Hercules Cement Analysis - Example

Financial Institutions and Markets Name Name of Institution Executive Summary Hercules Cement is a South African firm that has operations in South Arica. The domestic construction industry has faced challenges ever since the peak demand that was occasioned by the 2010 World Cup. Nevertheless, Hercules Cement has invested in a new plant that should allow it to access the growing market in Nigeria. The business seeks a $500 million loan from Rich Bank that should be repaid within ten years. This report analyses the firm’s operating environment, financial position, and the possible risks to recommend whether the loan should be granted. The finding is that Nigeria’s booming construction industry will allow the company to achieve its aim of exporting 80% of the output from the new plant. Hercules also has sufficient collateral, and its financial position in terms of liquidity, profitability, and leverage are satisfactory for a firm that has operated in the challenging South African business environment. An examination of potential risks shows that the market, credit, liquidity, operational, and risks related to country of origin can be managed by the company. The report recommends that Rich Bank should grant Hercules Cement the requested $500 million loan at the prevailing interest rate. Table of Contents Table of Contents 3 Introduction 4 Overview of Operations 4 Financial Statement Analysis 5 Potential Risks 7 Conclusion and Recommendation 8 References 10 Financial Institutions and Markets Introduction According to Koch and MacDonald (2014, p. 529), a bank can make two types of errors when it comes to the evaluation of loan requests. The first error involves issuing a loan to a customer who will not be in a position to repay while the second involves denying a request made by a customer who can repay the debt. Koch and MacDonald (2014, p. 534) suggest that credit requests should be evaluated by examining the management, operations, and the company’s industry as well as its financial statements. Glantz & Mun (2010, p. 4) also suggest a strategy that involves examining the management, purpose of the loan, internal and external sources of cash, soundness of financial statements, collateral, and the risks and rewards. This paper looks at the business environment in which Hercules Cement operates with a view of determining whether it is in a position to be successful. The paper also examines an extract of the company’s financial statements to determine its financial position. Finally, the paper concludes with the documentation of the risks that the firm is exposed to and a recommendation on whether the bank will receive good returns from granting a loan to the business. Overview of Operations The cement industry is a sector that forms an essential building block for the development of economies since few construction projects can take place without the use of cement and concrete. Hercules Cement is a firm that is based in South Africa, a nation whose construction industry has struggled over the last few years. According to PricewaterhouseCoopers (2015, p.3), the industry reached its peak during the construction of the projects that were related to the 2010 Soccer World Cup. In the recent past, labour unrests have delayed construction projects, a fact that might explain Hercules Cement’s decision to export 80% of the cement produced by the new plant to Nigeria (PricewaterhouseCoopers 2015, p. 3). An overview of the Nigerian construction sector shows that it presents a remarkable opportunity for the firm as the country has Africa’s largest economy and population. Additionally, Nigeria’s status as Africa’s leading oil exporter indicates that it is in a position to utilize its oil revenues in large construction and infrastructure projects (Deloitte 2015). These factors combine to create a booming construction industry that should allow Hercules to generate sufficient returns to repay any loans. Financial Statement Analysis Collateral Collateral is a critical factor in the evaluation of commercial loan requests since the collateral provides an external safeguard against default (Glantz 2003, p. 8). In the case of Hercules, any asset or the capacity to generate cash flow can be considered as collateral. It is worth noting that there has been a general reduction in the firm’s current and non-current assets in the period between 2012 and 2015. It is, however, notable that Koch and MacDonald (2014, p. 533) argue that loans should not be granted or refused on the basis of collateral alone. As such, Rich Bank should focus on the cash from operating activities as the main factor in determining whether to approve the loan request. It is notable that Hercules has maintained its cash from operating activities in the period under review while significantly increasing the cash it derives from financial activities and investing activities. The positive trend in the cash flow is an optimistic sign given that the business has developed a new plant while operating in the tough South African business environment. The entry into the booming Nigerian market should result in further improvements in cash flow, a factor that is helpful to the loan request. Financial Ratios Liquidity In addition to examining collateral and cash flow, various financial ratios can provide a clear picture on the performance of the business in terms of liquidity, leverage, and profitability. First, the liquidity ratios illustrate a firm’s ability to repay its short-term debts (Koch & MacDonald 2014, p. 537). In general, a firm should target a higher value in these ratios as they indicate that a business has a sufficient margin of safety to provide for short-term debts. An examination of Hercules Cement’s current ratio shows that it has been 1.65, 1.69, 2.22, and 1.27 in 2012, 2013, 2015, and 2015 respectively. The extract also shows that the business has maintained sufficient levels of net working capital over the period. These ratios and the working capital lead to the conclusion that the business can easily use its current assets to cover short-term debts. Leverage Koch & MacDonald (2014, p. 540) also note that leverage ratios are essential when evaluating a loan request. The ratios illustrate the degree to which a business relies on debt as opposed to equity. It is worth noting that a firm that has high levels of debt is not likely to get approval if they request for loans. This is because such a firm will need to spend a significant proportion of earnings to pay off existing debts and interest. In the case of Hercules Cement, the extract of the financial statement can facilitate the calculation of the debt to equity ratio by dividing total liabilities by equity. This gives 1.05, 1.04, 0.94, and 1.08 in the period under review. The low debt to equity ratio shows that Hercules Cement does not take large debts and is therefore exposed to low risk. Profitability The profitability of the business is also a factor that has to be taken into consideration when evaluating its suitability for a loan. Profitability ratios show how well a firm is managing its business with the trends in the ratios showing whether the company is getting better or worse over time. The extract from the financial statements of Hercules Cement allows for the calculation of two profitability ratios. First, the return on equity ratio (ROE) shows how well a firm converts investments into income and is given as a percentage. The firm’s ROE between 2012 and 2015 has been 3.8%, 4.3%, 4.7%, and 3.2%. The second ratio is the return on assets (ROA) ratio which shows how effective a company is in generating income from its assets. The firm's ROA has been 1.8%, 2.2%, 2.3%, and 1.7% in the last four years. The ROE and ROA show that Hercules Cement has not been sufficiently profitable over the last four years. These results are consistent with the general slump in South Africa’s construction industry since 2010. The construction of a new plant and the capacity to export products to Nigeria should play a big role in ending the period of low profitability. Potential Risks Risk management in banking involves identifying, measuring, assessing, and mitigating any harmful effects that risks may pose to the financial well-being of the bank. Rich Bank will be exposed to various risks if it decides to issue a loan to Hercules Cement. These risks will fall into categories that include market risk, risks related to country of origin of Hercules, credit risk, liquidity risk, and operational risk (Van Gestel & Baesens 2008). The markets risk include factors like changes in interest rates and foreign exchange rates which might expose the bank to losses. When it comes to risks related to the location of the borrower, Hercules Cement operates in the South African construction sector which has performed poorly over the last few years. Despite the intention to export to a booming economy, the firm might still record poor performance if the situation in South Africa remains the same or worsens. It is worth noting that the bank will face risks that are related to Nigeria, the location where Hercules Cement wants to sell 80% of the output from its new plant. A recession in Nigeria might result in reduced demand for cement and concrete thereby hurting the firm’s ability to maintain sufficient cash flow to repay a loan. As stated, Nigeria is Africa’s leading oil exporter, meaning that the economy is exposed to risks associated with the volatility of global oil prices. The country has also experienced political turmoil with the Boko Haram group having wrested control of large parts of the country in the recent past (Blair 2015). However, the election of a new government has intensified efforts against the group with Boko Haram losing much of its territory (Kaplan 2016). It is evident that the business environment in Nigeria and South Africa over the next few years presents a credit risk that might prevent the bank from receiving good returns from a loan issued to Hercules Cement. Conclusion and Recommendation In summary, this report has found Hercules Cement to be a firm that has achieved relative success in a challenging business environment. The firm has maintained acceptable levels of liquidity and leverage, with the low profitability being attributed to the tough economic conditions. The firm’s decision to invest in a new plant and focus on entry into the Nigerian market is a positive one owing to the construction boom in Africa’s largest economy. It can be concluded that the firm will strengthen its profitability while maintaining acceptable levels of leverage and liquidity. It is worth noting that the company faces significant risks with the risks related to country of origin and the desired market being the most important. However, Hercules Cement’s success over the past four years in a tough business environment means that it has the experience to remain competitive and repay any outstanding loans. It is recommended that Rich Bank issues the $500 million loan to Hercules Cement at prevailing interest rates as the bank will generate good returns from the project. References Blair, David. 2015. Boko Haram is now a mini-Islamic State, with its own territory. The Telegraph. Viewed 7 March 2016 Fiscal challenges in the construction sector in Nigeria. 2015. Deloitte. Viewed 7 March 2016 Glantz, M. and Mun, J., 2010. Credit engineering for bankers: a practical guide for bank lending. Academic Press. Glantz, M., 2003. Managing Bank Risk: An introduction to broad-base credit engineering, Vol. 1. Academic Press. Kaplan, Michael. 2016. Boko Haram News: Dozens Killed In Nigeria Amid Military Raids On Insurgent Camps. International Business Times. Viewed 8 March 2016 Koch, T. and MacDonald, S., 2014. Bank Management. Nelson Education. SA Construction. 2015. PricewaterhouseCoopers. Viewed 7 March 2016 Van Gestel, T. and Baesens, B., 2008. Credit Risk Management: Basic Concepts: Financial Risk Components, Rating Analysis, Models, Economic and Regulatory Capital: Basic Concepts: Financial Risk Components, Rating Analysis, Models, Economic and Regulatory Capital. OUP Oxford. Read More