For achieving a higher quality financial management in any organization, the underlying quality of financial governance and leadership is of primary importance. While good basic systems combined with effective processes and controls are also considered important, it is the overall financial culture of the organization which makes the difference in enabling the organization to have efficient management of its financial resources. Effective management of financial resources with consistent policies and practices will ensure the financial success of any organization.
By using specific models and techniques it is also possible to evaluate the effectiveness of such policies and practices to assess the overall financial performance of the company. This paper presents an analytical report on the management of financial resources by British Petroleum (BP). This analysis looks into various types of financial resources being owned and managed by the Company and presents an overview of the capital structure of the company. The paper highlights the management practices adopted by BP for managing its financial resources.
In general, the objective of a company must be to create value for its shareholders. Value is represented by the market price of the company’s common stock, which in turn is a function of the firm’s investment, financing, and dividend decisions. The basic idea of managing the financial resources in any business venture, therefore, is to acquire assets and invest in new products and services where expected return exceeds their cost, to finance with those instruments where there is a particular advantage, tax or otherwise and to undertake a meaningful dividend policy for stockholders (Ross et al., 2005).
These functions define the scope and role of financial management in any organization. The financial management function thus concerns the acquisition, financing, and management of assets with the overall organizational goals in mind. In line with the above principles of financial management, the company has taken the following actions in the financial discipline. The main areas of corporate financial management are the decisions concerning investment, funding, dividend payment, risk management, and working capital management.
The major objective of financial management is the maximization of the shareholders’ wealth on a long-term basis. It is therefore one important aspect of the analysis of the financial management policies is to see whether the managers have acted in the best interests of the shareholders from a long-term perspective. Similarly, analysis of funding includes an analysis of market efficiency, sources of finance, and capital structure of the company.
Definition of Terms
- The average cost of capital – A firm’s required payout to the bondholders and the stockholders expressed as a percentage of capital contributed to the firm. The average cost of capital is contributed by dividing the total required cost of capital by the total amount of contributed capital.
- Balance Sheet – A statement showing a firm’s accounting value on a particular date; It reflects the equation Assets = Liabilities + Stockholders’ equity
- CAPM – Capital Asset Pricing Model – An equilibrium asset pricing theory that shows that equilibrium rates of expected return on all risky assets are a function of their covariance with the market portfolio
- CAR – Cumulative Abnormal Returns – Sum of differences between the expected return on a stock and the actual return that comes from the release of news to the market
- Capital markets – Financial markets for long term debt and equity shares
- Capital Structure – The mix of the various debt and equity capital maintained by a firm; also called financial structure.
- Cash flow – Cash generated by the firm and paid to creditors and shareholders. It can be classified as (1) cash flow from operations (2) cash flow from changes in fixed assets and (3) cash flow from changes in the working capital
- Convertible bond – A bond that may be converted into another form of security typically common stock at the option of the holder at a specified price for a specified period of time
- Cost of equity capital – The required return on the company’s common stock in capital markets; It is also called the equity holders’ required rate of return because it is what equity-holders can expect to obtain in the capital market. It is a cost from the firm’s perspective.
- Dividend – Payment made by a firm to its owners either in cash or in stock. Also called the income component of the return on investment in stock
- EBIT – Earnings before interest and taxes
- Financial leverage – Extent to which a firm relies on debt; financial leverage is commonly measured by the ratio of long-term debt to long-term debt plus equity
- IPO – Initial Public Offering
- IRR – Internal Rate of Return – A discount rate at which the net present value of investment of zero. The IRR is a method of evaluating capital expenditure proposals.
- Liquidity – Refers to the ease and quickness of converting assets into cash. Also called marketability
- NPV – Net Present Value
- Primary market – Where new issues of securities are offered to the public
- Shareholder – Holder of equity shares; the terms shareholder and stockholder usually refer to owners of common stock in a corporation
- The weighted average cost of capital – WACC – The average cost of capital on the firm’s existing projects and activities; the weighted average cost of capital for the firm is calculated by weighting the cost of each source of funds by its proportion of the total market value of the firm. It is calculated on a before and after-tax basis.
British Petroleum – an Overview
British Petroleum Plc (BP Plc) is an oil company having its subsidiaries in different countries across the world. The Company presently operates in the business segments of oil exploration and production and oil refining and marketing. The Company is the third-largest integrated oil company in the world, next to Exxon Mobil and Royal Dutch Shell. BP operates its oil exploration business from 29 countries around the world and the Company carries an oil reserve of 18.2 billion barrels. “BP is the largest oil and gas producer in the US and also a top refiner, processing more than 3.8 million barrels of crude oil per day. BP markets its products in more than 100 countries and operates more than 24,000 gas stations worldwide.” (Hoovers.com, 2008) In order to further its image as an environmentally responsible enterprise, BP has created Alternative Energy. For this purpose, the Company has invested $ 1.8 billion to develop green energy. The Company’s sales for the year 2008 were $ 367 billion and the Company has employed 92,000 people as of the end of the year 2008.
Types of Financial Resources
The Company mainly has two types of financial resources to manage. They are the short-term financial resources represented by the current assets consisting primarily of cash, inventory, and accounts receivable. Against these current assets, the Company has certain current liabilities which represent the short-term financial obligations of the Company to be met from the realization of the current assets. The difference between the current assets and current liabilities form the working capital of the Company. Efficient management of short-term financial resources represented by the working capital will enable the Company to meet its short-term financial obligations with ease. The working capital needs of the company are mainly funded by bank overdrafts and bank loans. The company also enters into finance lease agreements for meeting the short-term fund requirements.
Apart from the short-term financial resources, the Company depends on a number of long-term financial sources for investments in property, plant, and equipment as well as for the expansion of the company. As far as the long-term financial needs are concerned the company meets its needs a majority through medium term notes and other fixed term debts. A part of the long-term funds is also managed through bank loans and long-term finance leases. Issuing common stocks and preferred stocks are other means of meeting the long-term financial needs of the company. There are different types of derivatives that can also supplement the financial resource of the company.
Control of Financial Resources
It is vitally important for the Company to manage both its short-term and long-term financial resources effectively so that the Company can enhance its profitability. Managing financial resources primarily involves the containment of the cost of capital to the Company so that the financial resources can be put to maximum productive use. There are different techniques and methods available, using which the Company presently controls the financial resources.
Control of Short-term Financial Resources
Short-term financial resources represent the current assets of the company including cash, accounts receivable, and inventory. The networking capital of the company can be enhanced by the efficient management of these resources. There are no universally accepted principles of managing short-term financial resources that involve decisions concerning the level of current assets and current liabilities. The most important difference in managing long-term and short-term financing is the timing of cash flows, as managing the short-term financial resources involves cash inflows and outflows within a year or less. There are some important questions that the financial manager should find answers to for efficient management of short-term financial resources. They are related to the maintenance of a reasonable level of cash on hand, the level of inventories to be maintained, and the extension of credit to the customers.
Efficient cash management involves determining the operating cycle and cash cycle. This calls for a thorough understanding of the firm’s short-run operating activities which consist of a sequence of events and decisions. These events and decisions create patterns of cash inflows and outflows that are unsynchronized and uncertain. The uncertainty is due to the fact that payment for the inventory and collection from the debtors do not happen at the same time. The operating cycle is the time lag between the arrival of inventory and the time when cash is collected from the customers.
The cash cycle begins when cash is paid for the inventory and ends when cash is collected from the debtors. The cash flow timeline consists of an operating cycle and a cash cycle. The need for the management of cash arises because of the gap between cash inflows and cash outflows. This gap is related to the lengths of the operating cycle and the accounts payable period. The Company manages cash by raising short-term borrowings or by holding a liquidity reserve for marketable securities. The gap between cash inflows and outflows can be shortened by efficient inventory management and managing the receivables and payables effectively.
In general, inventory management is a complex process that requires careful consideration of several factors that determine the level of inventory required as well as the time needed to replenish the stock items so that an uninterrupted supply of materials is ensured to increase production efficiency. In order to ensure this, there are several methods of inventory control, all designed to provide an efficient system of determining the quantity, time, and quality of materials that need to be organized. “Out of the available inventory control techniques, it is possible to use either a single or a combination of one or more techniques of inventory management.” (BusinessLink, n.d.)
Recent developments in inventory management include two broad concepts of inventory control namely the ‘Materials Requirement Planning (MRP) which is basically an information system “in which sales are converted directly into loads on the facility by sub-unit and time period. Materials are scheduled more closely, thereby reducing inventories, and delivery times become shorter and more predictable.” (Inventory Management, 2007)
Another development in the area of inventory management is the ‘just-in-time’ inventory management. ‘Just in Time’ (JIT) is defined as “a philosophy of manufacturing based on planned elimination of all waste and on continuous improvement of productivity” JIT is basically an approach with the aim of producing the right component at the right place and at the right time. “JIT (also known as lean production or stockless production) should improve profits and return on investment by reducing inventory levels (increasing the inventory turnover rate), reducing variability, improving product quality, reducing production and delivery lead times, and reducing other costs (such as those associated with machine setup and equipment breakdown).” (Schonberger, 1984)
The credit policy of the Company consists of the terms of sale, the credit analysis, and the accounts receivable collection policy. The terms of sale contain the description of the period of time for which credit is granted and the type of credit instrument. The optimal amount of credit that the Company can offer is a function of the carrying costs and the opportunity costs of lost sales from refusing to offer credit terms on sales to customers. An optimal credit policy reduces the carrying costs and the opportunity costs. The collection policy with respect to the accounts receivable is arrived at by looking at the past-due accounts.
The first step to determine the collection policy is to calculate the average collection period and analyze it. It is also important to prepare an aging schedule that relates the age of the accounts to the proportion of the accounts receivable they represent. The Company based on the information of average collection period and the age of debtors arrive at the collection policy. Once the collection policy is decided the Company decides on the collection method and follows the factoring method to augment the cash resources.
Control of Long-term Financial Resources
The Company needs long-term funds for financing its capital expenditure, meeting its working capital needs, and other long-term uses like expanding into new projects or lines of production. For instance, the Company has invested a large sum in the development of alternative green energy. Long-term debt involves contractual obligations set out in the debt instruments.
Since the long-term debts represent a commitment on the part of the Company towards payment of interest and repayment of capital on fixed dates it is important that decisions in relation to the availing of long-term funds through debts are taken after due considerations of all the aspects involved in the long-term financing. Another aspect of long-term financing is a careful evaluation of various investment proposals.
Capital budgeting is the making of long-term planning decisions for investments in projects and programs. It is a decision-making and control tool that focuses primarily on projects or programs that span multiple years. These planning decisions should be guided by the objectives of the organization and its strategies. The strategy describes how an organization matches its own capabilities with the opportunities in the marketplace to accomplish its overall objectives (Horngren et al., 2002).
The financial feasibility of any capital investment proposal can be judged based on the ability of the project to enhance the shareholders’ wealth by contributing positive net cash inflows from the proposed investments. Just any other domestic capital project is being evaluated, for the international investments can also be evaluated by calculating the ‘Net Present Value (NPV) future cash flows expected out of the project. The NPV of the project depends on the initial investment or initial cash flow, expected future cash flows, and the cost of capital.
Based on the comparison of the NPV of the future cash flows with the proposed capital investment the feasibility of the project can be established. While working out the NPV the effect of the factors like Sales creation (additional sales), cannibalization (loss of sales), opportunity cost, transfer pricing, and fees and royalties on the future cash flows should be taken into account. The Internal Rate of Return (IRR) is the other criterion that needs to be carefully looked into while deciding on the capital investment.
Optimum Capital Mix
The capital structure of a firm may consist of equity capital and long-term debt financing. The Company has to consider arriving at a proper capital structure with the correct determination of the proportion of debt capital and equity capital. Both means of financing have their own merits and demerits. While debt capital involves payment of interest there is the dividend payment in respect of equity capital and the payment of interest and dividend both entail a certain cost for the Company.
The Company usually considers the Weighted Average Cost of Capital (WACC) for deciding on the optimum capital mix which decides the proportion of debt and equity capital. There are other methods like the Capital Asset Pricing Model (CAPM) to arrive at the cost of capital to the company which helps in the determination of the optimum capital mix.
This paper outlined the types of financial resources available to BP, their classification into short-term and long-term based on the nature of the funds, and the ways of managing the short-term and long-term financial resources including investment appraisal techniques. The paper suggests that effective management of financial resources is of vital importance for the growth and profitability of any company and it also enhances the market reputation of the company.
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Hoovers. 2008. BP Plc. Web.
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InventoryManagement, 2007. Inventory Management: Definiton of Inverntory Management. Web.
Ross, S.A., Westerfield, R.W. & Jaffe, J., 2005. Corporate Finance Seventh Edtion. New Delhi: Tata McGraw Hill.
Schonberger, R.J., 1984. ust-In-Time Production Systems: Replacing Complexity With Simplicity in Manufacturing Management. Industrial Engineeing, pp.52-63.