Essay: Financial Performance Of BHP Billiton - FY2015 And FY2016.

BHP is one of the largest mining companies in the world which is based out of Australia and is engaged in mining of a host of minerals such as iron ore, coal, copper, uranium, petroleum. The objective of the current report is to undertake an analysis of the performance of the company during FY2015 and FY2016 using profitability and liquidity ratio which are compared with the industry average. Additionally, capital structure ratios have also been analyzed to extend a decision in relation to offering incremental financing. The above ratios have been compared with a peer group company i.e. Rio Tinto so that the firm’s financial performance could be adjudged properly. Also, the main limitations of the analysis have been offered. Besides, a bond valuation has been provided for the company (i.e. BHP) and Rio Tinto based on the given data and bond rating. Finally, the need to attain a given credit rating has been emphasized.

The two main measures of liquidity are current ratio and quick ratio. The relevant graph for these ratios is indicated below (IBIS, 2016).

In the given period, the liquidity ratios for the company have seen an improvement. This is apparent from the fact that the current ratio for FY2015 and FY2016 was 1.27 and 1.44 respectively. On similar lines, there has been a improvement in the acid test ratio which has also witnessed an improved from 0.94 as on June 30, 2015 to 1.16 as on June 30, 2016. It is apparent that the above movements in the liquidity ratio auger well for the company and indicate that the company is in a position to meet the short term liabilities that it currently has on the book of accounts (Titman et. al., 2016, p.71). However, the company’s ratio are inferior in comparison with Rio Tinto which boasts of higher liquidity ratios in both the years which implies that BHP needs to improve the liquidity ratios going forward. .

The profitability ratios provide an indication of the underlying profitability of the business. The relevant graph summarizing the relevant values is shown below (IBIS, 2016)

It is apparent that there is a marked deterioration in the profitability ratios in FY2016 as compared to the previous year i.e FY2015. The most noticeable change is that the company in FY2016 is making loss in comparison to profits for the year FY2015. This may be attributed to a drop in the commodity prices on continuation of lackluster demand from China owing to the ongoing economic slowdown and hence this trend is noticeable in case of Rio Tinto as well (IBIS, 2016). Even though the company in the last few years has cut down on costs but the revenue fall is too steep i.e. in excess of 30%. As a result of the losses, the net profit margins, ROA and ROE are all negative for the year FY2016. Further, the profitability ratios of Rio Tinto also tend to mirror the trends observed for BHP Billiton, however, a major difference is that the profitability ratios of Rio Tinto are much superior in comparison with BHP which implies the profitability is higher for Rio Tinto (Ross et. al., 2007, p. 123).

Liquidity Ratios

In accordance with the DuPont Analysis, the ROE or Return on Equity for BHP Billiton may be computed in the manner shown below (Damodaran, 2010, p. 56-57).

ROE = Profit Margin * Asset Turnover * Equity Multiplier

ROE (BHP) = -20.08 * 0.26* 1.98 = -10.33%

The corresponding calculations for Rio Tinto is as indicated below (Damodaran, 2010).

ROE = Profit Margin * Asset Turnover * Equity Multiplier

ROE (Rio) = -2.00 * 0.396* 2.07 = -1.65%

It is apparent from the above computation, that all the three parameters are superior for Rio Tinto in comparison with BHP Billiton which implies that the company has immense scope to catch up with the superior peer.

The suitable capital structure ratios used are debt to equity ratio, debt ratio and interest coverage ratio. These ratios would provide an analysis of the existing financial position and the ability of the balance sheet to assume incremental debt under the given scenario (Roshaiza & Azura, 2014). There relevant values are summarized below (IBIS, 2016).

It is apparent that there has been a deterioration of the capital structure ratios in the current year (i.e. FY2016) in comparison with the previous year (i.e. FY2015). The debt to equity ratio has increased from 0.77 at the end of June 30, 2015 to 0.98 at the end of June 30, 2016. Further, the interest coverage ratio has turned out to be negative as the operating profits have become negative in wake of the falling commodity prices. Also, the debt ratio has worsened from 0.43 at the end of June 30, 2015 to 0.50 at the end of June 30, 2016. However, the capital structure ratios of the company are superior in comparison to the peer group company Rio Tinto while the general trend of deterioration of capital structure ratios is an industry wide phenomenon (IBIS, 2016).

The above ratios may indicate that the loan shall not be extended ‘to such a company. However, there are certain other factors that are to be considered. The mining business is subject to the fluctuations in the commodity prices cycle which tend to impact the profitability. This is apparent from the fact that the profit margin for the industry is also negative. However, considering the fact that the loan would be typically long term, it would be fair to conclude that the commodity prices would eventually recover which would bring back the company in profits again. Meanwhile, the short term liquidity is not an issue with the company. Besides, the company is one of the largest mining companies in the world with assets around the globe which should provide ample support to the lenders in case of any potential default.  Considering the above factors, it may be concluded that the company should be extended loan (Payne and Gullifer, 2015, p. 67).

Profitability Ratios

BHP avails both short term and long term financing for the business needs. However, considering the capital intensive nature of mining business, majority of the debt assumed by the company is long term. During the last two years, the company has not raised any money through the issue of shares or equity and thus all the incremental capital has been raised through the issue of debt. The change in the debt financing composition over the last two years is summarized in the table indicated below (BHP Billiton, 2016, p. 187).

The above analysis of the company has been carried out using ratios. However, there are certain limitations of this analysis which have been briefly outlined below (Brealey, Myers & Allen, 2012, p. 63-65).

• The analysis is essentially based on the past data which may not be a good estimator of the future results. This is especially true for mining companies such as BHP as recovery in the commodity prices in the near future would result in a dramatic turnaround for the company.
• Besides, the ratio analysis is based on the accuracy of the underlying financial statements. In times of distress, when the company and stock is underperforming, it is likely that the financial statements may be subject to window dressing.
• Also, comparison with the industry average may not be relevant due to the difference in accounting policies and product base of the company. For instance, it makes sense to compare BHP with Rio Tinto rather than the industry as a whole.

In the given case, the objective is to derive the value the bonds for both BHP Billiton and the competitor Rio Tinto based on the information that is summarized below.

Face value of bonds for each of the companies = $ 100

Coupon rate on the bonds for each of the companies = 8% pa

Maturity period applicable on the bonds for each of the companies = 5 years

While the coupon payment done by BHP is on annual basis, however, the coupon payments made by Rio Tinto on the bonds is on a semi-annual basis or after every 6 months.

Also, credit rating of the bond offered by BHP = A+

Further, credit rating of the bond offered by Rio Tinto = B+

The prices for the two bonds would not be identical as it is imperative that incremental risk taken by the investors should be adequately and appropriately compensated. Based on the stated facts, it is apparent that credit rating of BHP is A+ is comparison with B+ for Rio Tinto. Hence, it is apparent that underlying risk is greater for Rio Tinto as a security because of the lower credit rating. However, the coupon offered by both the companies is the same at 8%. Thus, while the risk is different on both securities, but the underlying returns are the same. In such a circumstance, if the bond of Rio Tinto is not available at a lower cost than BHP, then no rational investor would buy the Rio Tinto bond as a same coupon payment is being offered by a superior rated security, hence the investors would not have any inventive to invest in the risky asset on offer by Rio Tinto. Thus, the prices of the two securities would not be identical (Damodaran, 2010, p.153-154).

DuPont Analysis

For computing the respective prices of the given bonds, the data of yield to maturity or YTM must be utilized as the appropriate discounting factor for the expected cash flows to arise from the project.

Applicable YTM for a A+ bond with a five year maturity period = 3.50% p.a.

Applicable YTM for a B+ bond with a five year maturity period = 4.00% p.a.

The current market price of the BHP bond can be estimated using the computations shown in the table indicated below (Berk et. al., 2013, p. 105-107).

Based on the above computations, it is apparent that the bond is trading at a premium to the face value with the price of $ 120.32.

The current market price of the Rio Tinto bond can be estimated using the computations shown in the table indicated below.

Based on the above computations, it is apparent that the bond is trading at a premium to the face value with the price of $ 117.97.

The difference in the value of the bonds can be explained on the basis of the difference in the associated risk with each investments and the failure on the part of Rio Tinto to compensate the investors by offering a higher coupon rate as compared to BHP. Thus, in order to compensate for the higher default risk on account of the lower credit rating, bond of Rio Tinto would naturally be selling for a lower amount as compared for BHP which has been emphasized above also (Damodaran, 2010, p. 183-184).

The three main international bond rating agencies are Moody, Fitch and Standard & Poor.The companies make attempts to ensure that the target credit rating is maintained on the underlying debt as the credit rating tends to reflect on the default risk associated with the outstanding debt. For instance, the default risk associated with a B rated bond is higher than a corresponding bond rated A+. In wake of a higher risk of default, it is obvious that investors would demand a higher return either in the form of a higher coupon payment or by pricing the bond lower than the corresponding higher rated security (Brealey, Myers & Allen, 2012, p. 173). The net result would be an increase in the overall cost of outstanding debt. This would lead to an increase in the cost of capital since debt is an integral part of the overall capital mix. With the increase in the WACC or Weighted Average Cost of Capital, it is quite likely that the project viability may be adversely impacted and projects which would generate a higher return only would be commercially viable (Ross et. al., 2007).

Conclusion

On the basis of the above discussion, it is fair to conclude that the operational performance of BHP Billiton has undergone significant deterioration in FY2016 primarily on account of significant fall in the revenues which has resulted in below average profitability ratios and capital structure ratios. However, the liquidity ratios of the company have improved in FY2016. Even though the capital structure ratios of the company do not merit the extension of incremental financing but considering the longer horizon, nature of business and market status of BHP, it has been concluded that the loan would be extended. Also, except capital structure ratios, all the ratios are superior for the competitor Rio Tinto which implies scope for improvement going forward. Further, the ratio analysis has a host of limitations that have been indicated. With regards to valuation of bonds, it is apparent that risk and return go hand in hand. Further, since the credit rating indicates the risk of default which in turn would impact the return and the cost of capital, hence firms need to keep it under control. 

References

Berk, J., DeMarzo, P., Harford, J., Ford, G., Mollica, V. and Finch, N. (2013) Fundamentals of corporate finance. London: Pearson Higher Education

BHP Billiton (2016), Annual Report FY2016, BHP Website, [Online] Available at https://www.bhpbilliton.com/~/media/bhp/documents/investors/annual-reports/2016/bhpbillitonannualreport2016.pdf?la=en [Accessed April 17, 2017)

Brealey, R.A., Myers, S.C. and Allen, F. (2012) Principles of corporate finance. 2nd edn. New York: McGraw-Hill Inc.,US.

Damodaran, A. (2010) Applied corporate finance: A user’s manual. 3rd edn. New York: Wiley, John & Sons.

IBIS World (2017) Company Reports, [Online] Available at https://www.ibisworld.com/ [Accessed April 17, 2017]

Payne, J. and Gullifer, L. (2015) Corporate finance law: Principles and policy. 4th edn. Oxford, United Kingdom: Hart Publishing.

Roshaiza, T & Azura, S 2014, ‘Overview of capital structure theory’, Studies in Business and Economics, vol. 9, no. 2, pp. 108–116.

Ross, S.A., Trayler, R., Bird, R. and al, et (2007) Essentials of corporate finance. Sydney, Australia: McGraw-Hill Australia.

Titman, S, Martin, T, Keown, AJ & Martin, JD (2016), Financial management: principles and applications, 7th edn, Victoria: Pearson Australia,