Financial analysis of BG and Shell

INTRODUCTION
According to the requirements stipulated in this assignment, this essay would be analysing two companies: BG group Plc and Royal Dutch Shell Plc. Both companies are oil and gas producers and they operate in the integrated natural oil and gas industry. They are involved in the exploration, development, production, and marketing of gas and oil. They are both quoted in the oil and gas industry sector of the FTSE 100 index.
a. Background of the Oil and Gas Industry

Over the last 50 years, the oil and gas industry has been by far the most successful industry in Britain; providing employment to 380,000 people, adding ?4 billion a year to balance payments and a massive investment over the last 25 years by ?150 billion. This sector has reinforced the British economy by supplying the energy and necessary chemicals for its transport industry and homes. Additionally, since the 1970s, the oil and gas industry generated ?150 billion in taxes and valuable export revenues.
b. Royal Dutch Shell
Royal Dutch Shell is a Multinational corporation consisting of two companies: Royal Dutch Petroleum Co., of Hague, Netherland, and Shell Transport and Trading Corporation PLC of London, England. These two companies commenced as rivals. In early 1897, Marcus Samuel took over his father’s business and began selling kerosene. After this, he shifted to the oil industry in East Asia and created Shell Transport and Trading Co., Ltd. At same time, in 1890 the Royal Dutch Co was established by a group of Dutch businessmen (Mallin, 2006). The aim of the company was to explore the Oil Wells in the Dutch Indies. To achieve these targets, in 1892 it constructed the first refinery in Sumatra, Indonesia. It was not until 1907 when the two firms merged to become the Royal Dutch Shell Group. The company has become known in different countries such as Egypt, Mexico, Iraq, Romania, Russia and Venezuela. Shell emerged as the largest energy company and the second largest company globally regarding its revenues. The main interests of this company are liquefied natural gas and petrochemicals, aviation, shipping, and automotive fuels.
c. BG group Plc.
BG Group plc is one of the most successful companies in the FTSE 100 index. It operates in the integrated natural oil and gas market and engages in the exploration, development, production, and marketing of gas and oil. The company’s headquarters is in Thames Valley Park in Reading, Berkshire, United Kingdom. It is an international firm which operates in 25 countries across the world and produces 680 000 barrels of oil per day (Jahn et al., 2008). The company was founded in 1997 when British Gas plc divested Centrica and became BG plc, which was reorganised in 1999 as BG Group plc (Bryant, 2003).
Question 1:
Analyse the liquidity, profitability and use of short term assets and liabilities of the two companies you have chosen and compare the ratios with the sector average and explain how the two shares have performed compared with the FTSE during the last financial year.
In order to assess the liquidity situation of both companies along with profitability condition, different liquidity ratios have been analysed based on the companies’ annual reports 2010 and Yahoo 2011 financial website for the year ended 2010.
The liquidity ratios of BG group and Royal Dutch Shell are illustrated in Figures 1 and 2 (for full tables see the Appendix). Royal Dutch Shell has maintained relatively stable current and quick ratios. Current ratio illustrates whether or not a company maintains enough resources to pay back its debts over the coming financial year (Watson, 2006). It is determined by the ratio of net current assets to net current liabilities. For Shell company the ratio increased by 7.45% over the 5 years period. Furthermore, the current ratios of the last five years exceeded one, which proved that Royal Dutch Shell would be able to honour all its short-term liabilities by its current assets without the need to utilise other sources; such as issuing shares or using new debts. Therefore, this gives clear evidence that the firm’s liquidity situation is in excellent health. The quick ratio represents the ability of a firm to utilise its cash/assets to cover its current liabilities instantaneously, which is calculated as a ratio of total assets to total liabilities. This has fallen by 8.87% over the past five years to 1.8669 in 2010.
In 2010, the current and quick ratios of Royal Dutch Shell were 1.1227 and 1.8669. These are below the average ratios of the company over last five years: 1.15694 and 1.88726 respectively. This ideally shows that the liquidity of the company has been slightly decreasing in recent years.
Figure (1): Current and Quick ratios of Royal Dutch shell over the last 5 years
On the other hand, the quick ratio of BG group has also decreased over the last five years; it began with 2.13 in the first period and decreased to reach 2.0389 in 2010. Moreover, the current ratio also diminished from 1.4684 to 1.1214. One reason could be that the reduction in the firm’s liquidity is as a result of the major issues that have affected the oil and gas industry recently. For instance, the oil spill in Mexico, and the massive impact on BP and other oil companies caused cost of drilling and exploring call in certain regions to rise.
Figure (2): Current and Quick ratios of BG group over the last 5 years
According to Watson (2006) having a liquidity ratio over one is not enough to assess whether a firm would have difficulties to confront any short term risk arising from the liabilities and, for this reason, the company’s current ratio should be compared to the overall industry or sector average ratio. Hence, after comparing the current ratios of both companies to the average of eight leading companies in major integrated oil and gas industry (see Appendix), the two companies hold almost the same amount of current ratio (1.12). However, they were below the average ratio of the industry by 8%. In a conventional industry, if the current ratio is over one then it is a good indicator. However, in major integrated oil and gas industries the average ratio is 1.2 which imposes on the two companies to adjust their ratio, or else they will face increasing threat of being cash strapped if they are not able to increase profitability, cash flow or reduce liabilities.
The profitability ratios of Royal Dutch Shell Plc and BG group Plc were calculated based on its ROE, ROA, profit, operating and gross profit margin. These were all compared to the average industry in order to draw an accurate representation of the companies’ financial situation. For both companies, Return on Equity and ROA exceeded the average sector by 1.63 and 2.62 for BG group Plc, and 1.7, 0.33 for Royal Dutch Shell Plc respectively. However, BG group Plc overperformed Royal Dutch Shell Plc and industry regarding the profit and operating marginal, but both companies were overtaken by the industry gross profit ratio. Profitability ratios attempt to determine a company’s ability to use and control its assets and expenses in a rational manner to generate acceptable rate of return (Buckley, 2004). Based on the ratios calculated, both companies have been able to improve their profitability sufficiently over the average sector ratios.
In summary, both companies are liquid firms and have been able to withstand the effects of the oil spill and oil price increases through effective cash management. They have constant and above average liquidity ratios, positive networking capital and acceptable profitability ratios.
Figure (3): Percentage change in stock price for BG group, Royal Dutch Shell and FTSE 100 index
Key: BG.L (blue): BG group Plc; ^FTSE (red): FTSE 100 index; RDSA.L (green): Royal Dutch Shell plc.
Source: Yahoo Finance (2011)
As illustrated in Figure (3), the stock market prices of BG group and Royal Dutch Shell fell during the middle of 2010, specifically in early May.
The oil spill by BP in Mexico had hugely deteriorated the market value of both stocks. However, the stocks of both companies tended to increase after the oil spill issue was solved. Moreover, the stocks of both companies and FTSE 100 seem to move in same manner to reach their peak by the end of 2010. In the beginning of 2010, both companies and FTSE100 stocks were moving in very close way, but the Mexico’s oil disaster caused investors to walk away from investing on oil companies’ shares. By the end of August 2010 stocks of both companies started to rise, along with FTSE 100, and by the end of 2010 all stocks of both companies and FTSE 100 reappeared to move in the same way but with higher values.
Question 2:
Critically evaluate each firm’s choice of capital structure and how their method of financing has affected shareholder wealth and explain whether or not it is possible for a company to have an optimum capital structure.
The capital structure of a company, as defined by Fridson and Alvarez (2002), as the ratio to which the company’s operating, financing or investing activities are financed through debt and equity. It is simply a ratio of the company’s debt to its equity, otherwise known as gearing or leverage. The capital structure determines the long term functioning capacity and also its attractiveness to banks and investors (Watson and Head, 2006). Consequently, the capital structure is an indicator of the company’s financial fitness.
As illustrated in figure 4 below, Royal Dutch Shell’s capital structure is based mostly on equity. Its gearing has fallen to over 85% in 2010, compared to 87% in 2009. This is due to falling profits. However, the amount of equity is five and half times the amount of debt. Therefore it represents a low geared company that relies on equity to finance a vast majority of its activities.
Figure 4: Comparison of the capital structure for Royal Dutch Shell between 2009 and 2010
A company that is considered as low-leveraged has complete freedom in its operations without the need to be concerned about issues that debt may have due to inaccessibility to future credit.
Figure 5: Capital structure of BG group Plc between 2009 and 2010.
Examining BG group Plc’s capital structure above shows that its gearing has increased by 4.8% to move up to 25.2% in 2010. The balance sheet therefore shows that it has changed its capital structure by increasing levels of debt from $19.212 billion to $23.615 billion, as well as also increasing shareholder equity from about $23.23 billion to over $26.684 billion in 2010. However, the debt increase exceeded the equity increase, thus resulting in a debt/equity ratio increased (BG group Plc, 2010).
Furthermore, analyses of the company’s financial annual report illustrates that it has issued ˆ750 million and ?750 million of bonds maturing in 2019 and 2025 respectively. Both of these are under the euro medium term note programme, and $350 million and $650 million of bonds maturing in 2015 and 2020 respectively could be taken as strong evidence that the company has shifted its system of rising money from equity to debt by issuing bonds. Therefore, measuring BG group’s capital structure based on its ability to repay future debts may be difficult due to the massive bond issues, which considerably exceeds the net amount raised from equity.
Judging by the current credit markets in which loan provisions are scarce and conditions for getting one are hard, BG would have slightly more difficulties than Royal Dutch Shell in obtaining working capital or long-term loans. Though its capital structure does look healthy from an external point of view, comparing the average sector debt to equity ratio which was 37.45% in 2010, both companies are in excellent positions as both of them are far away from any risk of interest rate volatility. Therefore, a good conclusion could be drawn about the ability of both companies to meet interest repayments, and to operate in an efficiently manner to expand their business as a result of their relatively low liabilities.
As mentioned, Fridson and Alvarez (2002) state that capital structure refers to the manner in which an organisation finances its assets; this could be either by combination of equity, debt, or hybrid securities. The relationship between capital structure and company value has fuelled the researcher’s interests to conduct more research on this area. According to literature, the debate has concentred on whether there is an optimal capital structure for a firm or the proportion of debt used in constructing the capital is irrelevant to the firm’s value.
The Modigliani-Miller theorem states that under a certain market characteristics such as: price random walk, in the absence of taxes, agency costs, asymmetric information, and bankruptcy and in an efficient market, the proportion of debt which has been used by company will not affect its value moreover it does not matter how the firm is financed (issuing stocks or selling debt). The Modigliani-Miller theorem is generally called the “capital structure irrelevance principle”(Hatfield et al., 1994). The aim of this theory is to establish capital structure which balances the risk of bankruptcy with the tax savings of debt. Therefore, it would provide better returns to shareholders than they would receive from an all-equity firm.
Despite its theoretical appeal and all efforts behind it, academics and practitioners in financial management have not found the optimal capital structure yet. The only prescription that could be achieved is to satisfy short-term goals. The main flaws of this idea are that it fails to consider either the complexities of the competitive environment, or the long-term survival needs of the organization. According to Welc (2008):
“The fact that an optimal capital structure has not been found is an indication of some flaw in the logic. We believe that the original question was framed incorrectly. Rather than: What is an optimal mix of debt and equity that will maximize shareholder wealth; it should have been: Under what circumstances should leverage be used to maximize shareholder wealthWhyBecause debt and equity have profound long-term implications for corporate governance that far exceed the exigencies of the moment.”
Question 3
Explain whether or not the share price on the 5th of November represents fair valuefor would be investor and explain whether or not the investor ratios give a guide as to the future share price. Critically evaluate the arguments for and against the efficient market hypothesis and explain how the npv criteria relate to investing in shares.
The term, “market efficiency”, has always been a fundamental concept in the financial literature. It describes the decisive impact of information on the price of financial assets and economists refer to it as operational efficiency, highlighting the way resources are utilised to ease the workings mechanisms of the market. However, the most common definition was provided by Fama (1970) who stated that at any given time, securities’ price on a particular stock market fully reflects all the available information on this stock market. Hence, according to the efficiency market hypothesis (EMH), all investors have access to the same information that is already available on the market; therefore, no advantage is taken from private or inside dealing information. In other words, market efficiency reflects the impact of changes in information about a given security on its price. Favourable information is expected to result in an immediate increase in a security price while unfavourable information will have the opposite effect.
The efficient market hypothesis is linked with the term “random walk” which has been used in the financial literature to refer to a price series where all changes in the prices reflect a random change, regardless of previous prices. This concept emerged from the works of Kendall (1953) and Roberts (1959) where, after analysing the UK stock and commodity prices series and the US stock market, they found clear evidence that the prices change randomly. The logic behind the random walk concept is that if the information is instantly reflected in stock prices, then the day after any price change would only reflect the news of that day and will be independent of the price change of previous day. According to the unpredictability of the news, the price changes must therefore be unpredictable and random. Hence, this statement implies that the investor would achieve the same result of buying and selling securities by himself as by the experts.
It was in the early years of the twenty-first century when many financial economists and statisticians started doubting that stock prices could be accurately predicted by emphasising the psychological and behavioural character of stock price determination. Moreover, these financial experts believed that future stock prices can only be slightly predictable based on the patterns of past stock prices and certain fundamental valuation metrics. However, some economists exaggerated by stating that these predictable patterns would allow investors to reap benefits from reducing risk and increasing the levels of return of their securities.
In order to assess whether the price of share for both companies fairly reflects the information available in the market, at 5th November 2010, a comparison was provided for the both stocks one week before and after that day (the result depicts in figure 5):
Table (1): stock prices of BG group and Royal Dutch Shell
Stock
1st November 2010
5th November 2010
8th November 2010
Closing price
Day’s change
Closing price
Day’s change
Closing price
Day’s change
BG group
?12.11
-0.05
?12.9
-0.04
?12.7
-0.14
Royal Dutch Shell
?20.16
+0.17
?20.44
-0.10
?20.26
-0.18
Source: Financial Times 2011
It is clear from table (1) that over the period of one week before and after 5th November 2010, the prices of both companies’ stock have moved relatively in stable manner. Moreover, regarding the available public information at that point, the prices of the stocks fully and fairly reflected all the information and data that was available which confirms that the UK stock market is an efficient market where all the past and available information is already reflected on its prices.
As the UK stock market is a developed market, the market is meant to be efficient. Therefore stock prices are expected to reflect all past and public information. So when investors invest money on BG group or Royal Dutch Shell stocks, they would obviously take its past performance into account. As it has been found in the previous question, both companies have outperformed the average industry in term of ROE, ROA and book value per share (see table (2) in appendix) which should ideally encourage prospective investors to invest in those companies. This would make their stock more attractive to investors.
One of the most commonly used techniques in finance is the Net Present Value (NPV). The NPV represents the expected change in the value of the firm in current time if a project is accepted. NPV adopts the time value of money principle in calculating all investments, which depicts that the cash flow on an investment is discounted based on the cost of capital, which decreases over the period in which the project is active (Watson and Head, 2006).
Under the efficient market hypothesis EMH assumptions, the price of a random share in the market has to be allocated on the Security Market Line (SML) or Capital Market Line (CML), therefore the share prices is consistent with share asset market values (intrinsic values) so theoretically it is meaningless to conduct any earned value analysis “EVA” (NPV and investors ratios). Share price allocated on the SML/CML by definition will have net present value NPV equals to zero and cost of capital equals to the internal rate of return, in which any evaluation of this measurements would be useless because EVA must equals zero. Since NPV measures the present value of any future cash flows, in an EMH world, NPV attempting to calculate a measurement which has already been reflected on the share price. Arbitrage theory ensure that any abnormal profit should not exist or occur, if the earned value analysis EVA were to be observed, it should occur in random value or statistically non-significant and the positive earned value analysis should be offset by negative earned value analysis (Chen, 2001). Furthermore, in an efficient market world it is unlikely to earn excess returns consistently. Thus within the logic of this theory EMH, earned value analysis which consists of calculating the investors’ ratios and NPV is a fiction and useless.
In conclusion, the price of the both companies appears to be fully and fairly reflected in all the data and available information, such as investor’s ratio (ROE, ROA and the positive NPV value). Therefore, investors cannot beat the market price under the efficient market hypothesis assumption even though the investor ratios and NPV show the attractiveness of the stock because the price of share is already reflect all the past information (ratios and NPV)

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Appendix

Table (2): Represents the financial ratios of the 8 companies in the industry
BP Plc (BP.L)
Petroleo Brasileiro SA Petrobras (APBR.BA)
Exxon Mobil Corporation (XOM)
Royal Dutch Shell PLC
BG Group PLC (BG.L)
Total SA (TTA.L)
ConocoPhillips (COP)
Encana Corporation (ECA)
average industry
Profit Margin
-1.25%
16.50%
8.89%
5.47%
19.52%
7.53%
6.46%
1.24%
8.05%
Operating Margin
-4.58%
22.21%
12.01%
7.48%
34.11%
14.19%
7.99%
6.11%
12.44%
Return on Equity:
-3.36%
15.05%
23.43%
14.22%
14.15%
18.83%
17.34%
0.50%
12.52%
Return on Assets
-3.35%
6.80%
9.60%
5.60%
7.89%
9.18%
5.69%
0.78%
5.27%
Current Ratio
1.16
1.88
0.94
1.12
1.12
1.42
1.26
0.67
1.20
Total Debt/Equity
47.28
38.01
9.83
29.60
36.37
49.69
41.39
47.41
37.45
Revenue Per Share
95.02
27.51
70.13
120.03
25.39
62.86
118.81
9.49
66.16
Gross Profit Margin
16.46
53.80
43.63
13.53%
25.39%
29.26%
29.74%
88.84%
38%
Book Value Per Share
30.33
29.95
29.49
48.10
38.87
27.00
47.92
22.97
34.33
Total Cash Per Share
6.42
5.50
1.58
4.37
3.74
6.88
7.91
1.10
4.69
Table (3): Represents the liquidity ratios of BG group and Royal Dutch Shell over last 5 years
Ratios
Company
2010
2009
2008
2007
2006
Quick ratio
Royal Dutch Shell
1.8669
1.8967
1.8393
1.8778
1.9556
BG group
2.13
2.2091
2.0637
1.9159
2.0389
Current ratio
Royal Dutch Shell
1.1227
1.1376
1.1046
1.2226
1.1972
BG group
1.1214
1.10125
1.0542
1.3041
1.4684
Net working capital
Royal Dutch Shell
12342
11668
11041
21013
15137
BG group
1079
104
506
2351
2584
Net profit
Royal Dutch Shell
20127
12518
26277
31331
25442
BG group
3532
3462
5907
3460
3198
Figure (5): The Net profit of the two companies
Figure (6): Net working capital of the two companies
Table (4): The financial ratios of the two companies in 2010
Financial ratios
Formula
BG
Shell
Profitability ratio
Tax Burden
Net Profit/Pre-tax Profit
= 3500/5730
= 61.08%
= 20474/35344
= 57.93%
Interest Burden
Pre-tax/EBIT
= 5730/5562
= 103.02%
= 35344/36340
= 97.26%
Margin
EBIT/Sales
= 5562/17166
= 32.40%
= 36340/368056
= 9.87%
Turnover
Sales/assets
= 17166/50299
= 34.13%
= 368056/322560
= 114.10%
Leverage
Assets/Equity
= 50299/26684
= 188.50%
= 322560/149780
= 215.36%
ROE
Net Profit/Equity
= 3500/26684
= 13.12%
= 20474/149780
= 13.67%
Return on asset ROA
Net Income / total asset
= 3500/50299
= 6.96%
=20474/322560
= 6.35%
Net gearing
Net debt / equity
= 23615/26684
= 88.50%
= 172780/149780
= 115.36%
Basic earning power ratio
EBIT / Total asset
= 5562/50299
= 11.06%
= 36340/322560
= 11.27%
Liquidity ratio
Current ratio
Current assets / current liabilities
= 9965/886
= 112.14%
= 112894/100552
= 112.27%