The Difference between a Companys Current Assets and Current Debts - Case Study Example

Boral Limited: Financial Analysis Boral’s working capital management policies Working capital referred to as the difference between a company’s current assets and current debts (current assets - current debts). It is referred to as the capital a company uses for meeting its daily operational requirements (Picardo, 2012). Working capital ratio or current Ratio (Current Assets / Current Liabilities) shows us the ability of a company to meet its short term liabilities. A negative value (less than 1) of the current ratio or WC ratio indicates the firm’s financial weakness, whereas a WC ratio more than 2 indicates that the firm is not using too much of its assets to maintain its liquidity. As a result, most financial analysts suggest that maintaining a WC ratio that ranges from 1.2 to 2 is a healthy WC ratio, and it indicates the company’s financial stability (Picardo, 2012). Here, it should be noted that working capital does not directly help the firm in creating values. Rather, it makes sure that the everyday regular and operational activities of the company are run smoothly, thereby ensuring viability and solvency. According to Nobanee & Al Hajjar (n.d.), working capital management is a crucial issue for every business. It is basically a tradeoff between the firm’s profitability and liquidity. It means, even though it is necessary to have sufficient resources in order to cover the short term liabilities, but having too much assets tied up in this purpose is going to harm the firm’s profitability, because these resources could have been used for generating returns and income for the company. Considering all these principles pertaining to working capital management, let us look at how Boral Limited manages its working capital. It was mentioned in Boral Limited’s 2015 annual report that the company manages its working capital pretty tightly. In 2015, the firm’s working capital increased by AU$37 million, which was way lower than the increase in working capital in 2014 (AU$91 million). The company attributed this change to its higher amount of tax payment in the year 2015. Now if we look at the company’s current ratio from the last ten years it can be seen that Boral has always managed to maintain a healthy current ratio that ranges from 1.4 to 1.9. In that sense, it is safe to assume that Boral’s liquidity and working capital management has been very successful. Now, let us look at Boral’s working capital turnover. This ratio shows how effective a company is in using its working capital for generating sales revenue ("Working Capital Turnover Definition", 2013). If this ratio is high, it signals that the company uses its short term liabilities and assets very efficiently. On the other hand, if a company has a low working capital turnover ratio, then it means most of the company’s current assets are tied up in inventory and accounts receivables. This can result in a high amount of outdated inventory and bad debts. Both these conditions are very harmful for the profitability of a company. In the last 10 years, Boral has managed to keep its working capital turnover ratio between 7.6 and 13.7, which again proves the company’s efficient working capital management. Boral’s weighted average cost of capital (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 earnings distribution and dividend payout policies A business’ dividend shows its intentions about what it wants to do with its earnings (Sáez & Gutiérrez, 2015). Companies around the world follow different types of dividend policies based on the following factors such as- the company’s profitability, the constancy or certainty in its earnings, issues related to its capital structure and taxation policy (both national and state), different types of dividend options at the firm’s disposal etc. After carefully going through Boral’s 2015 annual report, it can be said that in 2015, the company’s payout ratio was 56 percent. The company paid out AUD 18c/share in 2015. The dividend was fully franked at the corporate tax rate of 30%. That means dividend imputation was applied. In addition, the 2015 annual report also showed how much dividend Boral paid in the past 5 years. From 2011 to 2015, the dividend payment ranged between AUD 11c/share and AUD 18c/share (always more than AUD 10c/share). In 2014, the company paid out AUD 57.1 million as dividends and the next year it was AUD 129.1 million, which was a major increase from the previous year, signaling a very positive trend to the investors or shareholders, because investors generally like to avoid risk, and therefore, an increase in dividend payment mitigates some uncertainties about the company’s earning potentials. This also makes investors agreeable for paying a premium for the dividend stability and dividend payment (Javakhadze, n.d.). Moreover, regarding the franking credit issues and considerations for taxation, it was mentioned in the 2015 annual report that, “The balance of the franking account of Boral Limited as at 30 June 2015 is $77.3 million (2014: $65.8 million) after adjusting for franking credits/(debits) that will arise from: • The payment/refund of the amount of the current tax liability; • The receipt of dividends recognised as receivables at year end (Boral Limited, 2015).” Boral’s dividend reinvestment plan was suspended in 2014 and it will remain that way until further notice. To carry out the dividend reinvestment plan, the company issues new shares worth of AUD 43.8 million in 2014. In the 2015 annual report, Boral also mentioned that it will keep paying dividends per year like always and the common stockholders have the right to cast 1 vote/share at the stockholder’s meetings. The most important thing to notice about Boral’s dividend policy is that it follows a ‘Residual dividend policy’. In such a policy, the company distributes its residual earnings as dividends among the shareholders. But the dividend amount fluctuates, which portrays the fluctuation in the company’s capital expenditures and level of earnings. The same thing happens in Boral’s case. Here, if we match Boral’s dividends amounts per year with its net profits, then it can be said that the company pays more dividends when it incurs more profits and vice versa. 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 minimise 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 optimised 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. Association or relationship between the different financial management policies employed by Boral Limited From the above discussion, it is apparent that there is a link between the different kinds of financial decision made by Boral Limited. The main relationship or similarity here is that Boral 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, Boral has always managed to maintain a healthy current ratio that ranges from 1.4 to 1.9. In that sense, it is safe to assume that Boral’s liquidity and working capital management has been very successful. 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 both dividend and capital structure policy, Boral has always maintained a healthy rate of dividends, and an acceptable debt to equity ratio. Considering all these, it can be said that Boral Limited is a good investment alternative. References 10-Year Treasury Constant Maturity Rate. (2016). Federal Reserve Bank of St. Louis. Retrieved 21 August 2016, from https://fred.stlouisfed.org/series/DGS10 Boral Limited - Quote and News. (2016). Morningstar.com.au. Retrieved 21 August 2016, from http://www.morningstar.com.au/Stocks/NewsAndQuotes/BLD Boral Limited,. (2015). Boral Limited 2015 Annual Report (pp. 1-136). Sydney: Boral Limited. Retrieved from http://www.annualreports.com/Company/boral-limited Cheng, S. & Shiu, C. (2007). Investor protection and capital structure: International evidence. Journal Of Multinational Financial Management, 17(1), 30-44. http://dx.doi.org/10.1016/j.mulfin.2006.03.002 Growth, Profitability, and Financial Ratios for Boral Ltd (BLD). (2016). Morningstar. Retrieved 23 August 2016, from http://financials.morningstar.com/ratios/r.html?t=BLD®ion=aus&culture=en-US Javakhadze, D. Dividend Smoothing Around the World: Legal and Cultural Effects in International Dividend Policy. SSRN Electronic Journal. http://dx.doi.org/10.2139/ssrn.2289986 Nobanee, H. & Al Hajjar, M. Optimizing Working Capital Management. SSRN Electronic Journal. http://dx.doi.org/10.2139/ssrn.1528894 Picardo, E. (2012). Working Capital Definition. Investopedia. Retrieved 21 August 2016, from http://www.investopedia.com/terms/w/workingcapital.asp Sáez, M. & Gutiérrez, M. (2015). Dividend Policy with Controlling Shareholders. Theoretical Inquiries In Law, 16(1). http://dx.doi.org/10.1515/til-2015-006 Velez-Pareja, I. & Tham, J. A Note on the Weighted Average Cost of Capital WACC. SSRN Electronic Journal. http://dx.doi.org/10.2139/ssrn.254587 Working Capital Turnover Definition. (2013). Investopedia. Retrieved 21 August 2016, from http://www.investopedia.com/terms/w/workingcapitalturnover.asp Read More