Financial Performance Analysis - Essay Example

FINANCIAL PERFORMANCE ANALYSIS Prepared by (Student’s Name) Course Name Professor’s Name Date A. Capital Structure & Cost of Capital Arguments Barclay and Smith (2005, p.9) argues that effective corporate financial decisions can be fairly expounded using three theories that include; taxes, contracting costs and information costs. The first argument put forward by these authors posit that since the fundamental corporate profit taxes permits firm’s to deduct possible interest payments and not dividends in the course of computing for taxable income, then the decision to add debt to the underlying capital structures helps to reduce tax liabilities; and as a result, improve on its after-tax cash flows. In essence, it is noted that in the event that there were only corporate profit tax as opposed to personal taxes on a given returns of securities, the immediate value of a debt-financed entity would definitely be similar to a company whose capital composition is made up of all-equities and present value of its underlying interest tax cushions in place. Notably, the present value that fairly represents the overall contribution of debt financing to the market value of a firm can be merely computed through multiplication of a firm’s 35% marginal tax rate to the principal figure related to the outstanding debt level. In contrast, the authors’ notes that the issue with this theory rests with the fact that overstates the overall tax advantage of debt given that it only focuses on corporate taxes. Most of the investors that enjoy equity-related income in form of either dividends and capital gains are certainly taxed at a much lower rate and considering the fact that investors would definitely assess their after-tax returns, they are compelled to demand for compensation in form of high yield as a way of protecting the against the corporate debt. The high yields expectations from investors’ results to a significant reduction in tax advantage of debt in comparison to equity. Consequently, the authors argue in regards to contracting costs-whereby it is put forward that regardless of any given tax benefits pertaining to a higher leverage, it is expected that it is provided against the overall enormous level of probabilities as well as relatively higher expectation costs of possible financial constraints. Going by this argument, it is ascertained that the optimal capital structure for any given firm constitutes the one for which the next dollar of debt is expected to avail a supplementary tax subsidy that counters the resultant improvements made in the event that there lies expected cost of financial constraints. It is crucial to note that the costs of financial distress is certainly an underinvestment issue that posits that even though direct level of expenses that relate to bankruptcy process could appear insignificant in regards to corporate market values, certainly the indirect costs relate to the entire process is indeed significant. In fact, it is noted that highly leveraged firms as opposed o their low-level debt counterparts possesses a higher likelihood of enjoying valuable investment chances particularly so when it is rendered to likely experience a prospective default. The underinvestment issue ascertains that firms with a basic reliability on intangible form of investment chances or so growth options are more likely to eliminate debt funding in order to restrict possible loss that might arise in the process. In consequent, entities under a mature phase of the overall operational life cycle that possess relatively little profitable investment opportunities are certainly expected to portray a much lower expected cost that is attributed to the financial issue; indicating that such entities will all enjoy a high leveraged ratios in comparison to those experiencing a growth life cycle. For this reason, companies are expected to assure their non-investor stakeholders of their efforts to sustain a competitive advantage. In essence, by restricting the use of debt funds or even resorting to other forms of risk management could be a critical aspect of its commitment to eliminate the underlying financial constraint at hand. The authors argue that such assurances to these stakeholders serve to improve on the firm overall value by way of developing a loyalty amongst them and thus, help in the reduction of firm’s costs related to transaction process. A perfect example is when companies take to sustain a stringer statement of financial position thereby improving on their chances of suppliers’ willingness to avail products and services as well as capital at much fair terms and conditions. They further argue for the benefits that emanate from debt in the course of controlling overinvestment. Considering the fact that too much reliance on debt might result to underinvestment; it is also true that too little of it in capital structure would likely result to overinvestment hence deemed to be favorable to raise the amounts related to dividends for purposes of distributing excess capital. In truth, embarking on substituting debt for equities like in the case of adopting leveraged stock repurchases could assure a company of a much efficient solution to the problem related to overinvestment- a process for which a contractually commitment payment of interests and principal amounts portrays the role of dividend payments in eliminating possible surplus levels of capital. In these regards, it can be easily ascertained that companies that are able to produce a significant level of cash flow but experiencing fewer growth chances, the adoption of debt financing could help add value through compelling management to be more efficient in the process of evaluating capital spending patterns. Most importantly, the utilization of debt funds as opposed to equity helps to reduce or even eliminate the level of agency costs of equity- which represents the form value that emanates from the separation of ownership and control in extensive positioned company stakeholders. The authors further argue for information costs that help sharpen and direct corporate managers’ financial decisions since they mostly are exposed to perfect information relating to the value of their entities in comparison to external investors. Due to this distinguished ability to recognize information gap between these two stakeholders has fostered the development of well-defined but certainly related theories related to capital structure financing decisions. Under the market timing theory, it is ascertained that commitments of payments to bondholders are certainly predetermined hence the stockholders are expected to enjoy the unconsumed amounts hence indicating that stock prices are far much sensitive in nature in comparison to bond prices to given proprietary information in relation to a company’s future performance position. The signaling theory posit that corporate capital structure allocation decisions are formulated to provide a clear and concise communication that a firm is undervalued in order to improve on the value of the underlying shares. The solution for maintaining an efficient and effective financial decision, Barclay and Smith (2005, p.9) proposes a clear understanding of the immediate relation that exists between corporate financing stocks and flows. The CFOs are thus called upon to formulate a distinct company target in regards to capital structure related to the ratios of debt to total capital that is important for the minimization of taxes as well as contracting costs. The target ratio should embark on employing a company’s overall projected investment requirements, which basically constitutes the expected level of loss in value from being compelled to postpone investment due to possible financial constraints; as well as being the capacity of a company to improve on its equity capital on short term period. In the event that a firm does not possess the capacity to attain an optimal capital structure, the authors propose that the CFO should formulate a distinctive plan to attain a desirable target debt ratio. Myers (2001, p.82) agrees that while there is no definite globally-accepted theory that provides clear guidelines on debt-equity decisions, there are conditional theories like the tradeoff theory, which ascertains that companies would more likely employ debt levels that would help balance the tax advantages of possible debt against the costs related to a financial constraint. Particularly so, the author fails to agree with Modigliani and Miller perception that financing options of a firm does not matter at all hence does not possess any form of material effects on the overall value of a firm or even the cost of capital involved as a whole. Rather, just like Barclay and Smith (2005), agrees that it matters considering such aspects as taxes; as well as differences that arise between information and contracting or agency costs. The author further agrees that a company’s debt ratio are in most cases low or even have a negative mark in the event that the level of profitability and business risks are deemed to be high. Notably, it is noted that intangible assets are certainly attributed to lower debt ratios; a likely phenomenon that is experienced whenever companies depict a valuable growth chance. Notwithstanding, the author proposes that a company’s cost of capital remains to be constant not considering the level of debt ratios thereby its underlying weighted average will always depend on the aforementioned costs as well as the market- value ratios pertaining to debt and equity within the overall company value. According to Huang (2006, p. 15) static tradeoff models surely explains the existence of an optimal capital structure. The author agrees that a company should come up with target debt level and gradually work towards accomplishing it. In fact, the author notes that a company’s move towards achieving an optimal capital structure involves trade-off that relate to the overall effects of corporate and individual-based taxes, bankruptcy and agency-related costs. Notably, firms are perceived to prefer using retained earnings that are present within the liquid assets. Their immediate next of preference lies in the less risky debt and finally the external equity financing option. This set of preferences is ascertained to the existence of an asymmetric information issue that arises between insider and outsider investors. Most notably, the author agrees with the opinions of Barclay and Smith (2005) that debt ratios change whenever there is an imbalance of internal cash flow, net of any given dividends as well as real investment chances. Other than, non-tax shields, taxes and size of a company, Huang (2006, p. 16) also mentions that firm’s optimal capital structure and cost of capital is predetermined by the volatility of the market; as well as possible growth opportunities. Personally, I am of the opinion that firm’s should ensure to come up with debt target levels for purposes of sustaining a stronger balance sheet position. The set of funding preferences should first include; retained earnings, then possible less risky debt funds, before sourcing for external equity financing. This is set to prevent possible collapse of operations of a firm due to under and overinvestment-related issues at hand. I also agree that equity and debt funds should assume a 70 and 30% capital structure in order to prevent overburdening of a company from unnecessary payment of interest and principal amounts in the future operational periods. B. Past and Future Company Performance Tehrani, Mehragran, and Golkani (2012, p.8) argues that financial ratio analysis of companies has been the most preferred approach taken to evaluate the past and future performances and is mainly related to a company’s set of financial statements. The authors further argue that it seeks to provide a valuable set of information that relates to the underlying procedures; correlations; the benefits and flaws of corporate as well as the overall quality of financial position. In essence, it is provided that corporate financial performances for past periods possess the capacity to avail more insight to the existing management team to understand their future directions with the company. Considering such form of analysis, a company’s overall strength and weaknesses is determined over different operational periods thus, deemed important in ascertaining the past and present situations and of significant value to future directions. A company’s financial performance should analyzed in a manner that sets to establish and thus, distinguish crucial managerial information and avail proper guidelines in order to direct future operational performances. Orlitzky, Schmidt, and Rynes (2003, p.404) ascertains that there is a positive relationship between corporate social performance (CSP) and corporate financial performance (CFP) in determining an organization’s immediate operational performance. The authors posit the positive relationship between CSP and CFP under the stakeholder theory. Stakeholder theory motes that the satisfaction of numerous stakeholders is deemed to be influential in determining an organization overall past and future financial performances. In regards to the reputation viewpoint that emanates from the external effects of organizations’ the level of communication provided to external stakeholders in attribution to the corporate social performance; could assist with development of a much positive image with such parties as consumers; investors; and suppliers. This, in turn, has a direct effect on the ease for which an organization can easily access such important resources as capital either in form of debt and equities. It is further argued by these authors that corporate social performance is positively related with corporate financial performance since it helps to improve the level of managerial competencies; develop a firm’s positive reputation and goodwill with its extensive level of stakeholders. In my opinion, I think that the past and future performances of organizations can be fairly illustrated using the financial ratios. Consequently, such non-financial aspects like the effectiveness of corporate governance and engagement with corporate social responsibility helps to establish how the company would perform in the future. In fact, these non-financial aspects help an organization to maintain a positive brand image and reputation that fosters easier access to capital and improve on revenues as customer-base increases significantly over time. The overall financial performance for organizations is thus determined by conducting an extensive financial statement analysis and also, establishing their immediate relationship with external factors that have a capacity to alter the level of operations. Section 2: Abu Dhabi National Energy (TAQA) Financial Analysis For this section, the paper examines the 2015 annual reports of Abu Dhabi National Energy to establish its immediate financial position. To conduct this financial performance analysis, the paper adopts a ratio analysis framework for the period mentioned and thereby, immediate interpretations made. Abu Dhabi National Energy is a world-leading energy company that has its headquarters in Abu Dhabi. It has a set its energy-related operations to more than 11 markets across the globe. Popularly known as TAQA, it seeks to serve customers in such business areas as power &water and oil& gas. A. Liquidity Ratios The company’s current ratio decreases within the two periods from 1.28 to 0.92 in 2014 and 2015 respectively. The decrease is also noted for the other two ratios; quick ratio from a high of 0.98 to a low of 0.68; and, cash ratio whose ratio value decreases from 0.37 to a low of 0.29 within a similar period. The significant decrease of these ratios within the two financial periods ascertains that Abu Dhabi National Energy is slowly losing its capacity to meet possible short-term obligations as and whenever they fall due. The decrease is largely explained by the immediate increase in the amounts related to accounts payable within the period meaning that most of its cash and cash equivalents, which are in fact, liquid assets needed for managing short term commitments, were not enough in the period or rather did not increase in the same level the accounts payable did. The management of the firm notes that a substantial section of its existing base dropped in its overall book value due to significant exposure to depreciation, depletion and amortization and, also impairments that could not be countered using the set of introduced capital investments made within the period. B. Leverage Analysis Debt ratio increases slightly within the period from 0.71 to 0.80 in the period between 2014 and 2015 respectively. Despite this increase, it can be noted that TAQA strives to maintain most of its assets-base using a small fraction of debt funds. On the contrary, the company’s debt-to-equity ratio has continued to increase over time from 17.79 to 27.77 in the operation period between 2014 and 2015 respectively. The increase confirms that it has embarked on engaging most of capital investments using debt funds as opposed to equity from shareholders. This overdependence on debt funds can be largely attributed to easier access to borrowings with fair terms and conditions and with minimal rate of interest as in the case of Islamic bank loans. It might also mean that the experience of the oil prices plunging even further during the period resulted to low revenues that could not be enough in undertaking major investment projects. The firm’s time’s interest earned ratio also remains high and in fact, increases within the two periods from 46.93 to 51.15 in the operation period between 2014 and 2015 respectively. The increase in the level of the ratio is an indication that TAQA possess stronger capacity to pay-off its interest obligations for its immediate borrowings at a much faster rate. This can be attributed to its ability to generate a higher amount of income before taxes that could then be used in offsetting interest costs. The cash coverage ratio increases within the period from 47.15 to 51.35 in the operation between 2014 and 2015 respectively. This high ratio is an indication that TAQA’s capacity to pay-off interest obligations as and whenever they fall due using the cash and cash equivalents at the moment remains stronger to the future. C. Profitability Analysis The return on assets (ROA) remains lower within the two operational periods and in fact, decreases slightly from 0.371 to 0.370 in 2014 and 2015 respectively. This imminent decrease in the ratio value ascertains that TAQA capacity to generate profit returns on the existing asset base has dwindled and remains poor over time. This is attributed to the fact that the company’s asset management policies remains to be poor especially in relation to wear and tear or rather depreciation of such important assets like plant and machinery remains below the expectations of the industry as a whole. Unless the management acts decisively and on a timely manner; to replace any worn out plant and machinery then its capacity to attain optimal operations remains to be uncertain even in the near future. Notably, the return on equity (ROE) ratio remains high above the industry average at 1264% in 2014. The high ratio is an indication that TAQA possess the capacity to generate even more profit returns on the underlying equity held. References List Barclay, M.J. & Smith, C.W., 2005. The capital structure puzzle: The evidence revisited. Journal of Applied Corporate Finance, 17(1), pp.8-17. Huang, G., 2006. The determinants of capital structure: Evidence from China. China Economic Review, 17(1), pp.14-36. Myers, S.C., 2001. Capital structure. The journal of economic perspectives, 15(2), pp.81-102. Orlitzky, M., Schmidt, F.L. & Rynes, S.L., 2003. Corporate social and financial performance: A meta-analysis. Organization studies, 24(3), pp.403-441. Tehrani, R, Mehragran, M, R & Golkani, MR. 2012. A mode for evaluating financial performance of companies by data envelopment analysis: A Case study of 36 corporations affiliated with a private organization. International Business Research, 5(8), pp. 8-16 Waddock, S.A. and Graves, S.B., 1997. The corporate social performance-financial performance link. Strategic management journal, pp.303-319 Read More