Effect Of Financial Leverage And Market Size On Stock Returns

Availability of long-term finance

Discuss about the Effect Of Financial Leverage And Market Size On Stock Returns.

State Trading Organization PLC along with the subsidiaries are engaged in distribution, import, retail and wholesale of petroleum, construction materials and cooking gas, pharmaceuticals, medical supplies, electronics, home appliances, insurance products and supermarket products. The company was formerly known as Athireemaafannu Trading Agency and during 1969 it changed its name to State Trading Organization PLC. However, the company was established in Male, Maldives during 1964. Over the years the company entered into wide areas of business and other trade for meeting the rising demand of the developed nation with the growth in standards of living. Further, the company expanded geographically, formed partnership and spun of the subsidiaries for meeting the available opportunities. The company truly became diverse with regard to business organization (Sto.mv, 2018).

Various long-term sources available to the company are –

• Equity shares– the equity shares represent the firm’s ownership capital. The company may obtain the funds from the promoters or from public as the equity shares through issuance of ordinary equity shares. The ordinary shareholders are those who receive the return and dividend on the capital after payment to the preference shareholders are made. Main advantage of equity shares is that it does not involve any fixed charges. The company makes payment of dividends only when it earns sufficient divisible profits (Véron & Wolff, 2016). However, legal obligation is not there to pay the dividends. On the other hand, the main disadvantage of this is that the payment of dividend is not deductible as expenses under tax.
• Preference share– generally the preference shareholders are entitled to receive the dividends at fixed rate before payment of other shares. Long-term fund raised from the preference shares are done through public issue of the shares. However, it does not have any impact on the ownership of the business and no security is required. The characteristics of preference share involve both the characters of equity capital as well as debt (Peirson et al., 2014). However, like equity dividend the preference dividend is not deductible as expenses under tax.
• Debentures– it is the acknowledgement document of the debt with company’s common seal. It includes the conditions and terms related to interest payment, loan, redemption of loan and the offered security of the entity. Debenture holders are regarded as the company’s creditors with no voting rights. It can be issued with or without mortgage of any asset that means the debentures can be secured as well unsecured (Turner, 2014). Further, the payment of debenture interest is payable even if the company does not earn profit. However, the debenture interest is deductible expenses under tax.
• Borrowings from banks or financial institutions– many businesses raise funds through ban loans that is more available for the growing and well established businesses and not so for the start-up businesses. Repayment of the loan along with interest depends on the duration and size of the loan and the interest rate. The main advantage with the bank loan is that it does not have any impact on the ownership of the business (Dhaliwal et al., 2014). However, the main disadvantage associated with bank loan is that it requires security that shall be pledged with the bank.
• Retained earnings– it is the undistributed part of the profits in form of the free reserves that is used for diversification and expansion. The funds of retained earnings are belonging to equity shareholders and it increases the business’s net worth (Dhaliwal et al., 2016) Though it is used as the long-term finance option availability of retained earnings depend on various factors like tax rate, company’s dividend policy, appropriation policy of the company and extent of the profit earned.

From the annual report of State Trading Organization PLC for the year ended 2017 the long term capital structure of the company is as follows –

As per above table it can be identified that 80% of the company’s long term capital is raised from equity and only 20% of the long term capital is raised through loans and borrowings. Rate of interest on borrowing made from various sources ranged from 5% to 9.75% and payment schedule is made till the year 2028. On the other hand, the equity involves share capital, general reserves and retained earnings (Sto.mv, 2018).

The optimal capital structure is the financial measurement that is used by the company for determining best mix of the equity and debt for using in the expansion and operation of the business. The structure lower the capital cost so that the company is less dependent on the creditors and able to finance majorly through equity (Barton & Wiseman, 2014). Company’s capital structure can be computed through using the following ratios –

Debt ratio – it is the financial ratio used to measure the leverage extent of the company. It measures the total debt used by the company to obtain the assets and is expressed in percentage or decimal. From the above calculation it can be recognized that the debt ratio of the company is 0.67 which will be considered as high (Checherita-Westphal, Hughes Hallett & Rother, 2014).

Debt equity ratio – it states the percentage of debt and equity used by the company to finance the assets and extent to which the equity of the shareholders can meet the creditor’s obligation in case the business declines (Heikal, Khaddafi & Ummah, 2014). As per the calculation the debt equity ratio of the company is 2.07 that indicate that more than 2/3^rd of the capital is raised through debt and 1/3^rd of the capital is raised through equity.  

Long-term source of capital

Interest coverage ratio – it measures the ability of the company with regard to payment of outstanding debt. Generally, interest coverage ratio of 2 or more is considered good and indicates that the company is able to meet its debt obligation. The interest coverage ratio for State Trading Organization PLC of 2.29 is indicating that the company is able to meet its debt obligation.

If the debt ratio is considered, from the perspective of pure risk 0.4 or lower debt ratio is considered as better debt ratio. As the interest payment on debt is to be made irrespective of the profitability status of the company higher debt ratio like 0.6 or more will expose the company to operational risk. Further, the debt equity ratio of 2.07 is indicating that the company is highly leveraged and financial risk is high (Lebedeva et al., 2016).

The term leverage refers to borrowing or debt availed by the company for financing the purchase of its equipment, inventory and other assets. The company can obtain the fund through equity or debt for financing or purchasing the assets of the company. Using the debt or leverage will increase the bankruptcy risk of the company. However, it increases the returns of the company particularly the return on the equity. Further, payment on debt it deductible expenses under tax and the company can establish positive history for payment through making payment of debt in timely manner (Jarrow, 2013).  From the above calculation it can be identified that 67% of the company’s capital is raised from debt and only 33% of the capital is raised through equity. Therefore, the company will be considered as highly leveraged as higher proportion of asset is financed through debt.

It measures the fixed asset of the company as compared to the percentage of total assets. Operating leverage matrix is used for analysing the break-even point of the business and estimated profit levels on sale. Below mentioned two scenarios states about low operating leverage and high operating leverage –

 High operating leverage – Generally, large portion of the cost of any company are involved fixed cost and in such cases the company earns profit for each incremental sales. However the company shall attain enough sales volume for covering up the substantial fixed cost. If the company can do so then it may earn high level of profit on the entire sales after paying off for fixed cost (Kahl, Lunn & Nilsson, 2014).

Long-term capital structure of the company

 Low operating leverage – large portion of the sales are considered as variable cost and therefore the variable costs are incurred only when the sales take place. In such scenario the entity earns smaller amount of profit on each level of incremental sales. However, the company is not required to generate high level of sales for covering up lower amount of fixed cost. Therefore it is easier for this kind of entity to generate the profit at lower level of sales.  However the company is not able to earn high level of profits even when it generates additional sales.

Operating leverage is computed through multiplying the quantity with the difference in price and variable cost per unit and dividing it by multiplying the quantity with the difference in price and variable cost per unit reduced by fixed operating cost.

Operating leverage = Quantity * (Price – variable cost per unit) / Quantity * (Price – variable cost per unit) – Fixed operating cost.

However, in absence of the details regarding the variable costs and fixed costs the operating leverage of the company could not be computed.

Financial leverage is debt amount that the company uses for purchasing additional assets.  Leverage is used for avoiding usage of high level of equity funding for operation. Excess financial leverage increases the failure risk as paying off the debt becomes difficult. Financial leverage is computed through comparing the total debt of the company with the total assets. if the portion of the debt as compared to the assets goes up the financial leverage also goes up. Financial leverage will be considered as favourable if the return from debt is higher than the expenses of interest related to the debt (Acheampong, Agalega & Shibu, 2014). Various companies use the financial leverage rather than using the equity capital which in turn reduces the EPS for the existing shareholder. However, two major advantage of financial leverage are –

• Favourable for tax treatment – generally the interest payment on debt is deductible under tax that lowers the debt’s net cost.  
• Improvement of earnings – it may also facilitate to earn the disproportionate amount on the assets of the company.

Financial leverage of the company =

Total debt / Total equity = 52,14,346,408 / 25,23,476,478 = 2.07

From the computation of financial leverage it is found that the financial leverage of the company is 2.07. It indicates that more than 2/3^rd of the capital is raised through debt and 1/3^rd of the capital is raised through equity.  Further, financial leverage of 2.07 is indicating that the company is highly leveraged and financial risk is high. With the investors point of the view the company will be regarded as more risky as the high financial leverage indicates that major portion of the assets capital are funded through borrowing rather funding through own funds. This may also state that the company’s performance is poor and therefore, it is borrowing additional capital.

Optimum capital structure

Dividend policy is the approach of a company to distribute its profits to the shareholders or owners of the company. If the company is in growth mode it is in the position to decide that it will not pay any dividend, rather it will re-invest the profits into the business. However, if the company decides for paying dividends it shall decide how much of the earnings it will pay as dividends and how often it will be paid. Well established and big farms often pay the dividend on fixed schedule however sometimes they declare the special dividend. Payment of dividends has an impact on the perception of company in the financial markets which in turn have direct impact on the stock price of the company. Dividend policy guidelines are used for the company for deciding the proportion of earning that will be paid to the shareholders as dividend (Gopalan, Nanda & Seru, 2014). Generally, the investors are not concerned regarding the dividend policy of the company as they can sale a portion of equities whenever they want.  This is known as dividend irrelevance theory which indicates that issue of dividend have no impact or has very little impact on the price of stock. Various dividend policies available to the companies are as follows –

Regular Dividend policy – under this policy the investors gets the dividend at usual rate. Generally, the investors here are the weaker sections of the society or the retired persons who prefer regular income. This kind of dividend can be paid by the company if it has regular income. Main advantages of this dividend policy are –

• It helps to generate confidence in the shareholders
• It helps to maintain the company’s goodwill
• It helps to stabilize the share’s market value
• It provides the shareholders with regular source of income (Hunting & Paulsen, 2013).

Stable dividend policy – under this policy certain percentage of earning is paid regularly to the stakeholders. It is of 3 types as follows –

• Constant payout ratio – the shareholders here are paid fixed earning percentage each year as dividend
• Constant dividend per share – under this the company creates a reserve fund for paying fixed dividend amount each year when it does not have sufficient earnings to pay out the dividend. However, this policy is suitable for the companies those are having stable income (Perretti, Allen & Shelton Weeks, 2013).

• It helps to stabilize the share’s market value
• It provides the shareholders with regular source of income
• It helps to maintain the company’s goodwill
• It helps to generate confidence in the shareholders

Irregular dividend – like the name, under this policy the entity does not pay dividend to the shareholders regularly. This practice is generally used by the company for the following reasons –

• Owing to company’s uncertain earnings
• Due to slow growth of the company
• Lack of the liquid resources

No dividend policy – under this the company does not pay any dividend to the shareholders. This policy is taken generally to reinvest the profit for the requirement of capital or for the company’s growth (Naser, Nuseibeh & Rashed, 2013).  

The company targets to pay at least 10% of the profit as dividend to the shareholders. However, for last few years the dividend is paid at higher rate.  

From the above data of the company for past 4 years it can be identified that the company is regular in paying dividend to the shareholders and creating return for the shareholders. EPS, dividend per share and dividend yield of the company till the year 2016 was in decreasing trend. However, the company was able to increase both dividends per share and dividend yield in the year 2017, irrespective of the fact that the EPS of the company fell significantly. Therefore, it can be stated that the dividend payment by the company for the last 4 years are more that the target payout that is 10% (Sto.mv, 2018).

Risk attitude

Profitability is company’s ability to earn the profit. Profit is the amount left out of the revenue after paying off all the expenses associated with the business operation. Profitability of the business can further be analysed through computation of various profitability ratios like gross profit margin, operating profit margin and net profit margin (Delen, Kuzey & Uyar, 2013). Gross profit margin measures the profits of the company after deducting the cost of the goods sold from the revenue. It is calculated through dividing the gross profit by sales and stated in percentage form. Operating profit margin measures the profits of the company after deducting the cost of operation like staff cost, administration expenses from the gross profit. It is calculated through dividing the operating profit by sales and stated in percentage form. Net profit margin measures the profits of the company after deducting all the expenses that includes the financial expenses and tax expenses (Ehiedu, 2014). It is calculated through dividing the net profit by sales and stated in percentage form.

From the above table and graph it can be found out that the profitability status of the company except the net profit for the year 2016 are in decreasing trend. The gross profit of the company has been reduced from 20.58% to 15.7% over the period from 2015 to 2017. Moreover, the operating profit of the company has been reduced from 9.27% to 3.48% over the same period of time (Bauman, 2014). Though the net profit is increased from 5.95% to 6.18% over the year from 2015 to 2017, it significantly fell to 1.75% for the year ended 2017. Therefore, all the profitability ratios of the company are in decreasing trend.

Conclusion and recommendation 

From the above analysis it can be concluded that the company will be considered as lower leveraged as 80% of the company’s long term capital is raised from equity and only 20% of the long term capital is raised through loans and borrowings. Therefore, the company was majorly dependent on own funds rather than the creditors. Further, through the profitability trend is reducing, the company is regular in paying dividend to the shareholders and creating return for them. Therefore, it is recommended that the investors may consider the stock of State Trading Organization PLC in their portfolio to get regular return through dividends. Further, as 80% of long-term capital is raised through equity the investors will be protected as the company is not overburdened with the interest payment for the debt.

Leverage of the company

Reference 

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