Introduction
Capital structure refers to a company’s alignment of the long-term and short-term debts, common equity and the preferred equity. The term also include the analysis of how the company decides on how to allocate the cash flow into various components including a portion that is allocated to meet the financing needs of the debt capital and the other portion that is allocated to the shareholders as part of the dividend. Capital structure is a subset of the financial structure. Financial structure refers to the relative proportion of the various sources of finances that are used in the business operations. Capital structure thus covers the long-term sources of financing. It is usually made up of the debt and equity securities that are used in financing the company assets. Thus, capital structure only includes the long-term financing, preferred stock and net worth. The capital structure does not include the short-term financing. Each component has its own associated costs and thus in practice and in a generalized form, the capital structure includes the funds that are supplied to the business operations by either the owners of the business or by the creditors. Therefore, a question arises as to what would represent an ideal proportion of the two sources of finance. The proportion is usually determined by the individual company and thus it is specific to a particular company.
Definition
The general definition of the capital structure is the proportion of the long –term sources of finance that are utilized by the firm. It is made up of the debts and equity securities and refers to the permanent source of finance. This essentially includes the long term debts, preference shre capital and shareholders’ funds. There are various other definitions that have been proposed by various scholars. An example is Gerestenberg who defined capital structure as “a company refers to the composition or make up of its capitalization and it includes all long term capital resources viz., loans, reserves, shares and bonds.” Keown et al. defined capital structure as, “balancing the array of funds sources in a proper manner, i.e. in relative magnitude or in proportions.” Thus, the capital structure revolves around how the funds that are sourced from various sources are divided into either debt financing or equity to the company shareholders.
Financial managers are tasked with the roles of determining the ideal mix of the equity and debts financing. A general rule is that the mix should be such that they serve the interest of the shareholders. Thus, instead of the company raising the entire finance through shareholders contribution, a long-term loan though corporate bonds or debentures and a fixed payable amount is committed towards the loan repayment and as well the interests. The amount is basically an expense to the company, but it is an important tool that helps the company to achieve its goals (George).
Importance of capital structure analysis
Thus, capital structure is designed to enhance value optimization, cost minimization, increasing the value of the shareholders, tapping into the investment opportunities and growing the overall value of the investments (About Money).
Objectives
This paper will thus analyze the capital structure of BeWang International (Group) Holding Limited and compare the structure to three other companies that are in the same industry. The analysis will include a vertical analysis over a five years period and a horizontal analysis and comparison with other companies that are in the same industry. The overall aim of the paper is to assess the effectiveness of the target company capital structure and compare it with peer companies in the same industry.
Target Company (BeWang International (Group) Holding Limited)
The company’s core brand is Chinese Herbal Medicine guided by a corporate culture that is termed as “Culture of Chinese Herbal Medicine.” The company has managed to create its profile as one of the leading manufacturer of Chinese herbal medicines and has managed to expand its brand to the Chinese nationals. The company has embarked on research and development in an effort to push its products to the international market. We shall analyze the company capital structure based on the five years (2011-2015) financial statement below.
The capital structure is determined by assessing the portion of the company equity that is funded by long-term debts and comparing that with the portion that is being funded by the shareholders equity. Most companies work on the assumption that they will be able to generate more income than the interest expense incurred on the borrowed capital. Thus, they leverage the assets on the debts. For the investors, the more the company assets are leveraged, the weaker the company balance sheet. Thus, the process will involve taking all the company capital components in the financial statement. Then, we shall compute the percentage of the total capitalization that is represented by each capital component. Then, finally we shall evaluate the portion of the capital that is leveraged and expressed as debt to equity ratio.
Financing the company assets and operations with either debts or equity has far reaching consequences. These impacts affect the overall health of the company finances. The table below shows the company financing summaries for the five years period.
The above table shows the company debt to equity ratio over the past five years. The figures are based on the company audited financial reports. Based on the results from the above computations, the company debt to equity ratio has been increasing over time. The implication is that the company is getting more and more leveraged over time. This is an indication of a deteriorating balance sheet. The amount of assets that have been purchased on debt is increasing day after day. Another contributing factor is the company deteriorating performance over the period under review. In 2010, BeWang made a loss of (134,131). The figure went up in 2011 making a loss of (618, 537). The company has continued to accumulate more losses over the five years period and by the close of the period under review, the company had depleted its total profit reserve. Thus, as a way for it to continue in operation, it had to seek financing from other sources (BeWang International (Group) Holding Limited).
Capital Structure Analysis
The company has employed three major theories in its capital structure over the last five years. These theories have seen it survive over the years. According to the financial reports, between 2011-2013, the company had a small debt to equity ratio. By this, it made use of the Pecking-order theory which allowed the firm to sort capital for its new projects from its own revenue. It never borrowed loans from banks. However, between the year 2014-2015, the company’s debt to equity ratio increased to 0.301 and 1.309 respectively. One could suggest that the ratio in 2014 was promoted by the take-off theory made the company accumulate debt while at the same time taking care of its capital structure. It took a cautious step to balance between the leveraged assets and the debt.
In 2015, the company accumulated huge debts as the debt to equity ratio stands at 1.309. It is a massive debt, and the company has to keep borrowing in order to remain operational. As a result, the company is now using the Modigliani and Miller's Capital Structure theory. It has to depend on external funding but still, its total worth remains at stake since the company will eventually it assets to the liabilities side of the balance sheet. With time, the company may be declared bankrupt.
Calculations
Capital Structure =( DD+E )
=99015/293398
=0.3374
MV of equity of target company = VL – D
While;
VL = Leveraged Firm value = Vu + Tc × D
Ku = ROE before tax of low or no debt company (Refer to point a2)
= Profit before tax of low or no debt companyEquity =1444864/1889066 =0.09867
Vu = Unleveraged Firm value = Profit before tax of target company × (1- Tc)WACC = KuVu = 1444864× (1-0.09867)/0.09867 = 1319846
Tc = effective tax rate of target company = Income tax expense of target companyProfit before tax of target company
Tc = 142,572/1444864 = 0.09867
VL = 1319846 +0.09867 × 99015 = 1,329,615.81
MV = 1,329,615.81 – 99015 = 1,230,600.81
Sanofi S. A Company
It is a French based company that offers pharmaceutical services worldwide. It is a multinational company and was founded on 20th August 2004. Its major products include, over the counter drugs used to treat cardiovascular disease, oncology, disorders in the central nervous system, thrombosis, and vaccines among other types of drugs ("Sanofi - A Global Healthcare Leader Focused On Patients’ Needs"). The company debt to equity ratio was computed as follow:
Debt to equity = Total Debts / Total Equity
= (Current portion of long-term debt + Long-term debts) / Total Equity
= 18.09594/ 63.45 = 0.2852
The above results show that the company has a moderate leverage on equity. The company seems to use its assets to finance its projects since its revenue is not enough. Also, company policy could be the reason for such a move
Calculations
Capital Structure =( DD+E )
= 18.09594/ 18.09594+63.45
= 0.22191
Vita Green Health Products Co, Ltd
In this section, we shall compare the company debt to equity ratio to another company operating in the same market and offering similar products. Vita Green Health Products Co., Ltd is our comparison company. The company was established in 1993 and has two factories operations in Hong Kong. The company has managed to push its products in the local market and as well in the international market. One of the major brands that is distributed by the company include Doctor’s Choice vitamins that are available throughout the country and in Chinese traditional medicines. The company has operations in Asia, Europe and the United States. The company has received various award for its innovativeness in the brands and marketing campaigns.
Based on the 2015 financial statement, the company debt to equity ratio was computed as follow:
Long-Term Debt to Equity Ratio =
Total long term liabilities / Total stockholders equities
= 537,624 / 956,887 = 0.56
Based on the above computations, Vita green has a debt to equity ratio of 56%. This is an indication that the company has a strong balance sheet as compared to BeWang and thus, not much of its assets are leveraged. The high debt to equity ratio is attributed to the fact that the company has not been performing well in the last 3 years. The company has been making losses and thus, the accumulated losses have eaten into the shareholders equity. This is in line with the industry trends and the companies in this sector have been making losses. In a bid to improve its performance, the company is planning to carry out marketing campaigns that will steer it to the next level.
Calculations
Capital Structure =( DD+E )
= 537,624/537,624 + 956,887
= 537,624/1,494,511
= 0.3597
In establishing a global benchmark, we took three companies that are in the household items and computed the debt to equity ratio as follow:
Reckitt Benckiser Group PLC
This is a British multinational company that has its headquarters in London. The company produces health, hygiene and home products for markets around the world. The company was established in 1999, following the merger of Reckitt & Colman plc and Benckiser NV. This was a strategic decision that was meant to foster cooperation in the fields of research and development and as well in the marketing. The move also opened new markets for the products and on overall reduced the cost of production. The company major brands include dettol, strepsils, veet, air wick and durex among others. The company debt to equity ratio is computed as below.
Debt to equity = Total Debts / Total Equity
= (Current portion of long-term debt + Long-term debts) / Total Equity
= (2618+1004) / 10,335
=0.35
Calculations
Capital Structure =( DD+E )
= 3622/ 13957
= 0.36
Unilever PLC
Unilever is a Dutch company that is headquartered in Netherlands and London UK. The company products include food, beverages, cleaning agents, households and personal care products. The company is the third largest consumer care products after Proctor and Gamble and Nestle by revenues. The company products are sold in over 190 countries throughout the world. Its flagship brands include Omo, Blueband, Lux, Rexona, Dave, Knoor, and Royco among others. The company has been in operations since 1870s. We computed the company’s debt to equity ratio as follow:
Debt to equity = Total Debts / Total Equity
= (Current portion of long-term debt + Long-term debts) / Total Equity
= (0 + 0) / 16, 818
= 0
Calculations
Capital Structure =( DD+E )
= 0
Johnson & Johnson Inc.
Johnson & Johnson Inc. is an American multinational company that manufactures and distributes pharmaceuticals, household products, first aid products and other consumer products. The company was founded in 1886. The company flagship products include bandages and Johnson baby care products including lotion, jerry, and soaps. The company debt to equity ratio was computed as follow:
Debt to equity = Total Debts / Total Equity
= (Current portion of long-term debt + Long-term debts) / Total Equity
= (3116 + 20,233) / 72,647
= 0.32
Calculations
Capital Structure =( DD+E )
= 23349/ 95996
= 0.24
Theoretical Share Value
The theoretical share value of the company is computed based on the Modigliani and Miller theory. Thus,
Ku = ROE = Profit before Tax / Equity
= (110,578) / 41332
= -2.68
Tc = Effective Tax rate of the company
= Income Tax Expense of the Target Company / profit before tax for the target company
= 0
The company made a loss in the period under review and thus no tax expense was incurred.
Vu = Unleveraged firm value
= Profit before tax for the target company * (1-Tc) / WACC
Where, WACC is the weighted average cost of capital computed as follow:
Where:
Re = cost of equityRd = cost of debtE = market value of the firm's equityD = market value of the firm's debtV = E + D = total market value of the firm’s financing (equity and debt)E/V = percentage of financing that is equityD/V = percentage of financing that is debtTc = corporate tax rate
= 16
= 110, 578 * (1-0) / 16% = 691,112
Vl = Vu + Tc * D = 691,112 + 0 * 56,977 = 691,112
Based on the above analysis, the company capital structure is such that they have a mix of both the debt and equity financing. However, over the five years period, the target company financial performance has depreciated and thus forcing the company to shift the focus to the debt financing. An analysis of the other companies within the industry indicates that the company’s capital structure is split between debt and equity financing. The companies that have strong balance sheet opt to finance their projects from their equity. An example is Unilever which had nil long-term liability. The industry average is about 0.28. Comparing this value to our target company value of 1.379 at the close of year 2015, this is an indication the BeWang is performing below the industry average. The company thus will require a strategic analysis and a plan that will change way the company is operating and improve the performance. Another focus should be on the company expenses. This is to ensure that the company balance sheet remains strong and the company retain some reserves to finance its goals. Weak balance sheet will affect the credit worthiness of BeWang and thus in future, it may not be able to secure finances for the general operations. As an investor, BeWang financial performance show continued decline in the company profit.
Industry Capital Structure
Sanofi S. A Company
Assets = 111.85 Capital Structure = 0.2219
Vita Green Health Products Co, Ltd
Assets = 52.476 Capital structure = 0.3597
Reckitt Benckiser Group PLC
Assets = 15.2 Capital Structure = 0.35
Johnson & Johnson Inc.
Assets =133.4 Capital Structure = 0.24
weighted average of asset = (111.85÷312.926 ) × 0.2219 + (52.476 ÷ 312.926) × 0.3597 +
(15.2 ÷ 312.926) × 0.35 + (133.4 ÷ 312.926) × 0.24
= 0.189
The capital structure of the target company and the industrial are different. That of the target company is more, 0.3374 while that of the industry is 0.189.
Works Cited
About Money. "An Introduction to Capital Structure (Why It Matters)." About.com Money. N.p., 1 Apr. 2015. Web. 18 June 2016.
Artikis, George P. Capital Structure. Bradford, England: Emerald, 2007. Internet resource.
BeWang International (Group) Holding Limited. Annual Report. 2011-2015
Unilever Company Limited. Annual report. 2015
Reckitt Benckiser Group PLC. Annual report. 2015
Johnson & Johnson Inc. Annual report. 2015
"Sanofi - A Global Healthcare Leader Focused On Patients’ Needs". En.sanofi.com. N.p., 2016. Web. 23 June 2016.
