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Profitability Ratios

Question:

Discuss About The Visible Turbulence In The Mining Companies?

The company selected is BHP Billiton which is a leading mining company based out of Australia. It was formed in 2001 as a result of the Australia based BHP group and UK based Anglo Dutch Billiton Plc. The business of the company is divided across five verticals namely iron ore, coal, petroleum, potash and copper. The company has mine presence worldwide with majority of them located in Australia, South America, USA, Canada and Africa. The company is listed on both the ASX (Australia Stock Exchange) and LSX (London Stock Exchange) and has a market capitalisation in excess of $ 110 billion (BHP Billiton, 2016). The mining sector has recently been in quite a lot of turbulence on account of the falling commodity prices. While it is a testing time for these companies, but from an investor perspective this provides an opportunity for investment. Keeping this in mind, the objective of the given report is to highlight the financial performance of the company considering the available financial statements for the last five years. Based on the analysis of the financial performance and the underlying parameters, the guidance for future financial and market performance would be offered.

For the purpose of analysis of the financial performance of the company, a period of last five years i.e. 2012-2016 has been chosen. The reason behind choosing this period is to demonstrate the linkage between the financial performance of the company and the commodity pricing cycle. In order to critically analyse the same, the key tool that has been deployed is ratio analysis. It is an enabling tool which tends to highlight the performance of the company in various aspects and has been preferred over trend analysis which does not bifurcate the financial performance in this manner. The critical analysis of the company’s financial performance through ratio analysis is discussed below.

The relevant profitability ratios for the business over the period under consideration are highlighted below (BHP Billiton, 2016;2015;2012).

The first observation from the above table is that the gross profit margin for the company is very high. However, it is an aspect which is attributed to the nature of the business and not essentially unique to the company. The mining companies tend to have gross profit margins as the raw material consumption is typically very limited. Also, it is noteworthy that that net profit is highly variable for the company. Further, the trend is net profit is also replicated in the other profitability ratios such as ROE and ROA.

Efficiency Ratios

A key aspect which drives the profitability for the mining business is the price of the commodities considering that the cost structure does not vary too much which is also apparent from the high gross margins which do not show very large variances. The respective prices for the key products mined by the company for the last three years are captured in the table below (BHP Billiton, 2016).

It is apparent from the above table that the price of nearly all products mined by the company has plummeted over the period 2014-2016.  A similar pattern is exhibited in the various profitability ratios which is primarily because the top line being a function of the commodity prices. The commodity prices plummeted during the above period owing to decreasing demand from China on account of slowdown fears. As a result, not only the prices have gone down but the offtake quantity has also reduced (Smith, 2015). Considering that the revenue would depend on both the existing commodity prices and also the offtake quantity, it is quite straightforward to understand the criticality of the commodity prices for the financial performance of not only BHP but other mining companies as well.

It is essential to realise that majority of expenses for the mining industry are of fixed nature which do not tend to decrease when the offtake quantity decrease. As a result, the profitability of the business essentially depends on the commodity cycle. When the commodity cycle is positive, the profitability margins keep on constantly expanding as the proportional expense rise is quite less. As a result, when the commodity prices are falling, the decrease in margins would also be disproportionate. The impact of this can be realised from the FY2016 performance where the company has an operating loss of USD 6.24 billion. Therefore, the loss in 2016 should not be attributed to the company doing a lot wrong but the falling commodity prices which have plummeted more than 25-30% on an average as is apparent from the above table (BHP Billiton, 2016).

However, having cited the above, it does not imply that the management has not taken measures to reduce the expense. The management has embarked upon improving efficiency by rationalisation of the expenses and this has shown results but the same would be reflected only when the revenue would be kept constant. The asset turnover trend during the given five year reflects a falling trend which to an extent is attributed to falling prices besides the postponement of the capital expenditure by the company with regards to new projects on account of slack demand and low prices. Additionally, a key aspect which is visible in the above profitability ratios is the potential that the company and business has in terms of generating profits when the commodity prices tend to favour which is apparent for 2012 (BHP Billiton, 2016;2015;2012).

Liquidity Ratios

The relevant efficiency ratios for the business over the period under consideration are highlighted below (BHP Billiton, 2016;2015;2012).

For a robust business, inventory turnover should be high as it tends to convey the ability of the business to convert the inventory into sales. For a mining business, this is typically not very high owing to the nature of the business where the ores can be mined from the mines as per the ongoing demand from the clients and hence the inventory is typically small (Damodaran, 2008). However, the steps taken by the company to improve inventory management is apparent especially from 2014 onwards. From FY2013 to FY2014, the inventory turnover has declined as the offtake was lesser than the expectations of the company due to the China factor. But the company has since adjusted to this factor and hence used prudent inventory management resulting in higher inventory turnover over 2014-2016 despite the falling commodity prices (BHP Billiton, 2016; 2015; 2012).

With regards to receivables turnover, there are only marginal changes which indicate the ability on part of the company to ensure that the collection period does not increase. Infact, during FY2015 and FY2016, the receivables turnover ratio is higher than corresponding value for FY2014 which indicates that the company has taken conscious measures at lowering the collection period (BHP Billiton, 2016; 2015; 2012). This in turn enables the lowering of the cash cycle which helps in reduction of working capital money which becomes imperative for the company when the commodity cycle is negative (Parrino & Kidwell, 2011).

The relevant liquidity ratios for the business over the period under consideration are highlighted below (BHP Billiton, 2016; 2015; 2012).

It is apparent that despite the falling prices of commodities especially from 2014 onwards, during the given period the company has witnessed a constant improvement of the current ratio which tend to assume the maximum value of 1.44 in FY2016 during the given period. This may be attributed to the reduction in current liabilities by about USD 10 billion over the given period. A majority of this decrease is on account of decrease in account payables which augers well for the reputation for the company and additionally indicates to the external users that the short term liquidity for the company is not an issue. However, to an extent, it is expected considering the cyclical nature of commodity prices which mining companies are used to (BHP Billiton, 2016; 2015; 2012).

Solvency Ratios

Considering the nature of distribution of current assets where the inventories form only a small part of the current assets, the pattern exhibited by quick ratio is also similar to the current ratio. Thus, on account of the decreasing liabilities, the quick ratio has also shown improvement over the period under consideration. Hence, on account of the above two ratios, it would be appropriate to conclude that short term liquidity for the company is not a problem as ratios in this regard have shown constant improvement (Northington, 2011).

The relevant solvency ratios for the business over the period under consideration are highlighted below (BHP Billiton, 2016; 2015; 2012).

It is apparent that debt to equity ratio mirrors the trends in commodity pricing especially during 2014-2016. The company has shown marginal improvement with regards to debt to equity ratio during 2012-2014 on back of business profitability. However, as the profits of the business are falling, the debt equity ratio is also worsening. This is especially visible in FY2016 when the equity has decreased on account to losses and also corresponding increase in debt has also been observed as the operating profits were negative. For both FY2013 and FY2016, there has been a significant increase in both short term and long term debt (BHP Billiton, 2016; 2015; 2012).

The times interest earned has also worsened. The sudden drop observed in FY2013 is on account of rising debt and consequently higher interest costs. However, the drop in times interest earned which has been observed in FY2015 is driven by the fall in operating profits as the debt levels have come down in FY2015. Hence, a worsening of interest coverage cannot be denied even though barring FY2016, the ratio remains quite healthy for other years. The long term debt to equity ratio has moved in a narrow range of 0.36 to 0.41 during FY2012-FY2015. However, for FY2016, it has shown significant increase of 13 basis points which is attributed to the decrease in shareholder’s equity on account of the losses that the company registered in FY2016 (BHP Billiton, 2016; 2015; 2012).

Conclusion

From the above discussion, it may be concluded that the financial performance of BHP Billiton is heavily dependent on the commodity prices considering that the cost structure is largely fixed and hence the overall costs do not undergo a major change. As a result, the profitability of the business is driven by the commodity price which is apparent in the period under consideration also. From 2014 onwards, the commodity prices have plummeted and hence the profitability ratios of the company have worsened leading to losses in FY2016. The other profitability ratios also are driven by the profits only. In terms of efficiency however, the company has taken measures to reduce the overall cash cycle so to keep the incremental financing needs within limits. These measures of the company have worked and improvement is visible post 2014.

With regards to short term liquidity, the company has shown improvement during the period as represented from the liquidity ratios. However, the same cannot be said about the long term liquidity or solvency. The various ratios in this regard have been deterioration especially in FY2016. However, despite the increasing leverage on the balance sheet, the financial position continues to remain strong considering the market share and the deep financial pockets. However, going forward, it is expected that the commodity prices would start improving as China is coming back on track and hence in the near to medium term, the commodity prices would firm up. Considering the performance of the company in FY2012, it may be fair to expect that the company would see better days going ahead in terms of both the financial performance coupled with market performance.

References

BHP Billiton (2013), Annual Report 2013, BHP Billiton Website, Retrieved on September 10, 2017 from https://www.bhp.com/-/media/bhp/documents/investors/reports/2013/bhpbillitonannualreport2013_interactive.pdf?la=en

BHP Billiton (2015), Annual Report 2015, BHP Billiton Website, Retrieved on September 10, 2017 from https://www.bhp.com/~/media/bhp/documents/investors/annual-reports/2015/bhpbillitonannualreport2015.pdf?la=en

BHP Billiton (2016), Annual Report 2016, BHP Billiton Website, Retrieved on September 10, 2017 from https://www.bhp.com/-/media/bhp/documents/investors/annual-reports/2016/bhpbillitonannualreport2016_interactive.pdf

Damodaran, A. (2008), Corporate Finance (2nd ed.), London: Wiley Publications

Northington, S. (2011),  Finance (6th ed.), New York: Ferguson

Parrino, R. & Kidwell, D. (2011), Fundamentals of Corporate Finance (3rd ed.), London: Wiley Publications,

Smith, G. (2015, July 24), China’s slowdown pushes commodity prices to new lows, Fortune Website, Retrieved on September 10, 2017 from https://fortune.com/2015/07/24/chinas-slowdown-pushes-commodity-prices-to-new-lows/

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