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Question:

Discuss about the Harvey Norman Capital Structure, Asset Financing Policy and Distribution Policy.
 
 

Answer:

Introduction

In this report an attempt is made to examine and critically evaluate the financing and distribution policy of Harvey Norman Holdings Limited. This is an Australian company that ranks 130 out of top 2000 companies operating in Australia. The company is engaged in four segments retail business, property, franchise operation and other business. The company receives significant revenue form the franchise holders (Fields 2016). The company is engaged in retail business in different parts of the world. This company is considered to be the largest retailer of software and hardware products in Australia. Further the company also receives income from the rent of property. This report aims to discuss the capital structure, asset financing policy and the distribution policy of the company.

Capital Structure

Current Policy

The overall operation of the business and growth is financed by different sources of funds. The combination of different sources of funds that is used by the company is known as the capital structure. There are primarily two sources of funds owners fund and borrowed funds. The borrowed funds include debt, loans, bonds etc. On other hand the owners fund includes equity shares, preference shares and retained earnings (Hattula et al. 2015). The capital structure of the company is assessed by computing the ratios of long term and short term debt. The debt to equity ratio is also referred capital structure ratio. It is important to determine the debt to equity ratio of the company because it is useful in assessing the risk associated with the investment in the company (Dittmar and Field 2016).

The capital structure of Harvey Norman is analyzed using the annual report of the company. The capital risk management policy of the company is provided in the director’s report.  The main objective of the policy is to create value for the shareholders using a sustainable long term basis. The main focus of the management of the company is to maintain stable return for the shareholders and to provide benefits to other stakeholders (Ibert et al. 2017). This is achieved by the management of the company by taking decision that not are not related to short term. In the annual report of the company it is mentioned that it is the intention of the company to maintain a capital structure so that the cost for the company is minimized. In order to take the advantage of lower cost of capital and higher return on assets the company the company constantly changes its capital structure (David and Halbert 2014). The company is constantly altering the payment of dividend, capital repayment, issuing of shares and selling of assets so that the assets can be reduced.

 


On analyzing the annual report of the company it can be said that the capital structure of the company consists of equity and debt. The details of debt is provided in the Note 17 of the annual report of the company and the details to equity is provided in the Note 20 of the report. The net debt of the company is calculated by reducing the cash and cash equivalent from the total debt (Tihanyi et al. 2014). The details relating to cash and cash equivalent is provided in the Note 28(a) of the report. The company uses debt equity ratio as the tool for managing the capital. The annual report of the company provides that the tolerance level for debt for the company is 50%. The debt equity ratio of the company is calculated below:

Debt Equity Ratio

Particulars

2016

2015

Borrowings (a)

 $    654,077.00

 $    698,438.00

Less:

 

 

Cash and cash equivalent

 $  (139,847.00)

 $  (185,840.00)

Net Debt (b)

 $    514,230.00

 $    512,598.00

 

 

 

Total Equity (c )

 $ 2,710,724.00

 $ 2,578,910.00

Debt Equity Ratio (a/c)

24.13%

27.08%

Net debt Equity ratio (b/c)

18.97%

19.88%

 Table 1: Debt equity ratio

(Source: created by author)

Optimum policy

In the traditional capital structure theory it is stated that the capital structure of the company is said to be optimum if this conditions exist.  The first condition is maximization of market value of assets and the second condition is minimization of weighted average cost of capital. The Tradeoff theory states that initial increase of debt in the capital structure will result in increase in the value of the company (McLean 2014). This increase in value of the company with the increase in the debt in the capital structure will continue till the optimum capital structure is reached. Then after the optimum capital structure is reached any additional increase in debt in the capital structure will result in reduction in the value of the company. There are different methods that are applied for determining the optimum capital structure of the company. One of the popular method is the determination of debt equity of the company. Then after determining the debt equity ratio of the company it is compared with the other competitors and industry standards (Zabri et al. 2014). The assumption that is made in this comparison is that the companies or the industry are operating effective with the optimum capital structure. The willingness of the lender to lend to the company is also taken as one of the method for determining the optimum capital structure of the company. 

 

Recommendation for Changes in the Policy

The main reason for determining the optimum capital structure is to create value for the shareholders of the company. The primary aim of the capital structure determination is to minimize the cost of capital for the company. The process of determining the optimum capital structure is discussed above.  It can be seen from the above discussion that there are certain limitations for ascertaining the optimum capital structure. The first process of ascertaining the optimum capital structure is through comparison with the other participants or with the industry.  The main assumption that is made in this process is that other companies and industry are operating at the optimum capital structure. This assumption can be contested and cannot be held as truth. Therefore determining the optimum capital structure by applying this process is not desirable. The willingness to lend is dependent on multiple factors. Therefore determining the optimum capital structure by the application of this process is not desirable.

Current Policy

The asset financing is a process of obtaining short term loan by using the assets like short term investments, inventory and accounts receivables. The loans are obtained by the company after providing adequate securities in the form of assets to the company. In order to obtain working capital and short term loan the asset financing is the best method (Banks 2015). It can be seen from the annual report of the company that there are various financing facilities that are available to the company. The finance are arranged by the company from borrowings, bank overdraft, syndicate facility arrangement and commercial bills of banks. The short term loans of the companies are all financed using the short term assets of the company (LU et al. 2015).

Optimum Policy

There are two options for using the assets in order to obtain the loans. The first option available to the company is assets based lending and the second option that is available to the company is asset financing (Wang 2015). In asset based lending the loan is obtained by providing the assets that is being purchased as security. In case of asset financing the loan is obtained by providing different assets as securities.  The assets that are provided in the securities are mainly short term assets. Based on the above discussion it can be said that the asset based lending is used for obtaining mainly long term loan and the asset financing policy is used for obtaining mainly short term loan (Baker et al. 2017).

Recommendation for changes in the Policy

The annual report of the company shows that it has obtained finance from various sources by providing assets as securities for the loans. It has already been discussed that the assets financing is an idle method for obtaining short term loan. Therefore it can be concluded that the current policy of the company for short term loan using the assets as securities is a justified method.

 

Current Policy

The distribution policy of the company is the decision that the company has to make in determining the amount of profit the company is willing to distribute as dividends. There are two types of theories related to dividend. This theories are dividend irrelevant theory and dividend relevance theory (Luby 2014). The dividend irrelevance theory states that the dividend policy of the company is irrelevant and does not affect the value of the company. On the other hand it should be noted that many investors considers dividend as the primary source of income. Therefore, it is important to determine the optimum distribution policy of the company (Hope and Fraser 2013). It is the responsibility of the board to decide the amount of profit the company is willing to distribute as dividend. The decision is made by the board after considering various factors that influences the operation of the company. The factor that influences the amount of dividend is the investment opportunity that is available to the company. If the investment opportunity available to the company is high then the company will distribute less profit as dividend. On the other hand if there is low investment opportunity available to the company then in such case the company can distribute majority of its profits as dividend (Besley and Brigham 2013). There are other factors that influences the decision of the company for distribution as dividend. This factors ate tax consideration, legal consideration, return consideration, cash flow constrains and contractual constraints. The above mentioned factors also influences decision of the company for the amount of dividend. The director’s report of the company provides the dividend policy of the company (Arize et al. 2014). It is stated in the director’s report that the dividend policy of the company is to pay dividend in a manner that it does not negatively influence the capability of the company for obtaining the strategic objectives. In the year 30 June 2016 the company has declared dividend of 30% per share. The 95.66% of the profit is distributed as dividend during this year end.

Ratio of dividend to earning

Particulars

2016

2015

Earing per share

 $             31.36

 $             24.51

Dividend Per share

 $             30.00

 $             20.00

% of earning distributed as dividend

95.66%

81.60%

Table 2: Dividend to earnings ratio

(Source: created by author)

It can be seen from the above table that in 2015 81.60% of the profit is distributed as dividend. In the 2016 the company distributed 95.66% of the profit as dividend so it can be seen that almost all the profit in this year has been distributed as dividend. Therefore from the above table it can be inferred that the company follows a policy of high dividend payouts. This policy might have negative impact on the ability of the company to retain earnings and support growth of the company. The level of the payment of dividend for the company is high.  The dividends are paid in the form of cash and form analyzing the financial statement it can be seen that the dividend payment of the company is volatile (Szyszka 2014). 

Optimum Policy

There are different categories of dividend policy stable dividend policy, residual dividend policy and constant dividend policy. The stable dividend policy is the most popular form of dividend policy. In this policy a stable and predictable amount of dividend is paid on a regular basis. In this policy the dividend amount is not influenced by the level of earnings of the company. The aim of the stable dividend policy is to align the dividend policy of the company with its long term objectives. This policy provides the investors safety relating to the amount and time of dividend. However, the main disadvantage of this policy is that as the dividends are constant so the return for the shareholders does not increases if the earning of the company increases. The disadvantage of the stable dividend policy is addressed by the constant dividend policy. The constant dividend policy provides that if the earnings of the company increases then the dividend paid to the shareholder also increases (Lim et al. 2015).  In the constant dividend policy a percentage of the earning are distributed as dividends. In this policy the dividend payment of the company becomes very volatile as the increase and decrease of income causes fluctuation in the dividend payment of the company. Therefore, the main disadvantage of constant dividend policy is high volatility in the payment of dividend that make it difficult for planning. The residual dividend policy states that the dividend shall be paid by the company after deducting from income the capital expenditure and working capital requirements. The volatility in the payment of dividend also exist in the residual dividend policy.

 

Recommendation for changes in the Policy

The dividend policy as mentioned in the director’s report indicates that the company follows a policy where dividends are paid without compromising the future earning capability of the company. It should be noted that the company can attain its strategic objectives if sufficient amounts of profits are retained by the company. It can be said that the company is following residual dividend policy because as can be seen from the above that almost entire profit is distributed as dividend. This dividend policy will result in the reduction of available retained earnings for the company thereby reducing its capability. Therefore it is recommended that the company should reduce the payout level in order to increase the retained earnings for supporting future growth of the company.

Conclusion:

Based on the above discussion it can be concluded that the capitals structure of the company is justified. Further it can also be said that the company is justified in following the asset financing policy. It should be noted that the distribution policy of the company is insufficient so suggestions is made for changes.

 

References:

Arize, A.C., Kallianotis, I.N., Liu, S., Malindretos, J. and Maruffi, B.L., 2014. The Preponderance of stock picking techniques: The practice of applied money managers. Accounting and Finance Research, 3(2), p.p87.

Baker, H.K., Filbeck, G. and Ricciardi, V., 2017. How Behavioural Biases Affect Finance Professionals.

Banks, E., 2015. Finance: the basics. Routledge.

Besley, S. and Brigham, E.F., 2013. Principles of finance. Cengage Learning.

David, L. and Halbert, L., 2014. Finance capital, actor-network theory and the struggle over calculative agencies in the business property markets of Mexico City Metropolitan Region. Regional Studies, 48(3), pp.516-529.

Dittmar, A. and Field, L.C., 2016. Do Corporate Managers Know When Their Shares Are Undervalued? New Evidence Based on Actual (and Not Just Announced) Stock Buybacks. Journal of Applied Corporate Finance, 28(4), pp.73-85.

Fields, E., 2016. The essentials of finance and accounting for nonfinancial managers. AMACOM Div American Mgmt Assn.

Hattula, J.D., Schmitz, C., Schmidt, M. and Reinecke, S., 2015. Is more always better? An investigation into the relationship between marketing influence and managers' market intelligence dissemination. International Journal of Research in Marketing, 32(2), pp.179-186.

Hope, J. and Fraser, R., 2013. Beyond budgeting: how managers can break free from the annual performance trap. Harvard Business Press.

Ibert, M., Kaniel, R., Van Nieuwerburgh, S. and Vestman, R., 2017. Are Mutual Fund Managers Paid for Investment Skill?.

Lim, J., Sensoy, B.A. and Weisbach, M.S., 2015. Indirect incentives of hedge fund managers. The Journal of Finance.

LU, X., LI, H. and CHEN, S., 2015. Top Managers' Characteristics and Financial Fraud Behavior: Empirical Evidence from Chinese Listed Firms. Journal of Audit & Economics, 6, p.007.

Luby, M.J., 2014. Financing Suburbia: How Chicago Suburban Financial Managers Shape the Financial Health of Their Communities.

McLean, C., 2014. Market managers and market moderators: Early childhood education and care provision, finance and regulation in the United Kingdom and United States. Journal of European Social Policy, 24(2), pp.122-134.

Szyszka, A., 2014. Factors influencing IPO decisions. Do corporate managers use market and corporate timing? A Survey. International Journal of Management and Economics, 42(1), pp.30-39.

Tihanyi, L., Graffin, S. and George, G., 2014. Rethinking governance in management research. Academy of Management Journal, 57(6), pp.1535-1543.

Wang, M., 2015. Literature Review of Decision Behavior Biases of Enterprise Managers–Case study of overconfidence.

Zabri, S.M., Kamilah, A. and Lean, J., 2014. Owner/Managers’ Financing Preferences and the Proportion of Firm’s Capital Structure: Evidence from Successful SMEs in Malaysia. In The International Conference on Business Strategy and Social Sciences (pp. 16-17).

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