and retained by the company. It will demonstrate the capability of the firm to generate sufficient profits from utilisation of the shareholders’ equity. Return on capital employed – This is a long-term profitability ratio since it evaluates who the company has effectively utilised the assets. It is a indicator of future profitability of the company (Grier 2007). 3. 2 Asset utilisation 2011 2012 2013 Return on assets 5.02 -2.52 3.21 Asset turnover (average) 0.52 0.43 0.45 The company reduced the capital expenditure by 26 percent to US $ 12.9 billion in 2013 from a high of US $ 17.6 billion in 2012 and is committed to making further reductions. 3. 3 Liquidity ratio formula 2011 2012 2013 Current ratio Current assets/current liabilities (120,152-97, 828) /15,162 = 1.47 (118,437-97,927)/13, 980 = 1.47 (111,025-88,743)/15, 190 = 1.47 Cash ratio Cash + cash equivalents/ current liabilities 9, 762/15, 162 = 0.64 7, 135/13, 980 = 0.51 10, 216/ 15, 190= 0.67 Current ratio- The ratio indicates the capability of the company to pay its short-term obligations using its current assets. It provides an idea of the efficiency in the operating cycle (Chandra, 2008). 3. 4 Debt utilization Ratio formula 2011 2012 2013 Debt ratio Total liabilities/Total assets 61, 268 /120, 152 = 0.51 60, 697 / 118, 437 = 0.51 57, 523/111, 025 = 0.52 Debt-equity ratio Total debt/Total equity 61, 268/ 58, 884 = 1.04 60, 697/ 57, 740 = 1.05 57, 523/ 53, 502 = 1.08 Debt ratio = total debt/total assets. It demonstrates the percentage of the company assets that is financed through debt. The higher the ratio, the greater is the risk attached to the company (Besley & Brigham, 2008). Debt-equity ratio = total debt/total equity. It demonstrates how the company uses debt and shareholders’ equity to finance the company assets (Megginson & Smart, 2009). Rio Tinto net debt declined from US $ 19,192 million in close of 2012 financial year to US $ 18,055 million as per 31st December, 2013 due to offsetting of the outflows by divestment proceeds and operating cash inflows. Dividend growth projection (Retrieved from Zonebourse.com-Thomson Reuters) The dividend growth projection, the earnings per share will increase in the next three years due to increase in the projected income and efforts of the company to buy some of the stocks. However, the rate of dividend payout is likely to increase at a lower rate due to the ambitious reinvestment of the profits in new mining operations. Profit growth projection (Retrieved from Zonebourse.com-Thomson Reuters) The projected operating and net income of Rio Tinto will increase in the next years due to increase in the scope of operations and cost cutting measures that have been implemented. The sales are projected to increase due to increase in global demand for metals in the infrastructure industry while the operating margins will slightly improve due to cost cutting initiatives of the company. Book value per share and cash flow per share projection (Retrieved from Zonebourse.com-Thomson Reuters) The cash flow per share is projected to increase in the next few years due to increased operating income while the book value per share is likely to decline due to disposal of some of the non-strategic assets of the group. However, the investment in five new projected will eventually improve the book value per share of the company after completion in 2016. Critical financial ratios Ratio 2011 2012 2013 Industry average Operating income 13, 940 1, 153 7, 430 4, 500 Interest coverage 27.59 - 8.30 7. 91 6.5 Earnings per share 3.01 - 1.62 1.76 1.5 Book value per share 27.63 25.01 24.65 18.4 Asset turnover % 5.02 -2.52 3.21 2.00 Cash flow per share 3. 98 - 0.83 1.12 1.00 According to the above ratios, Rio Tinto has improved its operating income and interest coverage ratio above the industry average. In addition, the earnings per share are above the interest average, but the book value per share has declined due to disposal of certain obsolete assets. The asset turnover has improved signaling efficiency in asset utilisation while the cash flow per share is above the industry average. 4. 0 Strengths and weaknesses 4. 1 Strengths The company increased the retained earnings from 21, 496 US million dollars at the end of 2012 to 23,605 US million dollars at the end of 2013. Rio Tinto has maintained good governance and investment accountability and has able leadership that is capable of steering the company to a higher performance in the future due to the well laid out succession plans. The company improved the dividend payouts by additional 15 percent thus indicating possible future increase in the dividends payout to the shareholders. The global economy is currently on growth trajectory due to loose monetary policies, but the commodity markets has experienced a downward pressure on metal prices due to expansion of supply. 4. 2 Weaknesses The group is reliant on Chinese market and any decline in demand in that market will significantly affect the company’s cash position. The group sales are dominated in US dollars. The company incurred a exchange loss on US dollar net debt of 2,098 million US dollars in 2013 compared with a exchange gain of 416 US million dollars in 2012. In this case, Rio Tinto utilised the foreign currency translation reserve from 3,309 million US dollars as at 1st January 2013 to 1,191 US million dollars as at 31st December, 2013. For instance, the 10 percent strengthening of the US dollar as at 31 December, 2013 led to 1,442 currency-related losses on assets and liabilities denominated in Australian dollar and 3,077 losses on assets and liabilities denominated in Canadian dollar (Gibson, 2010). 4.3. Opportunities Rio Tinto has certain opportunities that it can exploit in order to enhance the return to the shareholders such as improving the operating cash cost improvements to a target of US $ 3 billion. The company must remain focused on the step-change technologies such as Mine of the Future Programme that will support Pilbara Minining operations. 4.4 Threats The significant threats faced by RIO include increased greenhouse gas emissions, high regulatory environment of health and safety issues in mining sector, and exposure to currency fluctuations. The operations are also vulnerable to natural disasters, operational failure and stringent regulatory environment. 4.5 investment regulations affecting a potential control of interest in RIO The Foreign Acquisitions and takeovers Act 1975 requires prior government approval for companies that aim at attaining an interest in prospecting, exploration and mining business especially if the control is valued at US $ 231 million and above. The Treasurer of Australia must approve acquisitions of interests in shares leading to 15 percent or more of control of ownership and the Corporations Act 2001 prohibits corporations from acquiring more than 20 percent of the voting powers, but the provision has certain exemptions. A 10 percent interest withholding tax is imposed on interest paid by Australian companies to foreign non-resident lender entities and transfer-pricing documentation is required where the taxpayer has cross border related dealings that amount more than $ 1 million. Australia has implemented sanctions on transactions involving funds or payments to certain former regimes such as Milosevic regime, Government of Zimbabwe, entities and individuals associated with Democratic republic of Korea and Burmese regime. 5. 0 significant operating and financial issues Rio Tinto managed US $ 2.3 billion in operating unit cash cost improvements in 2013 and reduced the exploration expenditure by US $ 1.9 billion. The company has demonstrated commitment to capital expenditure reviews since it reduced its capital expenditure from US $ 17.6 billion in 2012 to US $ 12.9 billion in five major projects that aimed at ensuring attractive returns such as Pilbara mine (Rio Tinto 2014). 5. 1 Currency management and performance evaluation of Rio Tinto The company has implemented a long-term strategy that covers foreign exchange risk, interest rate risk, commodity price risk, liquidity risk, credit risk and capital management. The group relies on the commodity prices and currencies in several countries in order to provide a natural hedge in the long-term (Brigham & Houston, 2009). Rio Tinto monetary assets and liabilities are denominated in a foreign currency and income statement items are translated in to US dollars at the average rates of exchange while the statement of financial position items are translated in to US dollars at period-end exchange rates (Fridson & Alvarez, 2002). 5. 2 Management of risk related to currency The company hedges the interest rate risk through derivatives that manage the counterparty credit risk and allow the company to take advantage of favorable market conditions. For instance, the company did not close any interest rate swaps in 2013, but US $ 200 million notional principle of interest rate swaps was closed out in 2012 leading to US $ 3 million including the accrued interest rate of US $ 3 million (Rio Tinto 2014). From my view, the Rio Tinto has adequately managed its interest rate risks since US $ 20.4 billion of 2013 adjusted total borrowing was at fixed rates after taking in to consideration the currency interest rate swaps. The ratio of fixed debt was 72 percent thus leaving only 28 percent of the total debt as floating debt in 2013. In 2012, the fixed debt was 67 percent compared to 33 percent as floating interest debt. Accordingly, the weighted average interest rate declined from 4 percent in 2012 to 3.8 percent in 2013, but the average weighted maturity declined by one year to 8 years in 2013 (Rio Tinto 2014). However, Rio Tinto sales are mainly denominated in US dollars, but significant costs are incurred in the local currencies. In this case, Rio Tinto does not hedge foreign exchange rates and the group is exposed to significant risks related to appreciation of other currencies against the US dollar. This will significantly affect the dividend payments (Geddes, 2002). 6. 0 Evaluation of Rio Tinto performance (2011-2013) The company reported a positive return on equity in 2013 and positive return on assets of 3.21 in 2013 from a negative return o assets of -2.52 in 2012. The company has a prudent liquidity management strategy since it has consistently maintained the current ratio at 1.47 implying that is can adequately meet its short-term obligations three times using the current level of current assets (Shapiro, 2009). 7. 0 Recommendations for investor Rio Tinto is a good investment since the company attained US $ 10.2 billion in earnings which represents a 10 percent increase from 2012 earnings. The cash flows improved by 22 percent from the 2012 levels. The growth was boosted by the increase in bauxite, thermal coal and iron ore production. In 2013, the company increased the dividends by about 15 percent to US $ 1.92 per share and forecasts show that the dividends for 2014 are expected to rise by 8.5 percent to US $ 2.08 according to the profit forecasts. In this case, investors are confident the sustained dividend growth rate will yield higher returns in the future. Accordingly, the company has improved its cash ratio from 0.51 in 2012 to 0.67 in 2013 as evidenced by the cost reduction measures and increase in the retained earnings. The debt ratio of an average of 0.52 is prudent and the debt-equity ratio of 1.08 implies that the company has an optimum use of both debt and equity in its financing activities (Pandey, 2009). The increase in the dividend paid to shareholders is an indicator of increase in future performance. Rio Tinto is currently valued at 135.69 billion US dollars. The valuation of the enterprise = market capitalisation plus the company debt less the cash held by the company. 9. 0 Reference List: Besley, S & Brigham, E.F. 2008. Essentials of managerial finance. Mason: Thomson. Brigham, E.F & Houston, J.F. 2009. Fundamentals of financial management. Mason: South- Western Cengage. Chandra, P. 2008. Financial management: theory and practice. New Delhi: McGraw-Hill. Drake, P.P & Fabozzi, F.J. 2012. Analysis of financial statements. New Jersey: John Wiley & Sons. Fridson, M.S & Alvarez, F. 2002. Financial statement analysis: a practitioner’s guide. New York: John Wiley & Sons. Geddes, R. 2002. Valuation and investment appraisal. Canterbury: Financial World Publications. Gibson, C. 2010. Financial reporting and analysis: using financial accounting information. New Jersey: Cengage Learning. Grier, W.A. 2007. Credit analysis of financial institutions. London: Euromoney. Megginson, W.L & Smart, S.B. 2009. Introduction to corporate finance. Mason: Cengage Learning. Pandey, I. 2009. Financial management. New Delhi: Vikas Publishing House. Rio Tinto PLc. 2014. Company financial results. Print. Shapiro, A.C. 2009. Multinational financial management. New Jersey: John Wiley & Sons. Read More