A Report on Management of Equity and Debt

Question: Discuss the management of Equity and Debt as part of the long term funding requirements of companies. Answer: Introduction Debt and equity management has a long standing relationship between the both as both of them provide funds to run business as well as expand the assets during capital expenditure. The issue has become a debate among the analysts in finding the suitable and effective funding instruments between the two. The major challenge in this perspective is to optimize the capital structure of a company as debt and equity are the main contributors of capital structure of a company. It is obviously a way to find out the return on capital is influenced by these two managements while it is also true for the managers to evaluate continuously an appropriate value for dynamic changes in debt and equity ratio to attain a balance (WELCH, 2011). In this report, the more emphasis will be given on the effective portion of debt and equity while both of them are utilized as the source of funds in business. In this report, two companies debt and equity will be analyzed for the last five years retrieving data f rom their annual report and will be compared to each other at the end. The report will consist of conclusion made from the analysis of two companies as well as management of debt and equity which will provide to further proceed towards making recommendations regarding the matter. Objective of the report is to establish the effectiveness of debt and equity management in a company as well as why a company must introduce in their business and in which form so that they can achieve their long term objectives and financial goals. Profile of the companies Selected companies in this case are Shell Plc and BHP Billiton; both of them are listed in London stock exchange which might be helpful in comparing their market capitalization. The comparative study between the two regarding their debt and equity management will be in line due to their huge operation as well same style of debt management. Shell Plc is engaged in gas and oil refining which has multinational presence in the world while BHP Billiton is engaged in mining of iron ore while both the companies have made some milestones in their respective fields. Shell It is an oil and gas company that is spread over the international market for many years. It is the fourth biggest company in the world and the biggest oil refinery company. The company has presence in USA, UK, India, Africa, Malaysia, Philippines, Singapore and in Europe. Therefore, the company has a multinational existence in oil and natural gas in the world. The company has many ongoing projects in many countries with active oil reserves in their field. Further, the company has also fielded its legs on alternative energy segments and the benchmark projects like rigging in arctic region for oil. The company has been acquitted for many controversies ranging from environment pollution to overstatement to the shareholders about oil reserve. Shell has many differentiated products and resourced products in its shelf. Source of finance of the company is both equity and debt. Further, reserves of retained earnings and other reserves like foreign exchange reserves are also present. In liabilities section there are non-current as well as current liabilities. Items 2014 In $ million 2013 In $ million 2012 In $ million 2011 In $ million 2010 In $ million Total equity 172786 181148 189927 171003 149780 Retained earnings reserve 186981 183474 180218 162987 140179 Non-current liabilities 94118 83106 73419 71595 72228 Current liabilities 86212 93258 96979 102659 100552 BHP Billiton - company background: BHP Billiton is an Anglo Australian multinational mining, metals and fuel company. This company is recognized as the world biggest mining business deliberate by 2013 revenues. The diversification of the BHP Billiton selection persists to be their defining quality. The superiority of their citizens, their advantage base and their unaffected policy of own and working large, durability low-cost, expandable, upstream possessions diversify by product, topography and market, together with their capability and promise to invest during the cycle and deliver projects on financial plan and to plan, what are set us separately from their peers.The lasting nature of their process permit them to set up long lasting relations with their host community where they work mutually to create a positive donation to the lives of citizens who live close to their process and to society added usually. Company has various sources of finance such as equity, retained earnings, liabilities. The sources are of different nature and works as different agent in business. From the table below, the portion of debt and equity financing in business for the company can be seen. Items 2014 In $ million 2013 In $ million 2012 In $ million 2011 In $ million 2010 In $ million Total equity 79143 70667 65526 56762 48525 Retained earnings reserve 74548 66982 62236 53131 44801 Non-current liabilities 47967 43748 40154 25427 26481 Current liabilities 18064 20139 22034 19738 13042 Debt and equity management Debt management is known as the decision making and risk taking of a companys management as debt has two applications in a business providing fund and increasing risk while doing business. As stated by Attaoui and Poncet, (2013), debt is considered to be the fastest achieved fund in market as they are readily available for business from the lenders such as banks, financial institutions and open market. It provides management of a company to run their day to day operation as well as maintain their growth in retaining fund for capital expenditure which is mainly a way of making assets in the portfolio. As observed by BAGHAI, SERVAES and TAMAYO, (2014), debt management is crucial as it extends the credit risk of a company which might not be in favor of the shareholders. The cost of debt sometimes also noted as cost of bankruptcy if it goes higher and makes the companys credit risk high. Bankruptcy cost is a major problem for the management as they have to avoid this situation for runni ng the operation smoothly as well as to get loans from the company. The creditors do not wish to provide loan to such a company which has higher credit risk as providing any fresh loan at that moment might make their fund to lose and make that sum as a non-performing assets for the lending institutions (Benninga, n.d.). It is a standard style to objectify the loan management for the managers as there are many types of decision making process are included in this process. Risk management as well as return to stakeholders is also dependent on the decision made in controlling debt management. Debt management has many parameters as it consists of different segmental choices short term, long term debt, preferred debt etc. the management of debt also allows a company to decide on the process and route of borrowings as it has also an impact on controlling the debt position of the company (Berk and DeMarzo, 2011). Equity management is one of the most difficult patterns in this case as it is the starting sum that needed for any company to start their business. Further, it is also true that equity may not be the single source for a company to invest and reinvest in their business. However, it is true that company may utilize the incremental equity in reinvestment for expanding the business or in other causes (Brealey, Myers and Allen, 2011). Basically, equity management is an essential part of the fund mobility as well as integrated fund management which may provide a manager in deducing the current situation of transferring funds in different fund as per the requirements of fund. As said by DeAngelo, DeAngelo and Whited, (2011), the equity management mainly consists of managing equity and number of shares which is the part of capital structure, retained earnings and other reserves of the company. Basically, a company needs to comply with reserve management appropriately as it enables the manage ment to make decision on incurring capital expenditure. Equity holds a special relation with debt management as reducing equity value in a capital structure reduce the portion of shares of the shareholders. Further, debt-equity management is important to make decision on dividend policy of the company. Dividend is also a return for the shareholders paying which affect the retained earnings as well as the reserve of retained earnings (Doukas, Guo and Zhou, 2010). Debt-equity management of a company is normally associated with debt-equity ratio of total debt to total equity. The ratio indicates the portion of business is funded by the lenders and the rest of the portion which belongs to the shareholders of the company. Therefore, it is observed that the ratio of debt to equity means many things for an analyst as it provides information on how much the shareholders of a company owe the creditors of their wealth value. However, Komera and Lukose (2014), deduced that current liabilities have limited impact over the equity as well as over the shareholders wealth due to its short life within the business. The higher debt to equity ratio means creditors has higher ratio of right on the profit from the business of the company while companys shareholders also owe much percentage of liabilities - due to becoming shareholders of the company, the liabilities also vested upon them. Conversely, a lower debt-equity ratio is the proof of much higher authorit y as well as rights on the stake of the company for the shareholders due to lower share of creditors. Moles, (2011), stated that strictly speaking, there is no portion of rights of the creditors in a company it is only the right of the shareholders which is normally designated as the right of the company however, legally creditors have stake on the assets of the company due to failing or defaulting of repaying the liabilities creditors might get their fund back from selling the assets of the company. The debt equity ratio varies from company to company as all types of companies do not take huge debt for minimizing the credit risk as it reduces the chance of borrowing lower and also the return to equity becomes poor (Pintus, 2011). However, the companies are engaged in the business of cyclical business as well as where higher rate of sunk and fixed cost is associated they normally borrow much. In debt equity ratio the significant part is for the non-current liabilities which is th e main source of long term fund in business other than equity. Therefore, business is run through evaluating the ratio of liabilities to equity as it provides the key insights of risk associated with debt positioning held by a company. Robin, (2011), observed that higher risk is associated with the business as well as the financial performance of the company due to making the business towards solvency. The horsepower of borrowing is due to its funding power of money in funding a new project either, or running the daily operation. Thereby, debt to equity is also measured evaluating the non-current liabilities to total equity. It also produces the loan funded by the wealth of the shareholders of the company (Ross, 2011). Debt equity management of Shell Plc Total liability of the company has been increased so far during the last five years period where current liabilities of the company have been decreased so far. Total liabilities of the company are the sum of the current and non-current liabilities of the company; thereby, current liabilities and non-current liabilities are the concerning matter for the company. From the below figure 1, we may say that companys management have increased the long term funding in its portfolio of fund as well as investment during the period of 2010-2014 which might be a growing phase of the company. The equity of the company has been volatile in this period as the other reserves have decreased during the period. Retained earnings of the company has grown since 2010 and till date the trend was same due to the managements decision of retaining much rather paying more dividends. The debt and equity management of the company has shown that companys debt to equity ratio is almost same during the period as th e total liability and equity have not been changed much during the period. The total equity of the company has not changed a lot in this case. The total equity was almost same at the end of the period as the total liabilities were same during the period, however; the equity has been low. Further, equity of the company has not made much progress so the ratio of non-current liabilities and equity of the company has been increased due to decreasing of other reserve mainly. Figure 1: Debt and equity management of Shell Plc (Source: Shell.com, 2015) Debt and equity management of BHP Billiton For BHP Billiton, total liabilities of the company have increased during the period both current and non-current liabilities have also increased during this period of the company. Total equity of the company has also increased during the period while the component of equity such as retained earnings as well as other reserves has also increased. This helps the company to maintain the ratio of the debt to equity at almost same at the end of the period. However, the ratio was increased during 2013 and 2012 due to more debt from current liabilities while the non-current liabilities were increased from 2012 onwards. The debt management of the com[any also shows a good decision making ability by controlling the non-current liabilities of the company during the period which was increased in 2012 and stayed almost within the ten percent range in the next two years. The current liabilities of the company was decreased at the end of the period and also the non-current liabilities to equity ra tio have not increased much during the period - also showing the stake of the liabilities funded by shareholders is almost two third of the total capital while the for every two shares, marginal borrowings can be changed. Figure 2: Debt and equity management of BHP Billiton (Source: Bhpbilliton.com, 2015) Comparing the situation of both the company, it can be observed that non-current liabilities to equity ratio of the companies differs from each vast. Onwards 2012, the ratio has increased for Shell Plc while the same ratio has marginally decreased for BHP Billiton during the period. The below figure 3 shows the difference of the periodical ratio of non-current liabilities to equity which depicts that debt and equity management of the company differs due to different decision making in the company and also different strategy intake. Figure 3: Comparative study on debt-equity ratio Analysis on shell 2014 2013 2012 2011 2010 Total debt to equity 1.0436609 0.97359066 0.897176284 1.019011362 1.15355855 noncurrent loan to equity 0.5447085 0.45877404 0.386564312 0.418676865 0.48222727 In the above table, we can see the debt equity ratio of Shell Plc for the year 2014 to 2010 respectively. The ratio of debt to equity is under controlled comparing with the scale of operation of the company in terms of revenue. Further, the ratio between noncurrent loan to equity is also under controlled. However, it is trying to increase during the period as seen from the trend recently. 2014 2013 2012 2011 2010 EBIT 30118 35234 52046 57033 36340 Interest 1804 1642 1757 1373 996 Interest Coverage Ratio 16.695122 21.4579781 29.6220831 41.53896577 36.4859438 2014 2013 2012 2011 2010 Debt To Capital Gearing Total Capital 353116 357512 360325 345257 322560 Equity 172786 181148 189927 171003 149780 Gearing Ratio 2.0436609 1.97359066 1.897176284 2.019011362 2.15355855 From the above table, it can be analyzed that company has enough money to pay its interest payment for the past years and the trend is going to be same in recent future. However, the trend of income from business is very poor during the period as the trend of income is downwards. Therefore, management of the company needs to be cautious about their borrowing cost. The debt gearing ratio depicts that Shell has a trend of running its operation by equity mainly. The last years figure depicts that half part of the whole is run by the equity. However, the limit of running the operation with debt may provide a chance of decrease the cost of interest and increase the return of shareholders by many parts. In this case, the trend of the company is to hike the gearing ratio means increasing the financial leverage in near future. Analysis on BHP Billiton 2014 2013 2012 2011 2010 Total debt to equity 0.561793 0.581052 0.598554 0.440256 0.536824 noncurrent loan to equity 0.544 0.458 0.386 0.418 0.482 The above table shows the debt equity ratio of BHP Billiton where it can be seen that company has low level of current loan during the period. It means company is using its own fund for running the cost of working capital rather depending on current loan from outside. The trend is uptrend means borrowing has increased at the ending period of the duration while current loan has decreased at the end of the period. 2014 2013 2012 2011 2010 EBIT 23412 21002 23752 31816 20031 Interest 1176 1276 730 561 459 Interest Coverage Ratio 19.90816 16.45925 32.53699 56.71301 43.64052 2014 2013 2012 2011 2010 Debt To Capital Gearing Total Capital 151413 142178 129273 102920 88852 Equity 85382 75291 67085 57755 49329 Gearing Ratio 1.77336 1.88838 1.927003 1.78201 1.801212 For the above table, we can see that the company is in a good shape for the last five years. The recent earnings history of the company shows that company can pay its interest from the income from its operation. However, it is also seen that company has better income prior to 2013, when income was 32 times of total cost of interest. Therefore, the trend of earnings of BHP is skeptic for the management. The gearing ratio of the company shows not much volatility in strategy of gearing the companys operation and the borrowing strategy of the company has not much changed during the period. Therefore, it is clear that company has considered running the operation depending on the liabilities and equity in a mixed way. However, capital is geared by the equity mainly. The company has low financial leverage during the period. Recommendations It is recommended that Shell has increased its long term funding by increasing its non-current liabilities while BHP has tried to control its liabilities as a whole by increasing its retained earnings during the period. Further, it is also recommended that both the companies must reduce their long term liabilities unless they have any major expansion plan as well as increase the retained earnings to increase the total equity of the company. 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