Financial Analysis of British Petroleum from Shareholders Perspective - Case Study Example

Financial analysis of British Petroleum from shareholder’s perspective Financial analysis of British Petroleum from shareholder’s perspective Introduction BP PLC or British Petroleum, originally registered in 1909 by the name Anglo Persian Oil Company that was renamed as Anglo Iranian Oil Company in 1935 and changed to British Petroleum Company Limited in 1954. In 1982, it became British Petroleum PLC which was changed to BP Amoco when it was listed as one of the largest oil companies globally after merging with Amoco Corporation of the United States (US). In 1955, BP became a holding company and in 1980s, it became a private company as British Government sold all the shares of the company. Till date, the company has acquired a number of companies for expansion of its business. The acquisitions include Britoil Plc, Burmah Castrol and Atlantic Richfield Company, which are independent oil and gas companies (“History of BP”). Over the years, British Petroleum has developed numerous oil fields and built refineries in different countries such as Alaska and the United Kingdom. The company is headquartered at London and presently listed at London Stock Exchange, New York Stock Exchange and Frankfurt Stock Exchange. The company has operations in approximately 80 countries and employs about 80,000 people. Presently, BP is one of the most powerful companies in the oil and gas industry. The operations of the company can be segmented in upstream and downstream and is classified as exploration, refining, distribution and trading of petrochemical products along with power generation. The company went public in 1954 and presently has a market capitalisation of £ 89, 083.25 as per the London Stock Exchange (“BP Worldwide”; “About BP”). Post the brief introduction, it is important to evaluate the performance of the company from shareholders’ perspective so that it can be determined whether a shareholder should hold and buy more shares of the company. In the following sections, the financial position of the firm will be evaluated critically using ratio analysis and analysis of company’s capital structure so as to ensure that if and when shareholders consider continuing their ownership at BP, it should be a right decision. Additionally, to understand performance of company’s stock, stock analysis will be conducted for last five years. Ratio analysis Ratio analysis is quantitative measure that aims at establishing relationship between different components of financial statements, namely, balance sheet, profit and loss statement and cash flow statement. Ratio analysis is undertaken for assessing a firm’s operational and financial performance in terms of efficiency, liquidity, profitability and solvency. For the purpose of ratio analysis, last five years’ data have been taken in consideration with respect to British Petroleum (Alexander 10-68; “Financial and Operating Information 2009-2013”). Liquidity ratio Liquidity ratio reflects the short term position of a firm. In other words, it measures a firm’s ability to meet its short term obligations smoothly. Two prime ratios measure the liquidity position of a firm, namely, current ratio and quick ratio. Current ratio The current ration is also known as working capital ratio as it compares total current asset and total current liabilities of a firm to determine firm’s ability to discharge its short term obligations. Current assets mainly include assets that are in the form of cash or cash equivalent (Will, Subramanyam and Robert 25-123; Penman). In figure 1, the current ratio of BP for past 5 years have been presented graphically. The current ratio of the company fluctuated between 1.14:1 in 2009 to 1.33:1 in 2013. The accepted standard is 1.33:1, therefore, it can be suggested that the company well positioned to payback its short term obligations. Figure 1 (Source: Author’s creation) Quick ratio Quick ratio or acid test ratio is considered more effective than current ratio as it highlights whether a firm is able to pay off its short term liabilities immediately. For this purpose, only those current assets which are most liquid (can be readily converted to cash) are taken in consideration and assets such as short term investments, prepaid expenses and inventories are excluded (Will, Subramanyam and Robert 25-123; Penman). The benchmark for quick ratio is 1:1, which has been consistently maintained at BP for past 5 years despite fluctuation in the quick asset and current liabilities (Refer to figure 2). Thus, it can be suggested that overall short-term financial position of the firm is quite satisfactory. Figure 2 (Source: Author’s creation) Long term solvency ratio The long term solvency ratio is also known as capital structure ratio because it helps in examining the solvency position of a firm in long run. The parties that are interested in long term solvency ratio of a firm include investors, debenture holders and financial institutions. Using long term solvency ratios, a firm’s ability to pay interests timely is judged. The capital structure ratios include debt equity ratio, debt to total fund ratio, capital gearing ratio, fixed asset to proprietor’s fund ratio and interest coverage ratio (Lev 149-151; Penman). Debt to equity ratio The debt equity ratio aims at establishing a relationship between the shareholder’s fund and long term liabilities such as borrowings, debentures and others, on which a company pays interest on regular basis. The acceptable debt equity ratio for any company is 2:1, any value above the same is considered risky and it is assumed that the firm is leveraging more than its net worth (Penman). In figure 3, it was ascertained that the debt equity ratio of BP has not crossed 1:1 in past five years. Debt equity ratio less than 2:1 (in this case 1:1) expresses that long term lenders of the company are secure from default risk and other external vulnerabilities. Figure 3 (Source: Author’s creation) Debt to total fund ratio The debt to total fund ratio represents the net percentage of debt in the total fund of a company. This ratio is significant for a company as well as its stakeholders because it represent risk position of the firm. In this context, it is noteworthy that high debt represents high risk for a firm. The benchmark for this ratio is 33%. In other words, a firm’s debt capital should not be more than 33% of the total fund of the company (Penman). In British Petroleum, the debt to total fund ratio has been varying between 40% and 50% during the period between 2009 and 2013. It was calculated that the company had lowest debt to total fund ratio in 2009 and highest in 2010. It was ascertained from the balance sheet of 2010 and debt to total fund ratio that the company’s reserves and owner’s capital was comparatively less. Moreover, the company encountered one of the greatest oil spills in Mexico resulting in heavy payment as penalty and charges related to restoration of natural balance in the Gulf of Mexico. Post 2010, the percentage of debt exhibited a declining trend. Figure 4 (Source: Author’s creation) Capital gearing ratio The capital gearing ratio represents relationship between the equity capital including reserves and undistributed profit and fixed cost bearing capital, that is, capital on which a company pays interest such as debentures and loans. A company is known as high capital gearing company if its fixed cost bearing capital is greater that equity capital, otherwise the company is referred as low capital gearing company (Lev 149-151; Penman). The capital gearing ratio of BP is represented in figure 5. It was observed that by British Petroleum is a low geared company as its foxed cost bearing capital is relatively lower than the equity capital. The low geared status of the company highlights that the company has greater amount of common stockholder’s equity. In context of shareholders, purchase of shares of BP can be considered as a less risky venture and even at the time of low profit, the company will be able to pay dividend to its shareholders. Figure 5 (Source: Author’s creation) Fixed asset to proprietor’s fund ratio This ratio is also referred as fixed asset to net worth ratio and it is an indicator of the proportion of new worth that has been invested in fixed assets of the company. In this context, it is important to note that a company generally purchases fixed asset using proprietor’s fund. If the proprietor’s fund is more than the net fixed asset then the residual amount can be invested in working capital. Overall, it highlights the long term financial soundness of the firm (Lev 149-151; Penman). In BP, contradiction to the general notion regarding fixed asset to proprietor’s fund can be observed. In figure 6, it can be seen that the company has fixed asset worth more than its shareholders capital. It can be deduced from the graph that the company is relying on external fund for purchasing its fixed asset as shareholders fund does not suffice for funding the same. Figure 6 (Source: Author’s creation) Interest coverage ratio The interest coverage ratio, otherwise known as debt service ratio, establishes a relationship between a firm’s net income before tax and interest and the fixed interest payable with respect to various debts. This ratio is significant to long term lenders, debenture holders and financial institutions as it reflects whether a firm will be able to furnish its interest payable with its net earnings before tax and interest. The higher the ratio, the better it is considered for a firm. However, a minimum of 6 to 7 times is considered most appropriate (Penman). The interest coverage ratio of British Petroleum has been represented in figure 7. The graph shows that except for the year 2010, when the company faced financial and ethical problems due to oil spill in the Gulf of Mexico. The interest coverage ratios have been highly stable. Therefore, it can be suggested that the company has been sufficient revenue to cover its fixed interest charges. Figure 7 (Source: Author’s creation) Activity ratio Activity ratios generally highlight the effectiveness of a firm in managing its assets. These ratios measure the firm’s capability to convert various accounts within the balance sheet into revenue. From investors’ perspective, activity ratios are important because these ratios reflect the efficiency of a company’s management in employing resources in fixed asset and working capital for generating profit. The important activity ratios are stock turnover ratio, debtor turnover period, fixed asset turnover ratio and working capital turnover ratio (Lev 149-151). Stock turnover ratio Stock or inventory turnover ratio represents the relationship between cost of sales of a firm and average inventories maintained during the year. The primary reason for using this ratio is to ensure that the firm has been utilizing its resources efficiently. There is no benchmark for this ratio but generally a high ratio is preferred (Nissim and Penman 109-154). In context of BP, the stock turnover ratio has been present in figure 8 where it can be seen that the stock turnover ratio of the company has been around 10. Generally a low turnover ratio reflects that a firm is unable to clear it stock by selling it. Keeping in view the growing demand of oil and position of BP as a global oil giant, it is natural for the company to have a high turnover ratio. Figure 8 (source: author’s creation) Debtor turnover period Debtor turnover ratio represents relationship between debtor and receivables and net sales. Debtor turnover period is the velocity with which debtors pay back the credited amount to the company. A high debtor turnover ratio and low debtor turnover period is considered favorable as it exhibits the efficiency of the credit policy of a firm. On the other hand, a low debtor turnover ratio and high turnover period represent poor debtor management on the part of the firm (Nissim and Penman 109-154). The debtor turnover period of BP has been represented in months in figure 9. It can be seen that the debtors of the company clear all the payments within approximately 2 months or less. This trend has been maintained for last 5 years and it reflects strong credit policy on behalf of the company. Since shareholders are co-owners of the company, an efficient credit policy is expected to influence them positively for making more investment. Figure 9 (Source: Author’s creation) Fixed asset turnover ratio Fixed asset turnover ratio is considered as one of the most essential ratio under the activity ratios for a company. The fixed asset turnover ratio represents the efficiency with which a firm employs its fixed asset to increase its revenue. This ratio is considered most useful in manufacturing related organization because these companies invest heavily in fixed assets (Kaufmann, Gadmer and Klett 213-250). BP is a reputed company in the oil industry and fixed asset turnover ratio is very important for it given its nature of activities. The company is involved in exploration, refining and distribution of oil and other petro-chemical products therefore has heavily invested in fixed assets. The fixed asset turnover ratio of the company in figure 10 shows steady growth in last 5 years with minor fluctuation from 2012 to 2013, which implies that the company has been efficient utilising its fixed assets for increasing revenue. Figure 10 (Source: Author’s creation) Working capital turnover ratio Working capital is defined by the difference between current asset and current liabilities. The residual amount of current asset after paying off all current liabilities is known as working capital because it helps a firm funding its day to day operations and purchasing inventories. Working capital is important for a firm because it strengthens the short term solvency position of the firm and makes uninterrupted production feasible. The working capital turnover ratio establishes relationship between working capital of a firm and conversion of the same into sales revenue. The working capital turnover ratio is useful because it represent whether the fund for operations is being utilized effectively for generating revenue (Will, Subramanyam and Robert 25-123). In figure 11, the working capital turnover ratio of BP has been present. The graph suggests that during 2009-2011 the company had a high working capital to sales conversion ratio which decline greatly in 2012. The possible reasons can be dropping demand in the overall industry, increased cost of oil and increased market competition. However, in 2013 the ratio has improved by approximately 44% (refer to excel sheet). Figure 11 (Source: Author’s creation) Profitability ratio The primary objective of any business concern is to earn profit and also to ensure that the profit is sufficient to cover the capital invested and various risks associated with the business. The profitability ratio, often referred as income ratio, is the measure of efficiency of a business in terms of profitability. The profitability ratios generally focus on whether a firm is earning adequate profit, the present gross and net profit and growth in the same in recent years and the returns firm is earning on capital employed and shareholders fund. The ratios that will be considered in this paper are gross profit ratio, net profit ratio, return on capital employed and return on shareholders’ fund (Will, Subramanyam and Robert 25-123). Gross profit ratio Gross profit denotes the basic profit that a company earns after deducting various costs associated with production and sales from revenue. It is the marginal difference between cost of sales and total revenue. The gross profit margin measures the margin of total profit available on the revenue. There is no benchmark for this ratio; however, a higher ratio is generally preferable. The gross profit margin should be high enough to cover operating expenses as well as depreciation, interest charges, dividend and creation of reserves (Will, Subramanyam and Robert 25-123; Nissim and Penman 109-154). The gross profit ratio is one of the important performance measures of a company and is used to compare performance of the company for recent years. In figure 12 the gross profit margin for BP has been studied for last 5 years. Figure 12 (Source: Author’s creation) In the graph, it can be ascertained that the gross profit of the company suffered a sharp decline as high as 111% in 2010 due to the major oil spill in Gulf of Mexico which cost the company an operation loss of £ 2364.44 million. Post 2010, the company has exhibited strong growth in terms of profit but the same has shown a good amount of variation in last 3 years. The reasons can be attributed to turbulent market, increased competition and lower product cost due to growing number of substitutes. Net profit ratio Net profit or net income defines a firm’s residual earnings for a year after paying various operating cost, interest and taxes. The net profit is used by a firm to pay dividend to its shareholders, create reserves and surplus or retain it in the business. Net profit is generally lower than gross profit because it is the real profit that a firm earns after paying off all the expenses. The net profit margin establishes relationship between net profit and sales (Will, Subramanyam and Robert 25-123; Nissim and Penman 109-154). Figure 13 (Source: Author’s creation) The net profit ratio of BP has been represented in figure 13. The net profit ratio shows similar trend as exhibited by the gross profit. However, the ratios are relatively better than the gross profit ratios. Hence, it can be established that the company managed to minimize its operating expenses so as to improve its net profit even when the gross profit was low. Return on capital employed The return on capital employed reflects overall profitability of a firm. It is also known as yield on capital. In this context, it is important to note that capital employed comprises a total of long term debt and shareholders fund. The ratio represents the relationship between profit before tax and interest and total capital employed by a firm. The main purpose of calculating return on capital employed is to assess the effectiveness of a firm in employing its capital to earn maximum profit. Return on capital employed has a great impact on profit maximization and shareholders wealth maximization (Sharpe, Alexander and Bailey 28-97; Will, Subramanyam and Robert 25-123). Figure 14 (Source: Author’s creation) It can be observed in graph presented in figure 14 that British Petroleum had earned about 10% return on invested capital in 2009 which declined significantly due to the oil spill situation in 2010. Despite the problem and cost associated with it, the company managed to earn about 9.55% in 2011 following by minor fluctuation in 2012 and 2013. It can be ascertained from the situation that the company is still coping with the losses related to the tragedy resulting to lowered return. Return on equity shareholders’ fund Return on equity shareholders’ fund is one of the essential ratios that highlight profitability based on investment made in business. This ratio is of utmost importance to shareholders because it informs them about earning capability of their fund in the business as well as efficiency of the management to utilize the capital resources. Unlike return on capital employed, this ratio takes in consideration only equity capital and net profit. The rationale behind considering net profit over gross profit is that the shareholders have a claim on the earnings only when all taxes and interests have been paid off (Sharpe, Gordon and Bailey 28-97; Will, Subramanyam and Robert 25-123). Figure 15 (Source: Author’s creation) The return on shareholders’ fund of British Petroleum for past 5 years has been represented in figure 15. The return can be seen to exhibit similar trend as it was observed in return on capital employed. However, it can be observed that the returns have been comparatively high except for 2010 and 2012. Therefore it can be assumed that company is putting best effort in maximizing return on shareholders’ interest. Share price analysis Given the large volume of data regarding share prices of the company for past five years, the opening and closing price of each year has been considered and analyzed. The graphical representation of difference in opening price (January) and closing price (December) for five years from 2009-2013 is shown in figure 16 (“BP PLC: Fundamentals”; “BP: Stock report”). Figure 16 (Source: Author’s creation) The graph shows that the difference of opening and closing gap was highest between 2009 and 2010. It was further observed that although the stock price fluctuates from time to time, post April 2010 the stock price of the company dropped severely. The reason that can be attributed to such a price fall is the Gulf oil spill. The oil spill is considered as the largest manmade disaster in the history oil industry as a result of which the company was almost on the verge of closing down by the US government citing reasons such as unethical business practices. By 2011, the stock price grew slightly (by about 5%) but the slump continues till then end of 2012 as the company was under trial during these 2 years at different national courts. In figure 17, it can be observed that the average price of the shares of BP declined from 2009 to 2012 but in 2013 the price show mild growth. Since 2013, it can be expected that the share price will be improving eventually and the reason can be the measures taken by the company to improve environmental condition in the gulf area (Cooper and Nakanishi 19-49). Figure 17 (Source: Author’s creation) Dividend and earnings per share analysis Dividend is defined as a certain portion of profit that a company pays to its shareholders as a token of appreciation for holding ownership of the company. Dividend is an important factor for shareholders because it motivates them to make further investment in the company. The dividend paid by BP to its shareholders has been graphically represented in figure 18. Figure 18 (Source: Author’s creation) It can be seen that in 2009 the company paid about 36.42% of dividend for each share. The tragedy faced by BP in 2010 did not prevent the company from paying dividend to its shareholders, even if it was as low as 8.68% that year. It can be further seen that the dividend percentage has improved since 2010. This suggests that the company is concerned about its shareholders and will continue to take measure to maintain its credibility. Earnings per share (EPS) represent the amount of net profit that can be allocated to each outstanding share of the company. In this context, it is important to note that EPS is different from dividend in terms that dividend is a certain percentage of the net profit that is distributed among shareholders while EPS is not actually realized by shareholders because the total profit is not generally distributed by a firm. In figure 18, the EPS of BP has been presented. Figure 19 (Source: Author’s creation) It can be studied in the above graph that the EPS of BP plunged as low as 12.65% negative in 2010 because during 2010 the company’s profit was in negative. Since 2011, the net profit has been exhibiting variation due to various unfavorable external conditions. Taken in consideration the EPS and Dividend per share, it can be concluded that the company valued its shareholders’ interest above its own financial position. Aligning financial objective of British Petroleum with the personal objectives of shareholders The primary goal of BP is to be one of the globally present oil and gas companies that believe in delivering value over volume. This strategy is being fulfilled by the company by setting clear priorities, active management of quality portfolio and maximum utilization of distinct capabilities of its resources. The financial objective of the company is to enhance shareholder value through creation of sustainable free cash flow (“Our strategy”). Shareholders generally invest in shares of different companies so as to maintain an additional source of income. It can be assessed that investment in shares involve a certain degree of risk but the returns are better than rate of return provided by banks on deposits. Investing in shares of a company requires the shareholders to take a certain degree of calculated risk. Though higher risk is often related to higher return, uncalculated risk may result in failure as well (Carroll and Buchholtz 15-85). If the portfolio of BP is considered for past five years, it will be observed that the company values its shareholders above its finance position. Dividends were paid to shareholders even when major loss was faced in 2010 by the company. The company’s goals suggest maximization of shareholder value and the same is reflected in the activities of the company. Keeping aside the tragedy related to Gulf of Mexico, the company’s overall operating and financial performance is worth praising. In this context, it is worth mentioning that the oil spill was an accident and not an intentional activity. Moreover, the company has taken measures and has been spending sufficiently to mitigate the effect of the tragedy on the natural habitats and people residing in the area (“Gulf of Mexico restoration”; “About BP”; Pearson “The spill: How much should BP suffer?”). From financial perspective, the performance of the company can be observed in the various ratios that have been discussed earlier. The company has strong short term as well as long term solvency position which are very essential for surviving in an industry with cut throat competition level. Hence, it can be suggested that the company’s objectives do align with that of shareholders. Reasons to buy/ sell/ hold shares of British Petroleum British Petroleum is one of the global leaders in the oil industry having operations in multiple countries. The reason for which shareholders invested in the company is its brand value and brand reputation. It was gathered during the study that in recent years, the company underwent a turbulent situation financially as well as from environmental perspective when oil spilling accident occurred in the Gulf of Mexico. A number of shareholders sold their shares in anticipation that the company will not be able to recover from the losses or might be shut down under governmental pressure as well. The company not only recovered from this situation but also took care of the aggrieved parties and its shareholders. If the ratios are studied well, one can find that despite negative EPS, the company paid about 9% Dividend to its shareholders. The company is very focused on maximizing its shareholders’ interest and the same are reflected in its return on shareholders’ equity (“About BP”; Pearson “The spill: How much should BP suffer?”). Apart from the tragic incident, the current market situation is also turbulent. Widespread recession can be observed as well as the price of crude oil and petro-products are also decreasing. The oil industry has become highly competitive because of entry of a number of Middle Eastern oil companies. Impact of all these factors are reflected on the overall performance of BP in past few years yet its performance ratios show growth trend. Therefore, it can be recommended to shareholders that they should invest in BP but not without evaluating the overall risk position of the investment (Johnson 1166-1168; Levy and Kolk 275-300). Works Cited “About BP.” British Petroleum. British Petroleum, 2014. Web. 3 September 2014. Alexander, Carol. Market models: a guide to financial data analysis. 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