Financial Management - Caterpillar Inc - Case Study Example

Financial Management Table of Content Table of Content 2 Introduction 3 Company Profile 3 Company Performance 4 Profitability 5 Liquidity 7 Financial Management Practices 12 Capital Structure 12 Dividend Policy 16 Debt Policy 18 Conclusion 20 List of References 21 Financial Management Introduction The primary aim of this report is to investigate the financial performance and practices of Caterpillar Inc. to evaluate its financial position. Therefore, the financial position of the company is analyzed using financial indicators (financial ratios). Moreover, the financial management practices company regarding its capital structure and dividend policy is also analyzed using updates financial statements. In addition, the financials and policies of Caterpillar Inc are compared with the financial performance and practices of its competitor i.e. Johnson & Johnson to compare the performance of Caterpillar with its competitors and determining financial trends prevailing in the industry. The analysis is conducting implying accounting theories and principles. Company Profile Caterpillar Inc is a leading American heavy equipment and machinery manufacturer and distributor. The company is a subsidiary of Caterpillar (CAT). The company is recognized as the leading manufacturer of construction machinery, equipment, engines and turbines. According to the Fortune 500 listing the company ranks number one among 44 industries across the globe and is currently headquartered in Peroria, Illinois (Annual Report: Caterpillar Inc., 2014). The Company was initially established in 1925 under the name of Caterpillar Tractor Company that was then re-organized under the name of Caterpillar Inc in 1986 (Annual Report: Caterpillar Inc., 2014). The primary operations of the company compresses manufacturing and distribution, having manufacturing plant located in more than 110 facilities across the globe among that 51 plants are located in United States and others are located in the different countries worldwide. In addition, the company also provides financial services to its customers in order to provide financial alternatives for the customers to acquire Caterpillar Products. The company acquires assets of net worth, more than US$89 billion with an average revenue turnover of US$55.6 billion (Annual Report: Caterpillar Inc., 2014). The growth and expansion of the company are subjected to its effective financial management practice and performance. The outlook of the financial practices and policies of the company are analyzed to evaluate financial management practices of the company. Caterpillar has constantly expanded with the passage and sustained its financial performance in different economic conditions. The company has ensured its financial practices and policies anticipating its financial positioning in the global market. Company Performance The section of the report present analyzes the financial performance of Caterpillar Inc using financial competitor Johnson & Johnson are analyzed for a comparative analysis of the performance of Caterpillar with its competitor. Therefore, financial ratios to determine financial positioning, performance and efficiency for the period of 2010-2014 are calculated to attain prevailing trends in the industry. Caterpillar Johnson & Johnson   2010 2011 2012 2013 2014 2010 2011 2012 2013 2014 Return on Capital employed 0.09 0.14 0.14 0.10 0.09 0.16 0.18 0.16 0.17 0.20 Gross Profit Margin 0.29 0.28 0.29 0.27 0.28 0.69 0.69 0.68 0.69 0.69 Operating Profit Margin 0.09 0.12 0.13 0.10 0.10 0.27 0.25 0.24 0.26 0.28 Net Profit 0.04 0.06 0.06 0.04 0.04 0.01 0.09 0.09 0.10 0.12 Quick Ratio 0.68 0.71 0.79 0.78 0.79 16.30 1.92 1.43 1.74 1.93 Returns on Asset 0.04 0.06 0.06 0.04 0.04 0.01 0.09 0.09 0.10 0.12 Receivable collection period 82.17 88.27 86.14 82.80 80.73 31.87 35.28 40.69 40.32 40.19 Inventory turnover 2.54 3.35 3.48 3.24 3.29 6.30 6.15 5.94 6.09 6.77 Payables’ payment period 70.39 68.35 52.38 45.84 54.94 109.22 102.63 98.27 102.37 122.49 Gearing Ratio 4.91 5.32 4.10 3.08 4.06 0.82 0.99 0.87 0.79 0.88 Interest coverage 11.55 18.06 18.36 12.10 11.01 36.32 28.29 29.83 38.13 39.32 Profitability The financials of Caterpillar Inc depict the profits of the company fluctuated during the period (2010-2014). In the past three years, the overall profitability of the company has declined. The decline in the operating profits of the company and decline in the revenues has influenced overall profitability of the company. The increasing competition in the industry has affected the sales volume of the company that has eventually decreased the profits of the company. However, the financials of the company reveal that the company is inclined to control its costs in order to improve overall profits of the company and enhance its operational efficiency. The returns on capital employed allow determining the efficiency of the company to utilize its capital in order to generate profits (Lee et al., 2009). It can be noted that there has been a constant decline in the ROCE of the company since 2012. It indicated that the company remains in efficient to deploy its capital to generate profit. On the contrary, Johnson & Johnson has higher returns on capital employed. The capital market had been influenced by the market conditions and market ratings that have also casted negative impact on the profits of the company. The gross profit margin of the company shows the efficiency of the company to utilize its labor and supplies in manufacturing process (Fitzgerald, 2013). The gross profit margin of Caterpillar the company is focusing to improve its gross profits (2013-2014). The company has focused to control and reduce its cost through implying lean management practices and adaption of advanced technologies that has allowed the company significantly reduce the costs of the company. The similar trends are evident from the financials of Johnson & Johnson. Operating Profit Margin measures the profitability of the company through measuring proportion of company’s revenues and cost of production (Fridson & Alvarez, 2011). In addition, it allows determining company’s pricing strategy and operational efficiency. Analyzing the operating profit margin of Caterpillar it can be determined that there has been decline in the operating margin of the company. the decline in the revenues because of the global economic market conditions decline in the consumption of mining and heavy equipments has adversely affected the revenues of the company (Annual Report: Caterpillar Inc., 2014). In 2013 and 2014, operating profit margin of the company remained 10 percent. Despite of strict control on the operating expenses of the company no significant change in the operating margin is observed. The reason for the decline in the revenues is because of the lower interest rates on retail finance receivables (Annual Report: Caterpillar Inc., 2014). It is because the revenues of the Caterpillar has significantly decline due to which the operating profits of the company. The weakness in the mining industry has lowered down the sales of the company, specifically the sales of the machinery that has lowered the sales of the company. On the contrary, increasing trend in Johnson & Johnson’s operating and net margin during 2013-2014 can be noted. The revenues of the Johnson & Johnson increased during the period, as well as effective cost management has allowed the company to control its costs and improve its profitability. Caterpillar needs to focus to increase its sales through attracting consumer across the globe in order to attain greater profits. Liquidity The financials of the Caterpillar reflect overall improvement in liquidity measures of the company. The prevailing market conditions have affected revenues of the company. The company is inclined towards accrual based transactions more and reduction in the credit sales of the company is evident. The liquidity of Caterpillar has improved. However, it is essential the company to sustain the balance between its credit sales and improve its efficiency for the collection against receivables. Therefore, it is essential for the company to re-assess it credit policies keeping in view prevailing economic conditions to overcome financial risks. The global economic condition has volatility and disrupts the capital and credit markets that have suppressed liquidity of the company. Caterpillar experience difficulty to meet its cash requirement that has adversely affected substantial liquidity of the company and deteriorate the access to credit markets (Annual Report: Caterpillar Inc., 2014). Quick Ratio determines the liquidity of the company by measuring ability of the company to its short term obligation (Lee et al., 2009). It mainly focuses on the availability of liquid assets that the company has to meet its short term obligation (Lee et al., 2009). According to the financial information it can be determined that Caterpillar is focused to improve its liquidity. The information presented in the annual report of Caterpillar highlights that the company stresses on cash based transactions more and reduction in credit sales. The financial of the company reflect that there has been a decrease of $463 million cash due to which the company is focused to focus on cash sales. In addition, the Caterpillar is facing credit rating downgrade that has increased the borrowing cost for the company. it has created an obstacle for the company to access in credit markets because of the economic deteriorate that has make the debt markets to be unavailable. The company has sufficient liquid asset to meet its short term obligation. The strict credit policies due to poor credit rating from the agencies and the market conditions the company decline in the credit sales of the company are evident. Receivable Collection Period ratio measures the collection period of the company against its credit sales (Lee et al., 2009). The receivable collection period ratio of the Caterpillar has declined during 2013-2014. The inefficiency to collect payments against its receivable may increase the chances for its creditors to go default resulting in loss. It decline in the receivable collection ratio show that the company is inefficient to extend its credit as well collect its debt (Annual Report: Caterpillar Inc., 2014). In the similar manner, decline in the receivable collection period of the Johnson & Johnson is noted; it may be because of the prevailing market condition. Hence, it is essential for the company to re-assess it credit policies to overcome the risks. The annual report highlights that the company encounters difficulty to enforce agreements and collecting receivables through foreign legal system that has created obstacles for the company to extend its credit sales. Moreover, increase in the number of default that resulted in the allowance of credit losses amounted $401 million that is 1.49 percent of the total receivables of the company (Annual Report: Caterpillar Inc., 2014). One of the reasons for the increase in the credit defaults was because of the adverse political and economic conditions prevailing in the different market in which the company operates Return of Assets determines the profitability of a company in relation with its assets. From the ratios of return on assets, the efficiency of management in usage of assets can be determined. Return on assets can be calculated by net income divided by total assets. From analyzing the data of Caterpillar from 2010 – 2015 it can be observed that the return on assets have fluctuated over the year. In the year 2010, the return on assets was 4 % which increased by 2 % in the next year and remained same for another year. In 2013, the profitability of the company in relation with its assets decreased by 2 % and remained at 4 % till 2014. The return on assets ratios determined from the data of Johnson & Johnson revealed that the company was only capable of earning 1 % of return from its assets in the year 2010. The performance of the managerial team in utilizing the assets improved as the return on assets ratio kept on increasing after 2010. In the year 2011, the return on assets ratio increased by 8 % and remained at 9 % till 2012. In 2013 and 2014, the return on assets ratio increased and was 10 % and 12 % respectively. From the data it is observed that return attained from the assets of Johnson & Johnson was much higher than that from Caterpillar. It indicates that the utilization of assets was performed in an efficient manner at Johnson & Johnson. Inventory Turnover ratio determines the number of times the inventory of a company is sold or in a fiscal year. It is calculated by dividing revenues with inventory. The inventory turnover ratio of Caterpillar is not stable and has fluctuated over the years. The inventory turnover ratio has increased and decreased over the five years and no stable trend is observed. The inventory turnover ratio was lowest in 2010 and highest in 2012 that is 3.48. In the year 2014 the ratio was 3.29. The inventory turnover ratio is less which elucidates inefficiency and deterioration of the products in the warehouse. The inventory turnover ratio of Johnson & Johnson decreased in the year 2011 and 2012 but after that it has increased. From the records of the past five years, it is observed that in 2014, the inventory turnover ratio was the highest at 6.77. In comparison with Caterpillar, Johnson & Johnson has a higher inventory turnover ratio. It means that Johnson & Johnson is comparatively more efficient than Caterpillar and its products do not tend to deteriorate in the warehouse. Payables payment period determines how long a company takes to pay to its creditors (suppliers). The formula of payables payment period is Payables Payment Period = Accounts Payable/ (Cost of Goods Sold/365) If the company takes a long time in paying back the debts then it is good because it has more working capital and free cash flow. If the company takes a very long time then it can bad as the creditors might refuse to extend the credit. In 2010, Caterpillar used to settle its debts in around 70 days but now they have reduced its time limit. Now in 2014, the time taken by Caterpillar to pay off its debts is approximately 55 days. On the other hand, Johnson & Johnson takes more time to settle the debts of the creditors. In 2010, the time taken by Johnson & Johnson was approximately 109 days and now it has increased to approximately 122 days in 2014. Gearing ratio are those financial ratios from which owners equity can be compared to the borrowed funds. It can be calculated by dividing total liabilities by total shareholder’s equity. In 2010, Caterpillar gearing ratio was 4.91 which increase in 2011 and was 5.32. In 2012 and 2013 it reduced and the ratios for these two years were 4.10 and 3.08 respectively. In the year 2014, the gearing ratio increased from 3.08 to 4.06. The higher the ratio is the company is riskier. The gearing ratio of Johnson & Johnson has been fluctuating over the past five years as over the time it has increased and decreased several times. The highest ratio value observed was 0.99 in 2011 and in 2014 it was 0.88. While comparing the gearing ratios of both the companies from the market’s point of view, it is observed that Caterpillar in much riskier than Johnson & Johnson. The liability if Caterpillar is more than its total shareholder’s equity and vice versa in the case of Johnson & Johnson. Interest Coverage Ratio is helpful in determining the credibility of a company to pay its outstanding debts. The higher is the ratio of the company the better it is. It indicates that the company can easily pay off its outstanding debts. In 2010, the Interest Coverage Ratio of Caterpillar was 11.5 which are considered to be good in the market. The performance of the company improved over the years as the ratio increased for the next two years. The ratio reached to 18.36 in 2012 which was the indicator that the company was performing well and had low interest expense and more earnings. In 2013 and 2014 the ratio has decreased which means that the performance of the company has reduced in these two years. In 2013, the ratio was 12.10 and in 2014, the ratio was 11.01 which indicates that either the earning of the company has reduced or its interest expenses has increased. The Interest Coverage Ratio of Johnson & Johnson shows that the ratio reduced in 2011 to 28.29 as it was 36.32 in 2010. From 2011 onwards the Interest Coverage Ratio of the company has improved and in 2014 it was 39.32. While comparing the Interest Coverage Ratio of both the companies it is determined that the Johnson & Johnson has a better performance in the market and it is much easier for Johnson & Johnson to pay off its outstanding debts than Caterpillar. Financial Management Practices Capital Structure Capital Asset Pricing Model (CAPM) The capital asset pricing model describes the relationship that exists between the risk and the expected return; it is used to identify the pricing of securities that are riskier. The investors of the organization needs compensation in two best possible ways the first one is that they may be interested in getting their returns in accordance with the time value of money and the second possible way is to be compensated through risk. The higher the risk the higher will be the returns of the investors. The risk free rate (Rf) represents the time value of money, it compensates the investors who have invested in the security over the period of time. It is the model the determined the relationship between risk and expected return. CAPM is used for the pricing of risky securities. The components that are used in this model are risk free rate, beta of the security, expected return. The investor needs time value of money and risk to take decisions. The time period will be helpful to investor to invest in the security and the investor will decide the time period of the security to be invested in. The investor will get an idea about the time period of holding a security with reference to the time period and compare with the premium in the market (Pahl, 2009). Advantages of CAPM Following are the main advantages of the model. Systematic Risk The model considers systematic risk with a view that investors must have diversified portfolios. Systematic risk is essential for calculating the risk involve in the acquisition of securities and investments (Hill, 2014). Realistic View It describes the relationship between systematic risk and expected return from investment. The calculation will provide realistic view and decision could be quite effective (Vidyamurthy, 2011). Superior than DGM The model is better than dividend growth model (DGM) because it only applies systematic risk. Systematic risk refers to undiversified risk that is related to the entire market segment (Sharifzadeh, 2010). Comparison With WACC It is loftier than weighted average cost of capital (WACC) because of the availability of discount rate of investments. Discount rate refers to interest rate that is used in discounting the cash flows to determine the present value of the security that has a long maturity period (Cvitanić & Zapatero, 2004). Disadvantages The model have some disadvantages that are given below: Difficulty in Calculating Risk-Free Rate Risk-free Rate Risk-free rate of return could not be determined because the government changes rate of return on daily basis according to economic circumstances. Risk-free rate of return determination is difficult for long period because of the interruption from government that changes the rate of return on daily basis (Pratt & Grabowski, 2010). Changing ERP ERP shown in the stock market is calculated on average base. There is a possibility that a stock market shows the negative return in short term and the situation might differ from the result of the return. It had been proved in past that the rate of return is not stable in the market for long period (Kürschner, 2008). Changing Values of Beta Value of Beta cannot be constant over time period. It changes over time and the result appear in the stock list have not reliability because of the change values of Beta. Rapid change in the value of beta creates difficulties in the application of Capital Asset Pricing Model. Importance of CAPM Model for Investors The model has significance for the potential investors because it contains the realistic view of the market. Availability of systematic risk will enable the investors to tackle the idea for what period the investor have to acquire the security. The investor could have the knowledge of the risk prevailing in the stock market regarding the particular security. The model is helpful in determining the position of the securities in the market and the investor could acknowledge all the significance aspects related to the purchase and holding of those securities (Essayyad, 2001). The investor could determine the time period of the securities to be held by him. The time period is effective for the potential investor because the present value is calculated to check the current position of the security held by the potential investors. The model will provide an effective suggestion to the investor to take efficient decisions for the purchase of securities from the market. An important factor that is required by the investor is to determine the effective rate of return for the investment to be made on particular security (Essayyad, 2001). The Model is also favorable to investors as it is not related to the discounting rate of the investment that represents that the present value is determined by the investor to know that if the security is to be sold before maturity, the current value of security could be obtained through the sale of that security which will be considering the discount rate. The security could be sold in the market with a deduction of discount rate from the future value of the security. It is not necessary to hold the security till the maturity date because the option is available to the investor to sell the security at any time before the maturity of that security (Essayyad, 2001). It can be represented as: Where "Rf" is the risk free rate, "β" is the beta value (that is used to compare the return on assets and the market over a time period), and "Rm" is the risk premium (formulated after subtracting the risk free rate from the Market return). In the case of Caterpillar, the values for the CAPM are: Beta 1.67 Risk free Rate (Rf) 2.45% Risk premium (Rm - Rf) 14.22% The beta value is calculated by taking the regression of all the expected returns of the company and the value is 1.67. The historical data was identified and the regression was applied to find out a single Beta value. The Risk Free rate is taken from “U.S. department of the treasury”, the Rate of return on LT Treasury Composite is taken on the date 03/17/15 (that is 2.45%). The Market premium is taken from internet sources as well, the value identified for U.S. market is 14.22%. The calculations are done on excel, using the Capital Assets Pricing Model (CAPM). By putting the values in the equation: E (R) = 0.0245 + 1.67 * (0.1422 - 0.0245) E (R) = 0.0156 + 1.67 * 0.1177 E (R) = 0.0156 + 0.196559 E (R) = 0.0212159 The value can be presented in the percentage by simply multiplying the answer by hundred. E (R) = 0.212159 * 100 E (R) = 21.21% The value of the return on assets is 21.21% approximated. This value can further be used to identify the Weighted average cost of Capital (WACC). Dividend Policy Dividend Policy is associated with the guidelines of the company that tells the amount of the earnings that the company will pay to each of its shareholder. In other words, it can be explained that the dividend policy of the company tells about the proportion of earnings the company gives to its shareholders. It is determined when the company pays off the dividend in present or future on the basis of profits (excess cash) and long-term earnings. The payment of the dividend is perceived positively by the investor and firm as it significantly impacts the share price. The companies that pay off dividends on regular basis are said to have lower risk. Walter’s Model is a dividend policy model that tells about the relevance of the payment of dividend to its shareholders on the basis of the value of share. The model explains that the dividend paid to the shareholders are mainly the reinvestment done by the shareholder in the company in order to gain higher returns. The model states that the when the rate of return of the firm is higher than the cost of capital the company should distributes profits in the form of dividends to its shareholders in order to attain higher rate of returns. On the contrary, it highlights it that when the rate of returns of the company are less than the cost of capital the company should focus on investing in the retained earnings that increases the investment opportunity for the company to yield higher returns in the future. The model stresses on the relationship between the rate of return and the cost of capital that is the main determinant of the dividend policy. The Walter’s model theory emphasizes on the basis if the relationship between cost of capital and rate of return in order to make decisions about the dividend policies. It states that the investment of the company would yielder higher benefits in the future, as well as the dividends paid out when the rate of return is higher than the cost of capital the potential returns from the capital is more than returns attained from the shareholders. r>ke zero payments and more investment r Read More