Financial Policies of US Corporates and Study of Capital Goods Sector

In recent years we have seen financial crises have become a common occurrence in the global economy and the countries, especially the emerging markets have been feeling the tremors largely. The increasing frequency of crises has been creating an environment of panic for the stakeholders.

Under such situations financial policies of companies safeguard the organization and reduce the impact of a slow economy. This article elaborates on the financial policies of companies in different sectors which includes Retail, Healthcare, Consumer Goods, Auto, Capital Goods and Transportation, Aerospace and Defense. It  gives a description of the financial policy which could help in minimizing the risk in the industry so that the after effects of crisis are less felt.

Financial Policy

Financial policy is the action and intention of the company’s management which impacts the balance sheet of the company. Moreover the policy also determines the intention of a company towards the interest of the stakeholders. Financial policies are determined by the management’s risk tolerance which impacts the financial risk of the company to a great extent.

The company management’s preference along with the business requirements, shareholder values and market sentiments are some of the factors which drive the financial policy at a broader level. Working in the interest of stakeholders with main objective of long term profit maximization of shareholders’ wealth is undoubtedly a good and usually followed policy by the Corporates but the same needs to be judged so as to comment on company’s creditability and performance. Shareholder rewards in terms of dividend payout and share repurchase are of course some of the key decisions of the management and are equally important to that of capital expenditure, mergers & acquisitions along with liquidity. Financial policy has nothing called best practice and can only be assessed and not measured. The relative grading of financial policy as conservative, very conservative, moderate, aggressive only helps in assessing the overall policy of the company’s management and gives a picture of the risk appetite and cannot be quantified.

Corporate Governance is the system by which companies are directed and controlled. It involves the relationship between company’s management, board of directors, shareholder and stakeholders. Company law provides suitable acts and articles which are aimed at prevention or mitigation of the conflict of interests of stakeholders. The main objective of a company stated in such acts and articles is that a company as an entity has to work for the interest of its shareholders with the prime objective of maximizing profits in the long term.  In order to maximize the profits company’s go for different financial policies.

Financial Policy is basically the criteria which describes a corporation’s choice regarding its debt/equity mix, currencies of denomination, maturity structure, method of financing investment projects, methods of restructuring, mergers & acquisitions, joint ventures and definitely the hedging decisions with a goal of maximizing the value of the firm and also to sustain the operation during the time of financial crisis.

Objectives of Financial Policy

Following are the main objective of any corporation’s financial policy:

• To maintain an optimum level of cash so as to meet any requirement which may arise and the operation can carried out successfully as and when required
• To maintain debt (both medium-term and long-term) at levels that are in reasonable proportion to growth in operations and will preserve the company’s “Investment Grade” credit rating
• Carry no short-term debt when not required
• To make investments properly so as to ensure maximization of future cash flows
• To invest cash surpluses in financial instruments for profit maximization
• To respond effectively and efficiently to any sort of external conditions which is beyond the company’s control so that stable cash flow is maintained and it can be protected from market risks
• To maintain adequate credit lines with major financial institutions like the banks, etc. so that funds can be raised at ease as and when required
• To maintain an appropriate risk rating.

Need for Financial Policy

Before we talk about the need of the financial policy by a firm, it is necessary to define and understand what financial crisis is.

Financial crisis is the instability seen in financials of a company, economy or globally. It is the state where a company, market, nation or global economy is underperforming. Financial crisis leads to a situation wherein negative changes in security, economic, political, societal, or environmental affairs are seen.

Financial Policy impacts the balance sheet of a company and thus has some of the important measures which are elucidated as under:

• Acquisition: Acquisition has always been an important financial policy decision taken by the management of the company towards its growth. But as we know all that glitters is not gold likewise all the acquisition is not favorable. It again depends on the sector, the company is dealing and the method of financing its acquisition.

• Shareholder Rewards: Shareholders are the main and the biggest stakeholders for a company and thus it is very important to safeguard their interest. The shareholders are rewarded by the following two main methods:

i) Share Repurchase – The buyback of shares by the company leads to the supporting of share price and also increases promoters stake in the company and thus allows company to return, the excess cash available, to its shareholders.
ii) Dividends – Dividends are the timely reward given to shareholders on a proportionate basis of the profits made by the company. It is the short term realized gain (known as dividend gain) on the stocks and is in most cases preferred over the capital gain which is uncertain. Again the dividend payout can be both good as well as bad for a company. The method of financing of dividend plays a very important role in determining its stability.

• Cash Balance – Again as already said cash is king and anyone and everyone loves cash and anything which resembles cash. Maintaining adequate cash level is important so that company can meet its short and long term obligations and also come over any sort of unavoidable circumstances as and when required.

• Capital Expenditure– Capex constitutes a major financial decision for any company. It is very important for companies to plan expansion and growth. It is done by expending money in assets to reap benefit in future. The degree of Capex of the company and the method of financing the same are very important measure to determine any company’s financial policy.

Capital Goods Sector

The recent economic crisis and the uncertain recovery prospects have affected the project pipelines for majority of the companies operating in the capital goods sector. Adding fuel to fire, the economic and market volatility (changing fuel prices) also compelled companies to re-define their financial policy. Furthermore, the Tsunami and earthquake in Japan shook the industry at large and being a highly capitalized industry the risk associated increased significantly and several and frequent financial policy changes related to acquisition, capital expenditure, shareholder rewards, use of cash were seen. Higher capital requirements and liquidity rules affected the credit terms available to power projects as a result of which a new model of financing was looked for.

Large capital investments carry huge risks of misspending money that can seriously harm the profitability of a company. As part of the financial policy in the capital goods sector, we see a different trend for both Investment Grade and Speculative Grade companies. Acquisitions were not conducive during the gloomy years of 2008, when the global economy was unstable and neither has it relived the booming years of 2007 for the engineering and construction sub-sectors. This can be mainly attributable to the fact that these industries require huge capital investments for inorganic growth activities and financing was a major concern during 2008. Recent improvements in hiring, business sentiment and consumer spending have given new hope and confidence is prevailing in US recovery. Undertaking acquisitions entails certain risks in the capital goods sector. Following are some of them:

• Unrecorded liabilities of acquired companies that the company fail to discover during investigations or that are not subject to indemnification or reimbursement by the seller;

• Difficulty in assimilating the operations and personnel of the acquired company within our existing operations or in maintaining uniform standards;

• Loss of key employees of the acquired company;

• The failure to achieve anticipated synergies; and

• Strains on management and other personnel time and resources to evaluate, negotiate and integrate acquisitions.

Thus acquisitions require proper strategy and planning so as to ensure profitability and value addition to the company. Companies in Capital Goods sector due to high cash requirements cut down on their acquisition during the years 2008 and 2009 on account of the global slowdown. Companies made it a policy to start debt repayment and support share prices of the stocks during these years out of the available cash as credit availability was limited due to high risk involved.

Risks of Capital Goods Sector 

Following are the major risks which the Capital Goods Sector companies face:

• Growth of Capital Goods Sector is highly dependent on global economic and political risks
• Companies growth are subject to a wide variety of laws, regulations and government policies that may change in significant ways
• Companies are subjected to legal proceedings and legal compliance risks
• Significant raw material shortages, supplier capacity constraints, supplier production disruptions, supplier quality and sourcing issues or price increases could increase the operating costs and adversely impact the competitive positions of companies’ products
• Increased IT security requirements, vulnerabilities, threats and more sophisticated and targeted computer crime could pose a risk to the systems, networks, products, solutions, services and data of the companies.

Conclusion

To conclude it can be said that financial policy is an important measure to judge the company’s performance. It is a highly qualitative analysis and cannot be quantified in numbers or on rating scale rather can only be graded relatively. It is nearly a distant dream to measure the financial policy of a company and thus it is always suggested to assess it instead of measuring. Financial policy can only be described and not scored. Assessment of management can sound really easy to few but at the same time it can be the reason for your headache. Financial policy is all about assessing management’s intentions about the company’s future growth policy which at the end impacts the balance sheet of the company. Financial policy in a way is the most crucial determinant on the overall risk profile of the company and goes a long way in shaping the credit worthiness (rating) of the company. Factors like business requirements, shareholder value, management preferences helps in assessing the financial policy of a company.