Principles Of Financial Markets: Business Return Investment Essay

Question:

Describe about the Principles of Financial Markets for Business Return Investment.

Answer:

Introduction

Every investor who invests money in company is ultimately aiming to get higher returns on their investment. For this, it is necessary that they undertake adequate analysis of the industry as well as the securities of the company. Fundamental analysis helps such investors to project the future cashflows of the security by analyzing the economic outlook of the industry and the company’s financial performance (Gitman et al, 2014).

The following report discusses the fundamental analysis in context of two companies, viz. BHP Billiton Limited and Rio Tinto Limited. Both these companies operate in the material and mining industry. The report takes a top-down view of the company to identify the broad macro economic factors that affect the Australian material and mining industry. These factors affecting the industry outlook ultimately affect the performance and value of the company. Further, the report analyzes the current financial position of the selected company using a bottom up approach. Finally, recommendations with regards to improving the value of their company are made.

Australian Mining Industry Overview

Material and mining industry in Australia is critical to the economic growth of the country. It is a primary industry and acts as a catalyst for GDP growth as a largest contributor. This industry generated revenues amounting to over $ 186 billion in the year 2015 and accounts for around 179,200 jobs. Despite its contribution, the industry is experiencing a negative annual growth rate of 1.8% and is significantly impacted by pricing levels, trends in commodity markets, fluctuations in Australian dollar and other macro economic factors (IBIS World, 2016). Over the years, this industry has transitioned from investment to production phase thereby providing a positive outlook to the Australian economy (AIR, 2015). Australia is almost self-sufficient in production of most of the commodities like iron, aluminum, bauxite, diamond, coal, petroleum and many more. This allows the mining industry to vital role in improving the standard of living of citizens; create jobs and development of infrastructure through investment. The major players in the Australian material and mining industry are BHP Billiton, Rio Tinto, Vale, and others.

BHP Billiton Limited: History and Mission Statement

BHP Billiton Limited, the global mining, oil and gas company, was established in 2001 through the merger of Australian Broken Hill Proprietary Company Limited (BHP) and Anglo-Dutch Billiton plc. It is headquartered in Melbourne, Australia and is the world’s largest mining company in terms of revenue and employs 29,670 people. The company is listed on major stock exchanges of Australia and London. Its scope of operations includes mining and processing of minerals like petroleum, iron, copper, coals and likes and spans around 25 countries of the world with mines in Australia, Brazil, Canada, USA, Algeria and South Africa (Market Line, 2016). The company aims to enhance its shareholder’s value through its operations by acquisition, development and marketing of its products at low-cost (BHP Billiton, 2015).

Rio Tinto Limited: History and Mission Statement

Rio Tinto Limited, an international mining company, was formed in 1873 as a result of purchasing of a mine complex in the river Rio Tinto in Spain by a group of investors. The company is now headquartered in London, UK and is dual listed on stock exchanges of London and Australia. The company is one of the world’s largest producers of aluminum, iron ore, diamonds, coal and copper. Even though it operates around the world, its operations are primarily concentrated in Australia and Canada. Currently, the company employs 54,938 people. The company’s mission is to improve its profitability through technology and innovation and reducing the environment footprint (Rio Tinto, 2015).

Fundamental Analysis

The fundamental analysis is based on the premise that there is a mismatch between the security’s intrinsic value and its market value. Thus, fundamental analysis allows an investor to estimate the intrinsic value of the security and invest in those securities whose intrinsic value is higher than its market value (Gitman et al, 2014). The analysis employs two approaches, viz. top-down and bottom-up, to analyse the value of security.

Top-down Analysis

Top down analysis focuses on the broad level factors that affect the whole industry along with the companies. This analysis tends to the macroeconomics factors can influence the growth and financial result of the companies. Top down analysis determine the position of economy at world level for a particular industry and with this regional and national level economy of developed and developing countries is evaluated (Viney and Phillips, 2015). There are many macroeconomics factors that affect the mining and material industry such as GPD, commodity price, exchange rate and interest rates. Diversification of investment portfolio is also segregated by down analysis, into the major profitable sector of the country.

  • Gross Domestic Product

Gross domestic production is a primary macroeconomic factor through which the financial position of the country can be examined easily. GDP is also a crucial component for the investment purpose, by analyzing it investors can decide they should invest or not. Highly GDP growth rate attract the major investors for capital deployment. Australian economy mainly based on mining industry which contributes the 13.5% of the GDP in economy (Trading Economics, 2016). Due to the resources boom in Australia the mining shares of GDP increased from last decade. Australia’s GDP is 2.9% of the whole economy (Budghet.gov, 2015). Australian GDP is decreasing from the year 2013, it was US $1563.9 billion and in 2015 it was US $1339.54 billion. It states that the decreasing scenario of the GDP can directly impact on the financial result of the industry reason being the lower demand in the market.

  • Interest rate:

Interest rate is an important factor that influences the operation of the business and strategy to expansion of the business at global level. It is a financial risk that is faced by the business in a fluctuation economy. The mining group is exposed to pay the interest on outstanding borrowings. The businesses activities are based on the interest rate, high interest rate affect the business in terms of taking loans from the banks for expansion of the business. By the industry is chosen in this financial management work, group’s interest is paid in US$ (rba.gov, 2016). Fluctuation in interest rate affects the future cash flow. It is analyzed that changes in one percent interest rate can reduce the equity and profit. Fluctuation in interest rate also affects the discount rate applied. In year 2016 US government increases the interest rate that will affect the future borrowings from the banks and profit of the business. Lower interest rate contributes to easily accessing the capital and promotes the economic activity. Furthermore, low interest rate encourage to households for more spending. On the other hand higher interest rate attract the foreign investment it resulted into risen of exchange rate

  • Exchange rate:

Exchange rate affects the movement of the economy operation at national and international level, it is the value of a currency for the conversion in another currency (Peter et al, 2014). In regards to this, from 2013 the exchange rate of Australian dollar is decreasing constantly. Decreasing of exchange rate improve the export competitiveness through which an exporter can sold for less in foreign currency. By lowering the Australian dollar value, major industries like manufacturing and education industry mostly benefitted. Exchange rate also has an impact on the financial result of the company. Positive exchange rate movement permits the companies for expansion of business operation and provides more return to shareholders. Fluctuations in exchange rate can influence the operating cost of BHP Billiton and Rio Tinto plc, because these businesses are operated at global level and need to payment in other currency. In addition to this exchange rate also affect the profit of the business. Exchange rate is determined by the economic condition of country.

  • Climate change:

Australian economy facing environmental and economic impact due to climate changes. Climate change is an important aspect that can influence the business of global level companies and industry also. Climate change is a major problem for the BHP Billiton and they are trying to reduce the emissions. Rio Tinto set the target to reduction of 10% green house gas and they are focusing on energy intension in operation of the business because mining industry poses the high use of the energy (Rio Tinto, 2015). Carbon pollution affects the environment negatively and sustainable growth needs an effective response to climate change. Climate change has negatively impact on the operation of business, productivity and market. Climate of Australia might be affected by the rain fall, water shortage and higher temperature. Effects of these natural calamities can influence the financial performance of the operation.

  • Commodity market and Commodity Prices

Material and mining industry is highly dependent on the fluctuations of commodity prices as commodities are the basic asset on which this industry thrives. Therefore, any fluctuation in prices of different commodities like iron, copper, aluminum and many others affect the industry as well as the financial performance of the companies belonging to this industry. The current commodity market is experiencing a modest growth. This growth is contributed by developed economies like US and Europe. However, emerging economies like China, Russia and Brazil are exhibiting declining and slow growth (BHP Billiton, 2015). Further, the commodity prices are also declining due to slow growth of global commodity demand and oversupplied commodity market (Els, 2016). This further negatively affects the profitability and revenue generation capacity of the companies operating in the industry.

Bottom-up Analysis

Bottom-up’ analysis is a fundamental approach adopted at a company level. In this approach, an analysis of a company’s financial performance is made with the objective of attracting investment in the company (B?llingtoft, 2012). Bottom-up investors always look for financial strong companies which can meet their needs in the form of high dividends and other monetary rewards. For this purpose, assessment of financial ratios of the company is made.

Analysis of financial ratios of BHP Billiton Ltd and Rio Tinto Ltd:

Profitability ratio:

Return on Equity: ROE is the measurement of a firm’s ability to utilize its shareholders’ funds to generate profits. The higher ratio shows that the company is efficiently using its stockholders’ money and also providing them better returns. On the other hand, low ratio indicates management inefficiency in dealing with investors’ money. ROE of BHP Billiton for the year 2015 is 2.94 and that of Rio Tinto is -2.31. It indicates that ROE of BHP is higher than that of Rio Tinto which means that BHP is efficiently utilizing is shareholders’ funds than Rio Tinto (Wang et al., 2014). Also, industry average reported is -2.13, which depicts that BHP is a better option for potential investors for making investment, as it is more profitable than Rio and provides higher returns in the mining industry.

Net Profit Ratio: This ratio determines the net earnings of a company after deducting all operating costs, interests paid, taxes and dividends paid to the preference shareholders. A high ratio indicates the company’s ability to manage its business affairs in an efficient way. In contrast, a low ratio is an indication of an inefficient management and lower profitability of a company. Net profit ratio of BHP and Rio for the year 2015, is 4.27 and -2.48, respectively. It depicts that BHP’s all over profitability is higher than that of Rio (Getzin et al., 2016). Moreover, the industry average is found as -43.23. It depicts that BHP is constantly improving its financial health and is earning higher than Rio. Also, it can be said that Rio’s net profit margin is better than the industry average.

Liquidity Ratio

Current Ratio: This ratio is helpful in measuring the liquidity position of a company. It determines whether the firm is able to fulfill its current obligations, or not. The ideal current ratio is always considered to be 2:1. In 2015, the current ratio of BHP and Rio is observed as 1.27 and 1.5, respectively. It means BHP has a better debt-repaying ability than that of Rio (Beeson and Wilson, 2015). However, when their liquidity position is compared with that of industry average, that is, 2.73, it is concluded that solvency position of both the companies is not satisfactory.

Quick Ratio: This ratio is the measurement of a firm’s ability to repay its current liabilities by using quick assets only. It measures a firm’s solvency position in a much better way. For the year 2015, it is found that quick ratio of BHP is 0.93 and that of Rio is 1.2. It reveals that Rio has a better leverage than Rio, against the liquidity risk (Beeson, 2016). However, the industry average is reported to be 1.74, which shows that both the companies are not maintaining an adequate buffer of liquid assets in order to avoid liquidity risk.

Leverage Ratios

Debt-Equity Ratio: This ratio is used to determine the financial structure of a firm. It identifies various sources from where the company obtains funds. Debt-equity ratio of BHP and Rio in 2015 is .25, while the industry average is 57.39. The lower debt-equity ratio of both the companies suggests that they are financially stable and less risky.

Interest Coverage Ratio: This ratio indicates how early a company makes interest payments on its liabilities. A high ratio is always considered favourable. The interest coverage ratio of BHP in 2015 is 9.51, which is less than that of Rio (18.44). It implies that Rio has a more favourable financial leverage against interest-burden. Also, the industry average for the year is 8.48, which shows that both the companies are operating well in the industry as they are left with some extra earnings even after paying their all debts.

Efficiency Ratios

Inventory Turnover Ratio: This ratio is a useful tool to determine how efficiently a firm manages and control its inventory level. A high ratio is usually preferred. In 2015, the stock turnover ratio of Rio is 1.37, which is more than that of BHP (1.15). It indicates that Rio’s purchasing activity is well-managed and stock does not remain idle (Floris et al., 2013). However, Rio’s stock turnover ratio is less than its industry average, which implies that the company has to make some necessary changes in its inventory policy to improve the ratio.

Debtors Turnover Ratio: This ratio measures how efficiently a firm collects its average account receivables. A lower ratio is always considered favourable. In 2015, the debtor turnover ratio of BHP was 14.93, which is higher than that of Rio (8.9). It reveals that BHP is able to collect its receivables more frequently than Rio (Huang, 2015). However, the industry average is found to be 12.61(higher), which implies that both the companies need to review their credit policies in order to decrease the collection.

Market value ratio

Earnings per Share: This ratio indicates the profits available for outstanding equity stockholders, at the end of the year. Higher the ratio, more satisfied is the shareholders. In 2015, the earnings per share of BHP and Rio are 35.9 and -47.5, respectively. It suggests that EPS of BHP is higher than that of Rio, which means that BHP is left with more profits at the end of the year, for the purpose of distribution to shareholders and also the company is seen more profitable in the view of potential investors.

Dividend per Share: This ratio measures the ability of a firm to distribute cash dividend to its shareholders. A higher ratio is always preferred. In 2015, the dividend per share of BHP is 124, while that of Rio is 226.5. It reveals that Rio pays a large dividend to its shareholders compared to the market price of shares (Beeson, 2016). In contrast, BHP pays less for the shares and thus, seems to be less profitable from the shareholders’ point of view.

Conclusion

From the above analysis, it can be concluded that fundamental analysis is an important tool in the hand of any investors seeking to invest in securities. This analysis takes two different approaches viz. top-down, to assess the current and future outlook of the industry and bottom-up to identify the growth potential of the company using the financial analysis technique.

In context of the chosen companies, the top-down analysis indicates that the overall outlook of the Australian material and mining industry is not so favourable form investment point of view. Even though the material and mining industry’s contribution is continuously increasing as the portion of the country’s declining GDP, the falling commodity prices, increasing interest rates and climate change is making the industry environment volatile thereby dampening the growth prospects for companies operating in his segment. However, only the value of Australian dollar with respect to other currencies is the favourable aspect of the industry that is allowing the companies to lower their operation costs. Further, the bottom-up approach shows that overall, BHP Billiton Limited is better than Rio Tinto Limited as far as financial strength and profitability of the company is concerned.

Recommendations

From the above analysis, it can be recommended that even though mining industry is experiencing volatile environment, there is immense growth potential for companies operating in the material and mining sector of Australia. Hence, any investor seeking to invest in share capital should invest in securities of BHP Billiton Limited to ensure higher returns to investment rather than Rio Tinto Limited. This is because BHP is financially stronger than Rio as indicated by its market value and profitability ratios. Moreover, BHP’s profitability is much higher than that of Rio indicating better profit generation capacity and efficient utilization of assets.

References

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