Comparison of Capital Structure and Operating and Total Expense Management

While Capilano Honey Limited (CZZ) and Select Harvests Limited (SHV) are in the same agricultural produce industry, they operates in different market segment. On one hand, Capilano Honey packs and supplies honey to food manufacturers in Australia and globe. The company supplies retail packed honey to supermarket chains, including industrial customes with drums, IBCs and pails. Capilano Honey comes in different brands – Wescobee, Barnes, Smiths, BeeVital, Allowrie and Capilano. On the other hand, Select Harvests grows and processes almond in various orchards located in South Australia, New South Wales and Victoria. It has two major divisions, Almond Business (manages orchards, harvests and initial processing of orchard) and Food Business (processing and marketing of products). The purpose of this mini-report is to compare the financial performance of the two companies in terms of capital structure, profitability margins and asset management.

Capital structure

Capital structure refers to the strategies used by firms to finance their operating activities and growth in terms of asset acquisitions and other investments. Capilano Honey and Select Harvests both uses a blend of equity and debt financing in different proportions. Debt financing is riskier, but less expensive compared to equity financing due to take advantage – interests on debt is tax-deducible (Bakry, 2016). Equity capital is expensive, but less risky because the firm has no obligation to pay dividends in case of losses and principal amount is not repaid.  Dividends are not tax deductible. However, there is an optimum level of debt beyond which tax savings would longer be feasible, as was described by Modigliani & Miller (1963). High level of debt would expose the firm to more risk of default and insolvency. Two capital structure ratios – debt to equity and debt ratio – were used to investigate the capital structure of Capilano Honey and Select Harvests, as showed in Table 1.

Ratio

Company

2017

2016

Debt  to equity ratio

CZZ

          0.55

          0.79

SHV

          0.73

          0.55

Debt ratio

CZZ

          0.35

          0.44

SHV

          0.42

          0.35

Table 1: Capital Structure Ratios (source: Morningstar DatAnalysis)

Debt to equity ratio describes the proportion of debt with respect to equity used by the two companies to finance their operations and investments, while debt ratio indicates the proportion of assets financed through debt capital (Bakry, 2016). Table 1 indicates that the debt to equity ratio of Capilano Honey has reduced in 2017 from 0.79 to 0.55, while that of Select Harvests have increased from 0.55 to 0.73. The reason for decreased debt equity ratio of Capilano Honey is because the level of debt decreased (-22.64%) more than equity increase (11.78%), while that of Select Harvests increased because the level of debt increased (27.19%), while equity decreased by 4.57%. Capitalo Honey’s total debt decreased despite of the fact that the company increased its long-term debt, which consequently lend to increase in financial expense or costs. On the other hand, debt ratio of Capilano Honey also decreased in 2017 from 0.44 to 0.35, while that of Select Harvests decreased from 0.35 to 0.42. The reason for decreased debt ratio for Capilano Honey is because the level of debt decreased at higher rate (-22.64%) than assets (-3.40%) in 2017, while that of Select Harvest increased because the level of debt increased at higher rate (27.19%) than assets (6.65%). From the analysis of debt to equity ratio and debt ratio, it can be deduced that Capilano Honey decreased its financial leverage while Select Harvests’ increased its financial leverage in 2017.

Operating and total expense management

The ability of firms to successfully manage their operating and total expenses can be evaluated by profitability margin ratios. A company cannot survive in the long-term if consistently generates negative profitability margins, as it would consequently run into cash flow problems, credit defaults and ultimately insolvency. EBIT margin ratio can be used to evaluate whether the company is able to finance its operating activities includes selling and administration expenses, payroll costs, and depreciation and amortization using revenue remaining after accounting for cost of sales or COGS (Bakry, 2016). EBIT margin is the ratio of EBIT or earnings before interests and taxes to total sales revenue.  On the other hand, ability to manage total expenses can be evaluated by Net Profit Margin or the ratio of net profit to the total sales turnover. This ratio shows the power of the company to cover cost of goods sold, operating expenses, financial costs, and taxes. Table 2 presents the EBIT margin and Net Profit margin of Capitalo Honey and Select Harvests for year 2016 and 2017.

Ratio

Company

2017

2016

EBIT margin

CZZ

12.36%

13.58%

SHV

-80.98%

6.67%

Net Profit Margin

CZZ

7.77%

7.11%

SHV

3.85%

11.82%

Table 2: EBIT margin and Net Profit Margin of CZZ and SHV in 2016 and 2017 (source: Morningstar DatAnalysis)

Table 2 indicates that EBIT margins of Capitalo Honey and Select Harvests reduced in 2017, with that of latter depicting a significant negative margin. Capilano Honey’s EBIT margin reduced from 13.58% to 12.36% in 2017 because of revenue reduction (by -0.28%) and increase in operating expenses (by 7.21%). On the other hand, Select Harvests’ EBIT margin reduced from 6.67% to -80.98% in 2017 because of revenue reduction (by -16.07%) and increase in operating expenses (by 7.89%). Select Harvests attributed the sales revenue drop to plummeting crop prices (Thompson & Huxley, 2017). Net Profit margin of Capilano Honey increased from 7.11% to 7.77% in 2017, while that of Select Harvests decreased from 11.82% to 3.85%. The reason for increase in Capilano Honey’s net income is because net profit increased at a higher rate (8.98%), compensating for lost sales revenue in 2017 (-0.28%). Select Harvests’s net income, on the other side, decreased because net income decreased at higher rate (-7263) than reduction in sales revenue (-16.07%) in 2017. Capilano Honey’s financial expenses reduced significantly by almost 6x due to reduction in long-term debt. From the analysis of both EBIT margin and Net Profit margin for Capilano Honey and Select Harvests, it can be deduced that the former has higher ability to manage its operating and total expenses.

Asset Management Efficiency

Asset management efficiency refers to the ability of a firm to manage its assets in the generation of the sales revenue. The ability of the firm to generate sales revenue using total assets can be evaluated by Assets Turnover ratio, which is the ratio of sales revenue to total assets (Bakry, 2016). Assets turnover ratio can be used to determine the amount of sales revenue in Australian dollars (AUD) that can be generated from every AUD $1 of assets acquired by the company. The higher the assets turnover ratio is, the higher the assets utilization rate in the generation of sales revenue. The assets turnover ratios of Capilano Honey and Select Harvests covering 2016 and 2017 are presented in Table 3.

Ratio

Company

2017

2016

Assets Turnover

CZZ

          1.38

          1.34

SHV

          0.50

          0.64

Table 3: Assets Turnover of Capilano Honey and Select Harvests in 2016 and 2017(source: Morningstar DatAnalysis)

            Table 3 indicates that assets turnover ratio of Capilano Honey increased from 1.34 to 1.38 in 2017, while that of Select Harvests decreased from 0.64 to 0.50 in the same period. Although Capilano Honey’s assets and revenue both declined in 2017, it can be noted that the assets decline by AUD $ 3,386,337, while revenue decreased by AUD $373,827. In this case, total assets decreased 10x faster than the amount of sales revenue decline in 2017, resulting to a larger assets turnover ratio where Capilano was able to generate AUD $1.38 from every AUD $1 of assets acquired by the company. On the other hand, Select Harvests’ assets turnover ratio decreased in 2017 because sales revenue decreased by AUD $ 45,936,000, while its assets increased by 29,919,000. From the analysis of assets turnover ratios of the two companies, it can be deduced that Capilano Harvests was able to generate more dollars in terms of sales revenue from its assets than Select Harvests in 2017.

Profitability of the invested capital

            Profitability of the invested capital can be evaluated by comparing the net profit with the equity invested in the company and also capital employed – determining return on equity (ROE) and return on capital employed (ROCE), respectively (Bakry, 2016). Capital employed is the total capital used in the generation of profits, calculated by deducting short-term debt obligations from total assets. The higher the ROE and ROCE are, the higher the profitability of the invested capital. ROE and ROCE of Capilano Honey and Select Harvests are presented by Table 4.

Ratio

Company

2017

2016

ROE

CZZ

16.58%

17.01%

SHV

3.33%

11.62%

ROCE

CZZ

14.82%

14.30%

SHV

2.65%

9.18%

Table 4: ROE and ROCE of Capilano Honey and Select Harvests (source: Morningstar DatAnalysis)

Table 4 indicates that ROE and ROCE of Capilano Harvests are higher than those of Select Harvests. While Capilano’s ROE decreased slightly from 17.01% to 16.58% in 2017, Select Harvests’ declined significantly from 11.62% to 3.33% in 2017. On the other hand, Capilano Honey’s ROCE increased slightly, while that of Select Harvests declined substantially. The results of this analysis indicates that Capilino Honey has higher profitability of the invested capital than Select Harvests.

Mains reason for changes in profitability in 2017 can be explained by economic changes specific to each firm. The profitability level of Select Harvests declined due to decrease in sales revenue, which was caused by crop price declined in 2017 (Thompson & Huxley, 2017). The increase in operating expenses can also be attributed to the decline of Select Harvests profitability. On the other hand, Capilano has continued to be driven by both local and global markets.

Conclusions and Recommendations

            In conclusion, Capilano Honey exhibited a higher financial performance than Select Harvests in terms of profitability, asset management, and capital structure. The analysis indicated that Select Harvests was hit hard by decrease in almond crop prices, which is the sole source of sales revenue. Since financial data are majorly generated for external users, such as lenders, several recommendations can be proposed. With regard to credit worthiness, Capilano Honey has lower level of debt than Select Harvests and this implies that Capilano is more worth to be given loan because of lower financial leverage and higher profitability. On the other hand, Select Harvests has a higher level of debt and that means that it has higher risk of credit default.

References

Bakry, W. K., 2016. Financing Enterprises 200910. Western Sydney University Library.

Thompson, P & Huxley, V, 2017. Select Harvests (ASX:SHV) - FY2017 Results Presentation. Accessed from http://www.selectharvests.com.au/documents/SHV_FY2017_Results_FINAL.pdf