Gearing Ratio Dividends Decision and Working Capital

SABMiller plc is one of the biggest brewers in the world. The company produces globally recognised brands as Pilsner Urquell, Peroni Nastro Azzurro, Grolsch, Miller Genuine Draft, etc., and is also one of the largest bottlers of Coca-Cola products.

SABMiller’s main office is located in the City of Westminster, London. It is listed on the London Stock Exchange and is part of the FTSE 100 Index.

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Contents

History

SABMiller has operations and distribution interests across six continents.

The company was founded as South African Breweries (SAB) in South Africa in 1895, where the business operations were limited until 1995 with the entry into the European market acquiring Dreher in Hungary. After this, the group began to expand operations and/or distributions all around Europe.

In 1999 the company began to be listed on the London Stock Exchange to raise capital for acquisitions. Thus, in 2002 the group purchased the Miller Brewing Company in North America from the Altria Group and added Miller to its original name.

SABMiller expanded its operations to the Latin American market in 2005 with the acquisition of a major interest in Bavaria S.A., South America’s second largest brewer, in Colombia. Actually the group has operations in another five countries of Latin America, including El Salvador, Ecuador, Panama, Peru and Honduras.

The next important acquisition in Europe was on 9 October 2007 when SABMiller and Molson Coors Brewing Company made a joint venture known as Miller Coors. It was followed by the acquisition of Royal Grolsch in Europe on 19 November 2007.

Moreover, SABMiller has brewing operations in another 31 countries from the African continent, and in Asia where is the second-largest brewer in India, has ventures in Vietnam and Australia, and produces a Chinese brewer brand in partnership with China Resources Enterprise Limited.

Adoption of International Financial Reporting Standards

SABMiller plc began to prepare its consolidated financial statements in accordance with IFRS from 1 April 2005. As the group’s financial year represents the period from 1 April to 31 March, the first consolidated financial statement prepared in accordance with IFRS was for the 2006 financial year, because this includes comparatives for 2005.

To be fully prepared for the transition in 2005 and for the first set of applicable financial statements for the year ending 31 March 2006, SABMiller established a project team involving representatives of businesses and functions to plan for and achieve a smooth transition to IFRS.

The main effects of the adoption of IFRS that impact the group’s 2005 published UK GAAP results included hedge accounting, accounting for embedded derivatives and other items as accounting for business combinations, pensions and post-retirement benefits, deferred tax, share-based payments, goodwill and the presentation of results of associates.

1. The company’s gearing decision.

Gearing

Gearing ratio means the contribution of owner’s equity to borrowed funds. The ratio explains that how much amount in business is funded by the owner as against the borrowed funds. Gearing can also be defined as the ratio between the company’s borrowing and owner equity. It is known as leverage. The interests cover or times interest earned and equity ratio are mostly common example of gearing ratio which is mostly used.

Types of gearing ratio:

Different types of gearing ratio are used to calculate the financial leverage of the company. The most commons way to calculate the gearing ratio is as follows:

Long-term debt over total equity, or

Long-term debt over long-term debt plus total equity

By using the any above formula gearing ratio can be calculated which determine the financial leverage of the company. It tells us the level to which the firm performance is funded by creditor funds.

Calculation of Gearing Ratio:

The higher degree of gearing ratio or leverage of the company, the more company is measured risky. Company with high gearing ratio is more at risk whatever the situation company must carry on their services to its debt apart from that how bad sale are. A larger quantity of equity provides a cushion and is look like calculate of financial strength.

Gearing ratio can be obtained by dividing long term liabilities with shareholder equity. The formula is given as below

Gearing Ratio of SABMILLER

We calculated the gearing ratio of SABMiller for four year by using the above formula and the result are shown below

Appendix1

Calculation of Gearing Ratios

Year’s

2007

2008

2009

2010

Long-term Liabilities

4,666

6,064

7,612

7,794

Shareholder equity

7,345

8,821

10,734

13,358

Gearing ratio’s %

75.62

80.50

85.24

66.41

The gearing ratio of the year 2007,2008,2009,2010 is 75.62, 80.50, 85.24, and 66.41 respectively. We took the figures of long-term liabilities and shareholder equity from the annual report of the company. The calculation of gearing ratio taken from the FAME.

Historical background

"Miller and Modigliani derived the theorem and wrote their path breaking article when they were both professors at the Graduate School of Industrial Administration (GSIA) of Carnegie Mellon University. In contrast to most other business schools, GSIA put an emphasis on an academic approach to business question. The story goes that Miller and Modigliani were set to teach corporate finance for business students despite the fact that they had no prior experience in corporate finance. When they read the material that existed they found it inconsistent so they sat down together to try to figure it out. The result of this was the article in the American Economic Review and what has later been known as the M&M theorem."

Modigliani and Miller

"The Modigliani-Miller theory (1958) forms the basis for modern thinking on Capital structure. The theory states that in a perfect world, in the absence of taxes, bankruptcy costs, and asymmetric information, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm’s capital is raised by issuing stock or selling debt. Therefore there is no optimal capital structure." Propositions:

Originally this theory was proven under no tax assumption. Two propositions constitute this theory which can be extended to a situation with taxes sometimes .e.g. consider two identical firms but with different financial structures. The first firm i.e.U is unlevered; it is only financed by equity. The second firm i.e. L. is levered; it is partly financed by debt and partly by equity. The Modigliani-Miller theorem states that the value of the two firms is the same.

Modigliani and Miller’s without tax

In 1958, Modigliani and miller assumed that "the company is a perfect capital market and ignoring taxation where the working capital and market value are remains constant at all levels of gearing ". As a result company having financial risk if the company gears up, the working capital decrease which is caused by having a greater amount of cheaper debt is exactly offset by the increase in the WACC as well as an increase cost of equity. Therefore a company cannot reduce its WACC by altering its gearing. As gearing increases, the financial risk to shareholders increases, therefore Keg increases. Benefits of cheaper debt >increase in Keg due to increasing financial risk. The WACC, the total value of the company and shareholder wealth are constant and unaffected by gearing levels. No optimal capital structure exists. "(WATON D and Head A, Corporate Finance: Principles and Practice, 4th edition, FT Prentice Hall)"

Modigliani and Miller’s with taxes

In 1963, when Modigliani and miller admitted corporate tax into their analysis, their conclusion altered dramatically. "As debt became even cheaper (due to the tax relief on interest payments), cost of debt falls significantly from Kd to Kd(1-t). Thus, the decrease in the WACC (due to the even cheaper debt) is now greater than the increase in the WACC (due to the increase in the financial risk/Keg). The WACC falls as gearing increases. Therefore, if a company wishes to reduce its WACC, it should borrow as much as possible. Benefits of cheaper debt > increase in Keg due to increasing financial risk. Companies should therefore borrow as much as possible. Optimal capital structure is 99.99% debt finance. (BREALEY and Myers, Principles of Corporate Finance, 6th edition, McGraw Hill)"

Conventional theory:

If there is only the cost of equity capital WACC begins. Because the capital is replaced by cheaper borrowing money more expensive, WACC decreases. However, since the debt will increase further, both debt holders and shareholders observe a higher risk, they may need to increase revenue for both. Inevitably, WACC should be increased to a certain extent. This predicts that there is an optimal ratio of capital to which the WACC is the minimum.

Bankruptcy cost

The Company’s Bankruptcy cost is including the cost of trustees’ fees, legal fees and other cost of reorganisation whereas the dead weight loss is incurred the firm’s value discounted value of the expected cash flow from operation. In 1977 WAENER measured the direct cost of bankruptcy in railroads (1933-1955). There are assumed that Modigliani and Miller is perfect capital market thus, the company would able to raise the fund and avoid bankruptcy. But in the real world a biggest drawback of the companies is their high level of debt which could backfires if they default to pay the rate of interest and in consequence company faced bankruptcy and this bankruptcy risk convey to shareholder and debt-holders. It is noted that shareholder suffer a high degree of bankruptcy risk as they come last in the creditor’s hierarchy on liquidation. However the debt and equity increase the Working Capital while it is reduce the company’s share price. It also gives high level of gearing if it is modified with-tax model and then an optimal capital structure appears with below the 99.99% level of debt which is previously recommended. Evidence seems to support the view that capital structure trades off tax shield gains against bankruptcy costs (SEE JU, PARRINO, WEISBACH, JFQA, 2005).Optimal capital structure take on increasing amounts of debt finance until the marginal gain from the debt finance is equal to the marginal cost of expected bankruptcy

Pecking order theory

The pecking order theory is explained an optimal capital structure by studying the trade-off between the return and drawback of debt finance. In this approach, there is no search for an optimal capital structure. Companies cleanly pursue a recognized pecking order which permitted them to move up finance in the most competent way, the order is as follows: "(Power T Walsh S & O’ Meara P, Financial Management, Gill & Macmillan)"

Use of retained earnings available for all

issue debt;

Then issue equity, as a last resort

The justifications that support the pecking order there are three:

companies want to reduce the cost issue

Companies will want to reduce the time and expense involved convincing investors outside the merit of the project…..

the existence of asymmetrical information, and are expected to exchange information, which management actions

MYERS (1984) ARGUES firms diverge significantly from long-run target capital structures owing to preference to fund investment internally. One of the pecking orders comes into the theory that we have reason to expect that very profitable firms would borrow at least, because they have a higher retained earnings finance investment projects. Baskin (1989) found a negative correlation between high profits and high levels of leverage. This finding is contrary to the idea of the existence of an optimal capital structure and provides strong expertise offered by the pecking order theory.

Agency Costs

An Agency costs are known as the ‘principal-agent’ problem. Most of the largest finance providers companies actively they are not able to manage the company. In effect the company need to employ an ‘agents’ which are not possible way to measure the equity or debt- holders. If the company want to invest in high return project by raise fund from debt holder where the level of company performance are satisfactory than shareholders action could potential. Because they would get share from higher level of return otherwise they would feel less interest to invest their money in high risk of project. But debt holder would not get a share of the higher returns since their returns are not dependent on company performance. Therefore debt-holder often imposes restrictive covenants in the loan agreements for limit management’s freedom of action. These agreements would:

limit the further debt,

set a target gearing ratio and current ratio.

restrict the excessive dividends

control the disposal of major assets or

manage the type of activity the company may engage in.

as gearing increases, the debt holder would include more obligation on company’s freedom of operating and investment flexibility which may lead to a reducing share price and it is not acceptable by management. Thus, they generally limit the level of gearing to limit the level of restrictions on them. "(J.M. Samuels, F.M. Wilkes and R.E Brayshaw, Financial Management & Decision Making)."

Interpretation:

The company seemed followed MM theory and the long-term borrowing had constant increment. Based on the 2007- 2009, and the ratios increased from 75.62% to 85.24%. In spite of 2009, the gearing ratio dropped to 66.41%, the debt still on an increased trend and the total long-term borrowing increased from $2915 million in 2007 to $7809million in 2009.

Whereas according to Pecking Order, the retained earnings should be the most favourable finance for the company, however, SABMiller seemed not a case. The company’s retained holdings was not utilized as the priority of the finance, by contrast, their main funding were from debt instead. Therefore it seems that SABMiller has some bankruptcy cost and agency cost.

2. The company’s dividend decision.

Dividends

Dividend is the distribution of value to shareholders. Dividends represent drawings by the shareholders of the company. Dividends are paid out of the revenue reserves and should be deducted from these reserves (usually retained earnings) when preparing the balance sheet. Shareholders are often paid an annual dividend, perhaps in two parts. An ‘interim’ dividend may be paid part way through the year and a ‘final’ dividend shortly after the year end.

Dividend Policy:

Dividend policy (1961) defines as the rules and regulation to provide dividend payment of companies shareholders. A specific dividend policy gives a high level of advantage of the company and its shareholders. Because it is determine the impact of business operation in terms of different number of test scenarios and therefore company should have an efficient dividend policy to attract the shareholder for further invest in business. There are two dividend policy company could adopt such as:

Dividend irrelevance Theory:

Miller and Modigliani’s (1958, 1961) Dividend irrelevant theory specify a frictionless market with a fixed investment policy, all feasible capital structure and dividend policies are optimal because all imply identical stockholder wealth, and so the choice among them is irrelevant. In the other sense irrelevant dividend policy is absence of taxes and transaction costs in perfect capital market which could not effect on shareholder value or stock price. There are three cases M& M irrelevant policy does not affect on the shareholders’ value when company may need cash or company necessarily to sell share to raise fund to paid shareholder or when shareholder desire to get cash. The effect of any dividend policy can offset by management adjusting the sale of new stock or investors adjusting their dividend stream through stock purchases or sales.

Dividend Relevance Theory:

The dividend relevance theory was anticipated by Myron J.Gordon and John Lintner. They suggested that "investors are generally risk averse and would rather have dividends today ("bird-in-the-hand") than possible share appreciation and dividends tomorrow". This theory is opposite of M&M Dividend irrelevant theory and dividend policy affect on the share price and it ensure that shareholders wealth is maximize.

The SABMiller Plc has an effective dividend policy which is as follows:

Dividend Policy of SABMiller Plc:

"In SAB plc’s listing particulars dated 1 March 1999, the directors stated their intention to adopt a new dividend policy. This would take account of the Group’s underlying performance; the opportunities for the profitable investment of retained profits; and would maintain an appropriate level of dividend cover, considering, among other factors, the level of dividend cover generally maintained by FT-SE All-Share companies and the Group’s peers in the international alcoholic beverages sector.

In the light of these statements, and having regard to the level of dividends paid by SAB Ltd in the past, the directors have determined to move the dividend cover – in the medium term – from the prior year’s approximately 1.8 times, to a range of 2.2 to 2.5."

Taxation: There is no impact on shareholders which are companies. However, taxation can distort investment decisions by individuals, residents of the UK. Britain there are two kinds of taxes which are: capital gains tax and income tax. Income tax for greater shareholder influence (taxes @ 40%), which is why they prefer the capital gains which are taxed 18%. Low band, taxpayers can take advantage of the dividend tax @ 20%.

"Deferred tax is recognised on the unremitted earnings of overseas subsidiaries where there is an intention to distribute those reserves. A deferred tax liability of US$31 million (2009: US$16 million) has been recognised. A deferred tax liability of US$ 46 million (2009: US$29 million) has also been recognised in respect of unremitted profits of associates where a dividend policy is not in place. There are not any further details given in the Annual report 2010 and FAME or Companies website."

Dividends declare over the years:

As the group reports in US dollars, dividends are declared in US dollars. They are payable in south African rand to shareholders on the south African register, in US dollars to shareholders on the UK register with a address in the United States (unless mandated otherwise), and in sterling to all remaining shareholders on the UK section of the register.

Appendix 2

Dividends paid

years

Total Dividends

Adjusted diluted Earnings per Share

Dividend per share

Million’s

Cent’s

2006

520

108.4

44

2007

681

119.3

50

2008

769

142.4

58

2009

877

136.8

58

2010

924

160.4

68

"The board has proposed a final dividend of 51 US cents to make a total of 68 US cents per share for the year- an increase of 17% from the prior year. This represents a dividend cover of 2.4 times based on adjusted earnings per share, as described above (2009: 2.4 times). The group’s guideline is to achieve dividend cover of between 2.0 and 2.5 times adjusted earnings. The relationship between the growth in dividends and adjusted earnings per share is demonstrated in picture below.

In addition, the directors are proposing a final dividend of 42.0 US cents per share in respect of the financial year ended 31 March 2009, which will absorb an estimated US$631 million of shareholder’s funds. If approved by shareholders, the dividend will be paid on 28 August 2009 to shareholders registered on the London and Johannesburg Registers on 21 august 2009. The total dividend per share for the year is 58.0 US cents (2008: 58.0 US cents)."

Dividend Announcement and Market Impact of SABMiller Plc:

The SABMiller Plc dividend declared on 1st December 2010 which is 20 cents US per share( Financial Time) however the board of SABMiller Plc declared a interim dividend of US 0.195 per share which is payable on 10 December 2010 to their shareholders who is registered on the London and Johannesburg stock exchange.

According to the last report on February 2011 we found that the SABMiller company the fourth quarter and full year ended December 2010 shows company’s net income increased by 38% of $146 Million for fourth quarter and 21.9 % of $1.087 Million for full year which is favourable for positive pricing , band mix and an effective cost management.

Leo Kiely the chief executive of SABMiller Plc comment that : "We continue to invest in innovation behind our premium light brands, drive growth in our craft and import portfolio and deliver synergy and cost savings as promised and Our consistent focus generated positive net revenue per barrel growth for the fourth quarter. We are building brand equity and improving our mix to meet the challenges ahead in 2011."

Interpretation:

It is assumed that SABMiller Plc is practicing M&M irrelevant dividend theory. Because the market is competitive however from the appendix 2 we can see that their dividend per share gone up over the five year whereas dividend per share growth increasing except 2009. In 2010 dividend per growth is 17.24% and dividend yield ratio is 2.30% which indicated company are concerned to reinvest of their profit.

3. The Company’s management of working capital

Working capital:

Working capital is a financial tool which helps to measure of both company’s efficiency and its short-term financial health. If working capital of the firm is in positive value it means company is efficient and healthy. But if working capital of the firm is in negative value that means company is unable to meet its short-term liabilities with its current assets e.g. cash, accounts receivable and inventory. The working capital also known as net working capital.

If a company current assets remain lower than its current liabilities, then the company would be in problem in paying back to its creditor’s the short term. The worst possibility is bankruptcy.

Calculating Working Capital:

The following formula is use to calculate the working capital of company.

By looking at the working capital position, we can predict the future financial difficulties. Even a business who’s fixed assets worth more than billions of dollars can bankrupt if unable to pay its monthly bills. Poor working capital i.e.: increase borrowing and delayed payments to creditor can build pressure on the financial position of a company which ultimately lower its credit rating. Consequently a company has to pay more money due to its lower credit rating as bank charge higher interest rate.

Negative Working Capital Can Be a Good Thing for High Turn Businesses

Negative working capital indicated that companies high inventory turns and business operated by a cash basis where working capital not as much. That means company can raise money any time then turn around and plough that money back into inventory to increase the sales .if financial crisis arise for the short period of time management can stockpile the proceed from their daily. Therefore there is not necessary a large amount of working capital since the cash could arise quickly.

Working Capital of SABMiller PLC:

The following tables showed the working capital of SABMiller Plc for five years.

Appendix3

years

current assets

current liabilities

working capital

WC ratio

2006

2829

4865

-2036

58.15005

2007

2989

5717

-2728

52.28267

2008

4127

6203

-2076

66.53232

2009

3472

5345

-1873

64.9579

2010

3895

5977

-2082

65.16647

As we know working capital of SABMiller Plc is in extremely negative which is not good for the investors and financial institution. The above data is taken from annual report and financial statement links for these above figures are being given in the end of assignment (Internet Reference).

Analyses of working capital using ratios:

Ratio Analysis enables the business owner/manager to spot trends in a business and to compare its performance and condition with the average performance of similar businesses in the same industry. To do this compare your ratios with the average of businesses similar to yours and compare your own ratios for several successive years, watching especially for any unfavourable trends that may be starting. Ratio analysis may provide the all-important early warning indications that allow you to solve your business problems before your business is destroyed by them.

Balance Sheet Ratio Analysis:

Balance sheet ratios measure liquidity and solvency (a business’s ability to pay its bills as they come due) and leverage (the extent to which the business is dependent on creditors’ funding). They include the following ratios:

The financial ratio analysis by Meir Liraz

Current Ratios:

The Current Ratios is one of the best known measures of financial strength. Its formula is

If you feel your business’s current ratio is too low, you may be able to raise it by:

Paying some debts.

Increasing your current assets from loans or other borrowings with a maturity of more than one year.

Increasing your current assets from new equity contributions.

Putting profits back into the business

Converting non-current assets into current assets.

Quick Ratios:

The quick ratio is sometimes called the "acid-test" ratio and is one of the best measures of liquidity. It is known as liquidity ratio.

The quick ratio is a much more exacting measure than the current ratio. By excluding inventories, it concentrates on the really liquid assets, with value that is fairly certain.

The SABMiller Plc’s Ratio

Appendix 4

SABMiller Plc

Consolidated Balance Sheet

2010

2009

2008

2007

2006

£m

£m

Total Current Assets

3895.00

3472.00

4135.00

2989.00

2829.00

Total Current liabilities

9204.00

7745.00

6257.00

5157.00

4865.00

Inventories

1295.00

1241.00

1362.00

928.00

878.00

Current Ratio

0.4231

0.4482

0.660

0.5796

0.5815

Quick Ratio

0.2824

0.2880

0.4431

0.3996

0.401

Form the Appendix 5 it noticeable that the SABMiller Plc’s current ratio is not favourable and it indicated that company are not capable to pay their obligation whereas their quick ratio is favourable cause it decrease 0.2880 to 0.2824% by 2010 compare than 2009.

Conclusion

The SABMiller plc is one of the leading brewers who operating across six continents. The report approached their financial performance and risk Analysis with theatrical impact. According to 2010 financial report group revenue up 4 %( US$8,330 million) and EBITA up 6% with margin growth of 30 basis points (bps) driven by robust pricing and cost efficiency as well as they also gain in share market. They have strong cash flow of $2010M with dividend per share up 17%. However The SABMiller Plc’s working capital is not favourable and company enjoying a high level of debt risk.

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