Finance for Managers
VS.
Introduction
Some financial outrages have put corporate governance in the business spotlight. Basically, the issues and interest in the subject corporate finance can be traced back at least to the eighteenth century and economists such as Adam Smith. Certainly, there is probably little new in the existing debate involving to financial negligence, except for the range of the financial and economic consequences which replicate the greater importance of finance in the current economy. The purpose of this paper is to examine the economic and financial context of corporate governance of two UK companies i.e. Barclays Plc and BP Plc. Basically, corporate governance has significant implications for the performance of the financial sector and, by addition, the economy as whole. Well-organised resource allocation is supported by strapping shareholder control rights, which assists investment in fresh development actions and confines the scope for corporate over-investment. Apparently, investment decisions are further linked to corporate governance insofar as investors prefer to invest in appropriately supervised corporations and be apt to avoid investing in ambiguous environments. In this way, the investor assurance created by sound corporate governance provisions and the security of minority shareholders encourages the financial market progress by encouraging share ownership and capable capital allocation across firms. Transparent financial reporting is necessary to sending efficient corporate governance.
For the last several years, the business industry in UK have seen the rapid growth of the number of firms offering financial situation analysis services even though we are currently in the stage of global financial crisis. Anyway, this serves as a proof that more and more organisations are realising the importance the analysis of their financial situation in order to keep up with the demands of the business world.
Background of Companies
British Petroleum (BP) Plc[1]
BP is one of Britain’s biggest companies and one of the world’s largest oil and petrochemicals groups. William Knox D’Arcy, the company’s founder, believed that oil deposits were to found in Iran so in the company’s first six decades, its prime focus lay in the Middle East. But from the late 1960s the center of gravity shifted westwards, towards the USA and Britain itself. Oil exploration and production account for 20 percent of BP’s revenues. In 2005, the firm reported a turnover of 2 billion and by December of the same year, they have 96,200 employees working for the organisation. Lord John Browne is the Chief Executive Officer of BP as of the moment. The recent 2003 merger with the Alfa Access Renova group creating the TNK-BP tie-up and the not-so-recent 1998 acquisition of the Amoco Corporation oil company has provided the groundwork for BP’s strategy in the Russian territory. As with any business deal, there have been debates on the economic rationale of the TNK-BP and Amoco deal, and Browne has been quick in justifying them.
Barclays [2]
Founded by John Freame and his partner Thomas Gould in Lombard Street in 1690, the name Barclay became associated with the company in 1736, when James Barclay – who had married John Freame’s daughter – became a partner. Today, Barclays is a UK-based financial services group, with a large international presence in Europe, the USA, Africa and Asia. It is engaged primarily in banking, investment banking and investment management. In terms of market capitalisation, Barclays is one of the largest financial services companies in the world. It has been operating for more than 300 years with 25 million customers and 147,000 employees in over 60 countries. Barclays is the 2nd largest bank in the United Kingdom, and on the global stage, the 4th largest financial services in the world by total assets (£1.40 trillion), the 25th largest in the world by Tier 1 capital (.5 billion), and the one of the largest in the world by Market capitalisation (.74 billion) (‘Top 1000 World Banks 2008’ 2008).
Discussions
Any business organisation fundamentally exists because it has certain responsibilities to fulfil for the people in the community as well as the various entities comprising it. The organisation has its human entity ranging from the staff, to the managers, board of directors, stakeholders, suppliers and so forth. All these groups have their own set of functions that contribute to the determination of the business goals, the delivery mechanisms of goods and services, and the operational patterns within the organisation. Furthermore, business organisations are part of the larger society where the markets and consumers are targeted and derived. The complexity of the internal and external surroundings of the business necessitates crucial deliberations and decisions in order to ensure the effective and continuous affairs of the organisation. The overall management of the internal and external affairs of the organisation is what basically forms corporate governance.
The Organisation for Economic Cooperation and Development (2009) defined “Corporate Governance” as the framework that directs and controls business organisations. The structure of corporate governance details the distribution of rights and the division of responsibilities among the different members of the corporation, including the board of directors, managers, staff, shareholders and stakeholders, and delineates the policies and processes for formulating decisions on matters of corporate affairs. It also provides the structure for the corporate objectives to be put in place, the means of fulfilling those objectives, and manners of evaluating corporate performance (cited in Encogov 2009).
As part of development in corporate finance, determining an appropriate value for the target company is important. Valuation is the process of calculating the value of an asset (liability). The value is the price of the asset (liability) times the quantity held. Valuations are required in many contexts including finance, property management and the antiques industry.
Generally speaking in advanced economies the valuation rests on some estimate of current price, or estimated fair price now, rather than book value i.e. book price (the latter being the acquisition cost of the asset or liability, or the depreciated book value, rather than it’s value now).
In a business industry, valuations are required for all financial assets (liabilities), for various reasons including tax, regulatory and accounting (including reporting to owners and stakeholders). The valuations are as of specified dates e.g. the end of the accounting quarter or year. They may alternatively be mark-to-market (estimates of the current value of assets {liabilities} as of this minute or this day) for the purposes of managing portfolios and associated financial risk (Luehrman, 1999).
Some assets (liabilities) are much easier to value than others. Publicly traded shares and bonds e.g. have prices that are quoted frequently and sometimes minute to minute. Other assets are hard to value e.g. private firms that have no frequently quoted price and financial instruments that have prices that are partly dependent on theoretical constructs of one kind or another. For example, options are generally valued using the Black and Scholes model, whilst the liabilities of life assurance firms are valued using the theory of present value.
It is possible and conventional for financial professionals to make their own estimates of the valuations of assets (liabilities) that they are interested in, and their calculations are of various kinds including analyses of companies that focus on price-to-book, price-to-earnings, price-to-cash flow and present value calculations, and analyses of bonds that focuses on credit ratings (e.g. assessments of default risk), risk premia and levels of real interest rates. All of these approaches may be thought of as creating estimates of value that compete for credibility with the prevailing share or bond prices (where applicable) and may or may not result in buying or selling by market participants.
The valuation of a business is a complex and time-consuming undertaking and yet the volume of business valuations being performed each year is increasing significantly. A leading cause of this growth in volume is the increasing use of mergers and acquisitions as vehicles for corporate growth. Business valuations are frequently used in setting the price for a business that is being bought or sold. Another reason for the growth in the volume of business valuations has been their increasing use in areas other than supporting merger and acquisition transactions. For example, business valuations are now being used by financial institutions to determine the amount of credit that should be extended to a company, by courts in determining litigation settlement amounts and by investors in evaluating the performance of company management. Lastly, business valuations are often required under a variety of accounting and tax regulations that are not directly related to mergers and acquisitions.
In most cases, a business valuation is completed by an appraiser or a Certified Public Accountant (hereinafter, appraiser) using a combination of judgment, experience and an understanding of generally accepted valuation principles. The two primary types of business valuations that are widely used an d accepted are income valuation and asset valuations. Market valuations are also used in some cases but their use is restricted because of the difficulty inherent in trying to compare two different companies.
The usefulness of business valuations to business owners and managers is limited for another reason–valuations typically determine only the value of the business as a whole. To provide information that would be useful in improving the business, the valuation would have to furnish supporting detail that would highlight the value of different elements of the business. An operating manager would then be able to use a series of business valuations to identify elements within a business that have been decreasing in value. This information could also be used to identify corrective action programs and to track the progress that these programs have made in increasing business value. This same information could also be used to identify elements that are contributing to an increase in business value. This information could be used to identify elements where increased levels of investment would have a significant favourable impact on the overall health of the business.
Apparently, depending on the complexity of the financial environment, in economics and finance scenario analysis can be a demanding exercise. It can be difficult to foresee what the future holds (e.g. the actual future outcome may be entirely unexpected), i.e. to foresee what the scenarios are, and to assign probabilities to them; and this is true of the general forecasts never mind the implied financial market returns (Myer, 1974). In scenario analysis “risk” is distinct from “threat.” “Threat” refers to a very low-probability but high-impact event – which cannot typically be assigned a probability in a risk assessment because it has never occurred, and for which no effective preventive measure is available. The difference is most clearly illustrated by the precautionary principle which seeks to reduce threat by requiring it to be reduced to a set of well-defined risks before an action, project, innovation or experiment is allowed to proceed.
In line with the previous discussion, the next section will be discussing the financial snapshots and evaluation of two companies in UK i.e. Barclays Plc and BP Plc.
Evaluation of Financial Details
The following report is done for the purpose of analysing the performance of Barclays Plc and BP Plc. The summary of the performance is based on the figures gathered from the companies’ financial statement for the past two years up to the current year (2005, 2006 and 2007). Furthermore, an evaluation will be given with regards to the companies’ financial snapshots.
Table 1
BP Plc. Financial Snapshot
Source: www.ft.com
Table 2
Barclays Financial Snapshot
Source: www.ft.com
In financial report, gross profit on sales is important as it reveals the profitability of a company’s core business. A company with a high gross profit has more money left over to pump into research and development of new products, a big marketing campaign, or better yet – to pass on to its investors. Investors should also monitor changes in gross profit percentages. These changes often indicate the causes of decreases or increases in a company’s profitability. For instance, a decrease in gross profit could be caused by an industry price war that has forced the company to sell its products at a lower price. Poor management of costs could also lead to a decreased gross profit. The gross profit on sales is computed by subtracting the turnover and cost of sales. Based from the figures in the financial statements, the gross profit for both companies shows constant progress. But as seen in the figures, the progress in Barclays is much better compared to BP plc. Actually, the yearly increase in the gross profit on sales of the companies will enable them to invest on future business endeavours.
Apparently, Net earnings or net income is the proverbial bottom line. It measures the amount of profit a company makes after all of its income and all of its expenses. It also represents the total dollar figure that may be distributed to its shareholders. Net earnings are also the typical benchmark of success. Interest expense refers to the amount of interest a company has paid to its debtors in the current year. Meanwhile, income taxes are federal and state taxes based upon the amount of income a company generates. Net earnings are particularly important to equity investors because it is the money that is left over after all other expenses and obligations have been paid. It is the key determinant of what funds are available to be distributed to shareholders or invested back in the company to promote growth. The annual net earnings of the company were computed by subtracting the profit before tax, interest expenses and income tax. Based from the calculated results, the companies had significantly increased its net earnings through the years.
Even though these two companies shows growth for their previous years of performance, there are problems that might occur and that is because of the current global financial crisis and the companies’ capability to allocate resources or funds are tightening because of the credit crunch. However these companies can still change the trend of economic crisis by doing some evaluation of their business strategies. It is suggested that companies should keep a close watch on its expenses for the coming years and to find alternative solution for increasing prices of raw materials and processes used for production and distribution.
Restructuring the Balance Sheet
The analysis of a balance sheet can identify potential liquidity problems. These may signify the company’s inability to meet financial obligations. An investor could also spot the degree to which a company is leveraged, or indebted. An overly leveraged company may have difficulties raising future capital. Even more severe, they may be headed towards bankruptcy. These are just a few of the danger signs that can be detected with careful analysis of a balance sheet. Thus, the structure of the balance sheet of the company should be able to present all necessary details for analysis. From the company’s balance sheet, the main parts of the report should be clearly grouped together. Assets, liabilities and equity should be arranged in this particular order. All the company’s fixed and current assets should be included in detail. For instance, fixed assets should include information about land, building, furniture and other related items under fixed assets. This also goes with current assets and liabilities. Fixed assets may also be divided into intangible and tangible ones. By filling in with this information, analysis will be easier. Moreover, possible problems can easily be spotted form a complete balance sheet. Comparison will also be easier with a complete balance sheet. This comparison may be conducted within the company’s annual reports or with other companies.
Risk Analysis
Once BP plc and Barclays plc has already identified the risk exposures to which they are involved with, the risk management process of these companies now must include the process of actual comparison of the identified risks to the tolerances of bearing those risks as defined by the stakeholders of the company. The means of the monitoring and comparison is independent of the means of the risk measurement. Some companies may opt to the exploration of alternative methods of risk measurement to enhance their learning on the way of expressing their risk tolerances.
One of the most basic forms of reporting market risk is the nominal exposure report, a report indicating the amount of capital at risk in a given exposure or portfolio of exposures. Think about a pension plan treating equity and fixed income risk as normal risks. They consider it as a need to be able to fund its obligations. Suppose a currency exposure is a risk, which deems to be unnecessary for the plan’s liability funding purposes. Therefore, currency exposure can be tracked and measured, even relative to a policy-defined maximum (Kinney, 2003).
Risk analysis within Barclays for example involves identifying the most probable threats to an organisation and analysing the related vulnerabilities of the organisation to these threats. It is detailed examination including risk assessment, risk evaluation, and risk management alternatives, performed to understand the nature of unwanted, negative consequences to human life, health, property or environment. It is also an analytical process to provide information regarding undesirable events. It is also the process of quantification of the probabilities and expected consequences for identified risks.
There are many security incidents or security-related occurrences or action likely to lead to death, injury, or monetary loss. There are many vulnerabilities in which a company or a person may be at risk. A simple approach to the planning of security requirements would be to consider the risks faced by the business from hacking, malicious users, etc. and then to ensure that these risks are mitigated. This mitigation can take the form of a risk register and plan that outlines how each risk is either accepted or addressed (Mascha, 2002). The security plan would provide for a mechanism to address the risk, to track the risk, and for communicating details to the business managers and staff involved. This is the classic risk management approach, but in the context of being effective from a business perspective it is far from adequate. A balance between business needs and protection must be achieved.
Conclusions
In any contemporary operating organisation, progress that the company is making is recorded as basis for, among a host of other essential things, decision-making and as a benchmark for measuring the firm’s performance for the period under scrutiny. A financial situation analysis is one such yardstick that documents current and future financial situation in an attempt to determine a financial strategy to help achieve organisational goals. As formally defined by Riahi-Belkaoui in 1998, financial analysis ‘is an information processing system used to provide relevant information for decision making’ (p. 1). The main sources of information for such analyses are published financial statements of the concerned company. Various accounts from published financial statements are evaluated in relation to each other to form performance indicators, which are then compared to ‘established’ standards. These performance indicators are better known as ratios, and constitute the main tools of conventional financial analysis. For the last several years, businesses have seen the rapid growth of the number of firms offering financial situation analysis services. This serves as a proof that more and more organisations are realising the importance of the analysis of their financial situations in order to keep up with the demands of the business world nowadays.
The results of the analysis carried out on financial and marketing indicated very significant effects on business sustainability, even amidst the threats of unrest. Therefore, we could conclude that the business strategies such financial and marketing could still be expected to improve business sustainability faster than average.
The review of financial and marketing’s capabilities and resources towards business sustainability revealed very little inconsistencies regarding its strategies. This is coherent with its traditional inside-out approach. However, the need to reconcile both the inside-out and outside-in approaches becomes imperative now for marketing
The analysis among financial details revealed certain gaps, most of which are biased towards the environment. However, these gaps paved the way towards determining a number of recommended strategic options to secure the business sustainability.
From the previous discussion, a number of conclusions can be drawn:
> In an age where the financial system has become simultaneously more complex and more accessible to the unsophisticated investor, it is essential that the challenge of effective corporate governance is addressed.
> Harmful incentive structures, conflicts of interests, and the absence of transparency seem to be key issues in addressing shortcomings in current corporate governance arrangements. In addition, the interests of minority shareholders have to b protected as larger investors may abuse their power. These problems can effectively be addressed by the use of forensic audits after major bankruptcies or suspected accounting frauds, by encouraging whistleblowers, by fostering of a process of diluting ancillary links between audit firms and their audit clients as well as between investment analysts and their clients. Greater transparency in the process of credit rating by the relevant agencies is also required. Other suggestions for reform include measures to tackle concentration in the provision of audit services, perhaps by lowering entry barriers.
References:
Kinney Jr., W 2003, ‘Chapter 5: Auditing Risk Assessment and Risk Management Processes’, Research Opportunities in Internal Auditing (pp. 131-160), Florida, USA.
Luehrman, A. 1997, What’s it Worth? A General Manager’s Guide to Valuation. Harvard Business Review. pp. 132-142.
Mascha, MF 2002, ‘Cost Management: Strategies for Business Decisions’, Issues in Accounting Education, vol. 17, no. 4, pp. 451+.
Myers, S. 1974, Interactions of Corporate Financing and Investment Decisions-Implication for Capital Budgeting. Journal of Finance. vol. 29 pp. 1-25.
OECD 2009, Corporate Governance, viewed 28 January 2009, Available at: <http://www.oecd.org/topic/0,3373,en_2649_37439_1_1_1_1_37439,00.html>
Riahi-Belkaoui, A 1998, Financial Analysis and the Predictability of Important Economic Events, Quorum Books, Westport, Connecticut.
‘Top 1000 World Banks 2008’ 2008, The Banker, viewed 28 January 2009.
What is Corporate Governance? 2009, Encogov, viewed 28 January 2009, Available at: <http://www.encycogov.com/WhatIsGorpGov.asp>.
[1] Information are from www.bp.com
[2] All information found in the section came from the companies’ respective websites, unless otherwise indicated.
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