The Relevance Of Dividends And A Comparative Analysis Of Melrose Industries PLC And Balfour Beatty
Dividend Payments Reflect Financial Strength
Dividends are basically the amount, companies paid to their shareholders from their earnings. The amount paid can be in the form of cash, shares or other property. Companies can declare dividends over different time periods and at different pay out rates (Baker, 2009). However, some of the organizations does not prefer to distribute some part of their earnings as dividends to their shareholders. In fact, they are more suitable with reinvesting their earnings back into the company.
Generally, the companies which are profitable and have stable earnings, pay dividends because they do not need to reinvest their income in the business for the purpose of growth. Moreover, investors are more likely to purchase that company’s stock which offers them stable income in form of dividends. Payments regarding dividends reflect the financial strength of the organization and is considered as a sign that the company will make profits in future, which eventually makes its stock more attractive. So for such mature and stable companies, dividend payments do matter (Clayman, Fridson and Troughton, 2012).In contrast to it, firms enjoying rapid growth choose to reinvest their profits or earnings in the business rather than distributing them to the shareholders as dividends. The reason behind doing this is to stimulate the future growth, to increase the value of share price by investing the funds in a new project, acquiring new assets, purchasing their own shares or buying another company. Moreover, the decision of not paying dividends may prove to be very beneficial for the investors from the aspect of paying tax. Reason being, dividend is treated as an income of the shareholders and investors and they are obliged to pay tax on them at a certain rate. So, for the companies who are willing to grow rapidly and want to avoid the risk associated with lack of capital, dividends do not matter as they put all the earnings back in the business (Forbes India. 2012).
However, there are many theories which sated the relevancy and irrelevancy of dividends. Generally, payments related to dividends are view positively by the investors and firms as it reduces the risk of uncertainty in the shareholders and increases the value of company’s stock. The two theories which support the relevance of dividends are given by Walter and Gordon. Professor James E Walter stated in his theory that it is the dividend pay-out ratio which always affect the value of firm (Bose, 2011). In addition to this, he also mentioned the importance of relationship between internal rate of return (R) and cost of capital (K) for the purpose of determining optimum dividend policy. Based on the certain assumptions, his theory concludes that if R>K, then the company should invest its retained earnings rather than using them for declaring dividends. Reasons being, investment opportunities will provide better returns than dividend payments. However, if R<K, then the firm should distributes its earnings among its shareholders as dividends rather than investing them somewhere else. Thus, it can be said that it is the relationship between R and K which decides, whether the company should have 100% pay-out or zero pay-out (Periasamy, 2009).
The Relevancy Theories of Dividends
In support of the above theory, a model was introduced by Myron J. Gordon, who also supported the relevancy of dividends. It is known as Gordon’s Model which believes in the fact that regular dividends affect the company’s share price. However, the assumptions and the findings of Gordon’s model were similar to Walter’s model but later Gordon revised its theory and takes into account the two factors named as risk and uncertainty (Pandey, 2015). It stated that investors are risk averse and the payment of future dividend is totally uncertain. This makes the investors to prefer current dividend over the future ones. Being a rational investor, they are ready to quote higher price for the shares on which current dividends are paid by the company. Hence, the discount rate (K) increases as and when the retention rate rises. So, on a whole it can be concluded that for some companies having an appropriate policy is very important, as it affects the market value of the firm (eFinanceManagement.com. n.d.).
Apart from the relevancy theories, there are some approaches which contradict the above theory and lay emphasis on the irrelevancy of the dividends. A Modigliani-Miller model is one of them which states that dividend policy of an organization is irrelevant. According to the theory given by MM, the value of a firm wholly depends upon its potential to earn more from its investment policies. The theory is based on certain assumptions and the findings shows that if the company invest the retained earnings in the business rather than distributing it as dividends, the shareholders could enjoy capital appreciation (Banerjee, 2012). The theory said that from shareholder’s point of view, it is totally irrelevant to divide the income between dividends and retained earnings. Reason being, if company distribute dividends, then the amount of dividend will be equal to the figure by which the capital could be appreciated. Hence, there is no relevancy and the market value of the firm is also not affected (Cassis, Grossman and Schenk 2016).
From the above debate it can be said that, dividends does and does not matter for the companies depending upon their earnings, profitability and objectives.
A comparative analysis of Melrose Industries PLC and Balfour Beatty is done in order to decide which company is better for the purpose of making investment. Profitability, gearing and investors’ ratios are calculated to measure the financial performance and position of the companies. Working capital is also taken into consideration.
A Comparative Analysis of Melrose Industries PLC and Balfour Beatty
The capital which is required for the smooth functioning of day to day operations of a business is known as working capital. It measures the cash and liquidity position of the business. From the above graph, it can be seen that Melrose has sufficient working capital for its operations and in 2015, its capital amounted to £2488.1 million. On the other hand, Balfour has negative working capital which means its liabilities are more than its assets and the company does not have sufficient funds for operating smoothly (Sagner, 2010).
Operating profit ratio, net profit and gross profit ratios are type of profitability ratios which represent the profits made by a company during a fiscal year. They show the amount of profit as a percentage of sales (Tracy, 2012). From the above graphs, it can be seen that the profitability position of Melrose Industries is better than Balfour Beatty. Reason being, in 2014 and 2015, Melrose has earned profits whereas losses were reported in case of Balfour. The highest net profit margin of Melrose was in 2015 at 5.39 while in the same year a Balfour made loss of £260 million. Apart from the value of gross profit, which is positive, Balfour Beatty cannot be consider as profit making company.
Gearing ratios generally represents the long term debt of the company in comparison to its equity or capital employed. It shows the proportion of debt taken by an organization against its equity capital. Among the various gearing ratios, debt-equity, debt ratio and interest coverage ratio are the most widely used ratios which tell about the debt position of a company. From the above graphs and calculations done, it can be said that Melrose is less risky as compare to Balfour. Its debt equity ratio was 36% in 2014 which reduces to 27% in 2016. On the other hand, in 2014, Balfour’s debt equity was 76% which increased to 95% in 2016. This implies that most of the assets of Balfour Beatty are financed through debt. Also the debt ratio of the company remains same for the two years at 18% and reduces to 15% in 2016, whereas Melrose reported its debt ratio at 18% in 2014 and in 2015, the same figure become zero. This shows that Melrose has low debt which makes it less risky (Levi and Segal, 2015).
Taking about ICR, Melrose Industries has positive ICR of 3.37 and 0.11 in 2014 and 2015. While in the same year, Balfour’s ICR was negative at -3.23 and -2.64 respectively. This means that company does not have enough earnings to pay its interest expense. Though the trend got reverse in 2016 for both the companies but still, Melrose is better at paying off its interest expenses (Ferrarini, Hinojales and Scaramozzino, 2017).
The ratios which are generally preferred by investors while evaluating the performance of a company are known as investors’ ratios. These ratios fully reflect the position of the organization in the market and also assist the investors in taking appropriate decisions regarding their investment. The ratios calculated are Price earnings ratio, Dividend Pay-out ratio and Return on equity.
Generally, a high P/E ratio indicates that company will have a positive performance in future and investors are willing to invest their money in that company’s shares. Melrose’ P/E ratio is somewhat better than Balfour in 2014 and 2015. Reason being, company’s price per share has increased and also it has positive earnings per share. In 2016, the same figure turns negative while Balfour has a positive P/E. Though the share price of Melrose is less than that of Balfour, but it has positive price earnings ratio for two years consecutively. In addition to this, dividend pay-out ratio and return on equity of Melrose are positive whereas the same was negative in case of Balfour Beatty. This implies that company has enough earnings to declare dividends and offer returns to its shareholders on regular basis. From an investor’s point of view Melrose Industries will be better option (Leach, 2010).
The above analysis of both the companies states that Melrose Industries PLC is performing better than Balfour Beatty in terms of profitability, liquidity and risk. It will be better for the investors to invest their funds in this company as it is making profits, has string liquidity position and is less risky.
Working capital management refers to the management of its two components that are current liabilities and current assets. A proper control over the current assets is very important because they are been used in order to pay off the current liabilities. Current assets basically include accounts receivables (debtors), cash and bank balance, inventory and marketable securities. Management of all these items are very necessary for the successful operations of a business. A most common dilemma faced by the businesses is to establish a right balance between liquidity and profitability. Most of the times, it has been seen that even after making profits, companies lack the availability of cash in their business. The reasons for this situation are untimely collection of receivables, money tied up in form of inventory and many more. Hence it is very necessary to manage the working capital especially in context of debtors so that a proper balance can be there in the liquidity position and profits of the company (Preve and Sarria-Allende, 2010).
It is the responsibility of the financial executives to manage the short term loans as well as the level of debtors. The two main objectives of managing working capital is liquidity and profitability. These two factors contradict each other in a way that too much focus on profit earning can lead to the severe problems of liquidity. Similarly, giving more focus to liquidity, can dilute profits. So, in order to establish the best trade-off between these two, working capital management is required. Focusing on the principle of collecting cash from debtor early can result in the best liquidity management. Profitability of a company can be increased if it has sufficient cash in its business for its operations. A large part of the cash amount can be derived from the debtors, to whom the services and goods are provided on credit. Through collecting its receivables in time and in an effective manner, a company can raise enough funds to meet its short term financial obligations. Timely paying off the debts can result into higher profitability and improved performance. Thus, it can be said that, by properly managing its receivables, organization can maintain a balance between its profit and liquid position (Soprano, 2015).
References
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