Financial Management Assignment : Exploring the Working Capital Investment and Financing Policies of Fortescue Metals Group Ltd

Question

Required: The documents, prepared employing information from the annual report documentation and any other documentation or sources of information considered to be relevant, are required to identify and outline the following aspects of Fortescue Metals Group Limited’s management finance policies:

• The nature of the firm’s working capital management policies. Focus in this determination should be on overall current asset investment and financing policies, rather than the company’s adoption of policies relating to specific current asset categories, such as inventories or receivables.
• The nature of the firm’s capital structure determination policy, including identification of specific policy adoption or usage if relevant, whether the firm appears to have target or optimal capital structure ratios, and the determinants of the firm’s capital structure choice.
• The nature of the firm’s earnings distribution and dividend payout policies. This should include discussion of the type of dividend policy employed, whether the firm has a target dividend policy or payout ratio, changes in dividend payout amounts or patterns, and the consideration of taxation, dividend imputation and franking credit issues and any other relevant elements associated with the firm’s overall earnings management and distribution practices.
• The nature of the firm’s corporate governance structure, and particularly the board, committee and key decision-making structures and mechanisms in place, and any changes in this corporate governance structure in recent years.
• The nature of any association or relationship between these various financial management policies employed by the firm, and how this may relate to Fortescue Metals Group Limited’s share and/or accounting performance outcomes.

Answer

Executive Summary
A company operates on a smooth scale when the working capital of the company is managed in a prudent manner. Overall, the company can perform in a formidable manner when the working capital management, capital structure, earnings and corporate governance fall in a line of action. In this report, Fortescue Metals Group Limited, a pioneer in the iron ore and exploration is considered for the purpose of study. The company is considered and the various components are studied in the light of the company.

1. Determination of the Working Capital Investment and Financing Policies employed by the firm
Working capital is defined as the excess of current assets over current liabilities. The company needs higher level of current assets as it helps in meeting the obligations of the company. The working capital ratio is the same as the current ratio that indicates the ability of a firm to discharge its obligations. As per the computation, it is seen that Fortescue has a working capital of more than one in all the past years that gives an indication that the company has strong short-term liquidity (Horngren, 2013). There was a paid increment in the current assets till 2015 indicating that the company had an expansion. The current liabilities increased, as well as decreased in all the five years.

The working capital ratio of the company is under problem when a huge amount is blocked up in inventory because that implies in terms of difficulties the stock needs to be sold to pay off the obligations (Melville, 2013). To this effect, the quick ratio has been computed and the ratio indicates that the company has a quick ratio of more than 1:1 that is the standard ratio. In all the years except 2014, the ratio is more than 1:1 indicating that the company $1 of current assets for every $1 of current liabilities with the inventories kept intact .

For a company of a stature such as Fortescue, the working capital can be tagged as moderate in nature that implies the company has maintained the current assets and liabilities. The working capital of the company is more than 1 in all the years that ensures the company is free from dangers. The management and the capital investment policy indicate that the company has utilized the resources in an effective manner and that there are hardly any issues of discharging the liabilities (Libby et.a l, 2011). The approach by the company is conservative in nature because Fortescue has more cash on hand and hence, current assets are financed by the funds of permanent nature.

2. Determination of the capital structure policy employed by the firm
The size of Fortescue Metal Group Limited is huge that stands at A$10,897.02 billion that attracts the investors and one of the vital reason for its potentiality. The aura of the company that is too big to fail gives an indication that the company is strong, as well as stable. Over the past five years, the debt of the company has risen and fallen. However, in the past 12 months, the debt of the company reduced from $12,257.81 to $8992.73 meaning that the company has paid off the debts. With the payment of the debt component, the cash from operations stands at $4070.832 that signals the debt of the company is adequately covered by the operating cash.

Further, the capital structure of the company can be properly commented with the help of debt-equity ratio. As seen, Fortescue has the component of debt and equity and debt-equity ratio projects that the reliance on debt has increased over a term of five years. The higher debt-equity ratio is not sound for the company as it indicates that the businesses have more of capital funding from the lender's side instead of the shareholders. A huge amount of debt is a risk for the company (Henderson et. al, 2015). As per the numbers, it can be commented that both long term debt and total liabilities has declined. However, the debt equity ratio stands at more than .50 indicating that the company in the future course of time needs to square off the debts to have a balances ratio. Since, Fortescue is a huge business therefore the ratio of 0.76 would not be a problem to the operations as it can make payments even in adverse situation.

The total revenue of the company increased in all the previous four years however, it declined in 2016 further, the net profit jumped to a huge extent meaning whatever, was the production, there has been considerable sales. As the debt level of the company fell, the net profit of the company witnessed a huge jump. Since, it is a large company, it contains an advantage over the small caps in the fact that the cost of capital is lower owing to the process of cheaper financing (Spiceland et. al, 2011). The size of Fortescue is huge and it can easily cover the payment of interest hence, it is efficient in nature.

Accordingly, large companies often have an advantage over small-caps through lower cost of capital due to cheaper financing. No matter how high the company’s debt, if it can easily cover the interest payments, it’s considered to be efficient with its use of excess leverage (Vaitilingam, 2010)

3. Determination of the earnings distribution and dividend policy employed by the firm

As per the information, the initial factor that needs to be considered is the declaration of dividend and the dividend payout ratio projected an uptrend in the year 2013-2014. Further, it needs to be noted that the group declared a dividend in all the years, however, a huge drop was seen in the year 2015 with the decrease in the net income of the company. however, with the increment in the net profit in the next year that is 2016, the dividend also increased signaling that the dividend payment is strong when it comes to the profit scenario of the company. it needs to be noted that the payment of the dividend will increase if the number of ordinary shares does not decline (Ferris et. al, 2010). As per the details and extract from the annual report 2016, it can be said that the business will have paramount growth and hence, a progressive dividend policy can be witnessed. Hence, the scenario is optimistic for the investors.

The imputation tax system was proposed by Australia in 1987 and has a major influence on the dividend policies of Australian companies. Due to dividend imputation, double taxation on the income dividend can be eliminated. When it comes to dividend from the after-tax net and franking credit that relates to the corporate tax, will be shared with the shareholders of Fortescue. At the marginal personal tax rate, they are more engaged to personal income tax on the grossed up received amount (Slee, 2011).

In 2016 the company paid $0.07 as dividend per share and the total shares that were issued is 3113.80
We have: Dividend = $0.07x3113.8 = $217.966

Going by the general trend in the share price, it can be said that the net income enhanced and the dividend decreased in the year 2016, the prices of share witnessed ups and downs.

The share price did not varied to a greater extent because the debt level kept on increasing and decreasing that means the company squared off a huge chunk of liabilities when it was essentially needed. All such factors provide a general indication that there was a variation when it comes to the product lines and the global market influenced the overall scenario, the dividend decision of Fortescue will not undergo a huge change and going by the solidity of the company it can be said that the company will declare dividends as usual (Gibson, 2012).

4. Determination of the corporate governance structure and policies employed by the firm
Efficient corporate governance is vital for Fortescue in contributing to its long-term success. Besides, the board and all management levels are totally committed in enhancing and maintaining corporate governance so that it assists in attaining the company’s mission and vision. Overall, the company has a formal corporate governance structure as it aligns with the requirements specified under ASX Corporate Governance Principles and Recommendations. This can be proved by the fact that principles like integrity, transparency, stewardship, and corporate accountability is duly considered by the company. Besides, the company has its board sub-committees that includes remuneration and nomination committee, audit and risk management committee, and finance committee for compliance with overall organizational procedures and policies and safeguard from risks as well (Williams, 2012). The composition of the board is such that it reflects an adequate balance of non-executive and executive directors to obtain the efficient business governance and development of shareholders’ interests. Such corporate governance practice allows Fortescue in attaining various capital projects, international experiences, sales and marketing, and infrastructure, resources, and mining experience. Nevertheless, the skills and experience of directors are also relevant to Board requirements in addressing their duties towards shareholders (Fortescue Metals Group , 2016). The company’s policy is to evaluate all significant candidates without considering gender, race, age, physical capabilities, etc.

Further, the Board also reviews the executive and remuneration performance of senior executives regularly. Overall, the influence of the company’s corporate governance structure is clearly observable in other elements like the ownership structure, significant affairs, and involvement in international markets on the part of the company. (Fortescue Metals Group , 2016) The corporate governance structure of the company is totally compliant with the expectations of formal industry and the reason behind this can be attributed to the fact that the company has recognized material risk exposures in its structure that allows it to highlight various uncertainties that can negatively and positively influence its corporate objectives. Besides, the expectations of formal industry are clear that a company must disclosure material items to them so that they can make proper decisions after considering such disclosures (Brigham & Ehrhardt, 2011). Recent changes in composition and board membership have been witnessed wherein the company has maintained majority of independent directors in 2017 but was later altered to the fact that the board does not possess majority of independent directors. However, even though such changes took place, the Board is satisfied that their directors exercise independent judgement for the interests of stakeholders respectively.

5. Nature of associations and relationships between the various management policies employed by the firm, and relationships with firm performance outcomes
In relation to Fortescue, the company has various financial management policies that has allowed it to remain competitive in the entire industry. It has paid dividend to its shareholders in all the five years that shows significance towards dividend policies. Besides, such dividend payout ratio has enhanced over the years that sums up the fact (Fortescue Metals Group , 2016). Furthermore, such dividend policy of the company has a direct link with its working capital management and the reason behind this can be attributed to the fact that over the years when dividend payout ratio has increased, the total liabilities has decreased. In short, when total liabilities depicted a declining trend, the dividend payout of the company witnessed a higher trend (Berk et. al, 2015). This sheds light upon the positive association betwixt the dividend policy and debt levels of the company. Furthermore, it can be observed from the annual report of the company that it has a relaxed fat cat policy for the year 2013 and 2014 together with a conservative policy stance wherein long-term sources of finance have been majorly used to finance permanent current assets, fixed assets, and few temporary current assets (Arnold, 2010).

The company has a high level of debt over the years that show higher reliance on capital structure than equity financing. Furthermore, the net income after tax of the company has also witnessed a subsequent rise from 2012 to 2014 but has declined in 2015 and 2016. This means that the trade-off theory applied by the company in the previous years has been altered and due to which there is an increment in total liabilities and decline in net income after tax respectively (William, 2010).

Recommendation & Conclusion
The company is occupying a major number of retained earnings but has failed to utilize debt to fund its assets for the past few years. Further, it is desirable that the company must decrease its debt funding and enhance equity funding so that interest payments that have increased over the five-year period can be controlled to a potential level, thereby again enhancing dividend paid and net income.

Overall, the company’s policy portfolio is risk-taking in nature and this is the reason why it has emphasized debt funding to carry out its operations. Besides, its corporate governance structure prioritizes risk taking ventures into the business and that is observable in its financial management policies. Hence, such relationship has also portrayed a significant variation in the company’s performance outcomes respectively.

References
Arnold, G 2010, The Financial Times Guide to Investing, Prentice Hall.

Berk, J., DeMarzo, P. & Stangeland, D 2015, Corporate Finance, Canadian Toronto: Pearson Canada.

Brigham, E.F. & Ehrhardt, M.C 2011, Financial Management: Theory and Practice, USA: Cengage Learning.

Ferris, S.P., Noronha, G. & Unlu, E 2010, ‘The more, merrier: an international analysis of the frequency of dividend payment’, Journal of Business Finance and Accounting, vol. 37, no. 1, pp. 148–70.

Fortescue Metals Group 2016. Fortescue Metal Group Annual report and accounts 2016. [Online] Available at: https://www.fmgl.com.au/ [Accessed 25 April 2017].

Gibson, C 2012, Financial statement analysis, Mason, Ohio: South-Western.

Henderson, S., Peirson, G., Herbohn, K., & Howieson, B 2015, Issues in financial accounting, Pearson Higher Education AU.

Horngren, C., 2013. Financial Accounting. Australia: Pearson.

Libby, R., Libby, P. & Short, D 2011, Financial accounting, New York: McGraw-Hill/Irwin.

Melville, A 2013, International Financial Reporting – A Practical Guide, 4th edition, Pearson, Education Limited, UK

Slee, R., 2011. Private Capital Markets: Valuation, Capitalization, and Transfer of Private Business Interests. Hoboken, New Jersey.: s.n.

Spiceland, J., Thomas, W. & Herrmann, D 2011, Financial accounting, New York: McGraw-Hill/Irwin,University Press

Vaitilingam, R 2010, The Financial Times Guide to Using the Financial Pages, London: FT Prentice Hall.

William, L., 2010. Practical Fianncial Management. Australia

Appendix