ii

CARLTON SCHOOL OF MANAGEMENT

MSc (Finance)

COMPANY FINANCIAL ANALYSIS AND VALUATION:

THE CASE OF FORTUNE OIL PLC¨

By

Alfa 1ere

Submitted in partial IulIilment oI the requirement Ior the degree oI MSc Finance

March 2011
iii

TABLE OF CONTENTS

LIST OF
TABLES ............................................................................
.......................................... v
LIST OF
FIGURES ...........................................................................
........................................ vi
ABBREVIATIONS .....................................................................
............................................. vii
ABSTRACT ..........................................................................
..................................................viii

CHAPTER ONE:
INTRODUCTION ......................................................................
.................... 1
1.1
OVERVIEW ..........................................................................
............................................... 1
1.2 FORTUNE OIL PLC: A BRIEF
BACKGROUND ................................................................ 2
1.2.1 Historical
Background ........................................................................
................................ 2
1.2.2 Fortune Oil`s
Strategy ..........................................................................
.............................. 2
1.2.3 Structure oI the
Company ...........................................................................
........................ 3
1.2.4 Recent Trading
Development .......................................................................
...................... 4
1.2.5 Financial Accounts and Reporting
Standards ...................................................................... 4
1.2.6 The Company`s Treasury Risk
Management ...................................................................... 5
1.3 FINANCIAL ANALYSIS AND VALUATION
APPROACH .............................................. 6

CHAPTER TWO: FINANCIAL PERFORMANCE AND POSITION OF THE COMPANY ...... 8

2.1
INTRODUCTION ......................................................................
.......................................... 8
2.2 FINANCIAL PERFORMANCE
ANALYSIS ....................................................................... 8
2.2.1
Overview ..........................................................................
................................................. 8
2.2.2 Financial PerIormance Analysis oI Fortune Oil
Plc ............................................................ 9
2.2.3 Limitations on Using Ratios in Financial
Analysis ........................................................... 26
2.3 CAPITAL STRUCTURE
ANALYSIS ..........................................................................
...... 27
iv

2.3.1
Overview ..........................................................................
............................................... 27
2.3.2 The Miller and Modigliani Irrelevance
Theory ................................................................. 28
2.3.3 Capital Structure: The Trade-oII
Theory ...........................................................................
28
2.3.4 The Pecking Order
Theory ............................................................................
................... 28
2.3.5 Fortune Oil Plc`s Capital
Structure .........................................................................
.......... 29

CHAPTER THREE: VALUATION OF THE

COMPANY ....................................................... 31
3.1
OVERVIEW ..........................................................................
............................................. 31
3.2 VALUATION
MODELS ............................................................................
........................ 31
3.2.1 Dividend Valuation
Models ............................................................................
.................. 31
3.2.2 Gordon`s Growth
Model .............................................................................
..................... 34
3.2.3 Earnings Valuation
Model .............................................................................
................... 35
3.2.4 Net Assets
Valuation .........................................................................
............................... 37
3.2.5 Price-Earnings
Model .............................................................................
.......................... 38
3.2.6 Market Valuation
Method ............................................................................
.................... 39

CHAPTER FOUR:
CONCLUSION ........................................................................
.................. 43
REFERENCES ........................................................................
................................................. 45
APPENDIX 1: BALANCE SHEETS (2005 2009) FORTUNE OIL
PLC ............................ 46
APPENDIX 2: INCOME STATEMENTS (2005 2009) FORTUNE OIL PLC .................... 47

LIST OF TABLES

Table 2.1 Fortune Oil Plc`s Balance Sheet Structure (2005

2009) ........................................... 13
Table 2.2 Ratio Analysis Ior Fortune Oil
Plc .............................................................................
17
Table 2.4 Value oI the Fortune Oil Plc using Dividend Valuation
Models ................................. 33
Table 2.5 Fortune Oil`s Book
Value .............................................................................
............. 38
Table 2.6 Fortune Oil`s Price Earnings Valuation
Model .......................................................... 39

vi

LIST OF FIGURES

Figure 2.1 Logical Scheme oI the Discussion oI Financial Results and

Analysis ....................... 10
Figure 2.2 Structure oI Data
Presentation ......................................................................
............ 11
Figure 2.3 Financial Analysis
Ratios ............................................................................
............. 12
Figure 2.4 Changes oI Main Income Statement Accounts (2005
2009) ................................... 16
Figure 2.5 Fortune Oil Plc`s Inventory
Turnover ....................................................................... 21
Figure 2.6 Fortune Oil Plc`s Inventory Days Comparison with Green Dragon
Gas .................... 21
Figure 2.7 Fortune Oil Plc`s Receivable Collection
Period ........................................................ 22
Figure 2.8 Fortune Oil Plc`s Receivable Turnover Comparison with Green Dragon
Gas ........... 23
Figure 2.9 Fortune Oil`s Asset Turnover Comparison with Green Dragon
Gas .......................... 24
Figure 2.10 Fortune Oil`s Debt to Equity Comparison with Green Dragon
Gas ......................... 25
Figure 2.11 Fortune Oil Book Value
Trend .............................................................................
.. 38

vii

ABBREVIATIONS

HSE: Health, SaIety and Environment

CBM: Coal Bed Methane
CNG: Compressed Natural Gas
LNG: LiqueIied Natural Gas
FLG: Fortune Lilian Gas Company
IASB: International Accounting Standards Board
IFRS: International Financial Reporting Standards
NWC: Net Working Capital
NWC/S: Net Working Capital to Sales
GPM: Gross ProIit Margin
OPM: Operating ProIit Margin
NPM: Net ProIit Margin
ROA: Return on Assets
ROFA: Return on Fixed Assets
ROCA: Return on Current Assets
EBIT: Earnings beIore Interest and Taxes
ROE: Return on Equity
ROCE: Return on Capital Employed Ratio
IT: Inventory Turnover
DI: Days in Inventory
ACP: Average Collection Period
ART: Accounts Receivable Turnover
APT: Accounts Payable Turnover
TAT: Total Assets Turnover
FAT: Fixed Assets Turnover
FL: Financial Leverage
GR: Gearing Ratio
PE: Price Earnings ratio

viii
ABSTRACT

The proiect study Iocuses on undertaking the Iinancial analysis oI Fortune Oil
perIormance Irom
year 2005 to 2009. The trend analysis has been adopted as a bench mark
Ior analysis and
interpretation. The Introduction Chapter shows a summary oI company activities and
its current
position. Chapter Two conducts a Iinancial perIormance and capital structure
analysis oI Fortune
Oil Plc.

The study also involves looking at the prediction ratios and seeing whether the
dividend policy
and company structure as well as what should be done to inIluence
shareowner`s returns on
capital employed and investment prospects oI the company. In addition, the proiect
looks on the
strength, weakness, opportunities and threats analysis oI the company and
tries to recommend
what actions should be taken to resolve the problems.

The analysis evaluation is done on the view oI potential investors and to provide
the evaluation
oI the company shares. The report issued annually by a corporation to
its stockholders is
important as it provides basic Iinancial statements, as well as management`s
opinion oI the past
year`s operations and the company`s Iuture proiection. It should be noted that iI
the management
is to sustain the company`s value; it must take beneIit or the company`s strengths
and correct its
weaknesses.

CHAPTER ONE
INTRODUCTION

1.1 OVERVIEW
Business activities oI a company always attract certain attention Irom various
market participants
such as associates, investors, competitors or authorities, who are
expressly or by implication
interested in its business and Iinancial results. The third parties are able to
estimate business and
Iinancial perIormance by analyzing accounting statements available Ior public use.

Measuring business and Iinancial perIormance is complex because oI the

many obiectives oI
business. ProIit maximisation remains one oI the key obiectives oI business,
although the debate
around this issue has not reached any Iinal conclusions. Balance sheets and
proIit/loss accounts
are the traditional and most popular means oI measuring business
perIormance. Financial
analysis serves as a primary tool Ior this purpose. The inherent
weakness oI these measures,
however, is that they Iail to capture non-Iinancial parameters such as
goodwill and customer
loyalty. These parameters become more meaningIul when so-called
'Iinancially sound¨
companies are liquidated overnight or go out oI business in due course. Proponents
oI accounting
based perIormance measures give due cognizance to non-Iinancial parameters,
but they do not
oIIer a measurement technique.

The main idea oI Iinancial analysis is to obtain enough oI key values

(the most inIormative
ones), that represent obiective and exact Iinancial situation within a
company: its proIits and
losses, structural changes in assets and liabilities, level oI competitiveness,
relations with debtors
and creditors. This analysis can be used both Ior estimation oI current Iinancial
condition and Ior
its prediction in the nearest or more remote Iuture.

With a historical view oI assessing a company`s results, business and

Iinancial perIormance
engagement is an analysis oI a company`s past and current business and
Iinancial perIormance
and compares such perIormance to similar sized companies within its industry
providing insight
2

into a company`s historical growth, proIitability, debt capacity and

overall liquidity. All such
Iactors can be important indicators oI a company`s ultimate value. Using
Fortune Oil Plc, this
proiect report analyzes the past Iive-year history oI Iinancial statements
as well as Iinancial
inIormation relative to industry and geographical market in which the company
operates. We use
various business perIormance analysis measures and calculate Iinancial
ratios (liquidity,
coverage, leverage and operating) Ior the company.

The basis oI the comparative analysis may be aIIected by the nature oI

the business, its size,
geographic location, business practices, and other Iactors that aIIect the
company`s operations. In
this study, we analyse the valuation and Iinancial perIormance oI Fortune
Oil Plc, which is
incorporated in the UK but has an operational headquarters in Hong Kong.

1.2 FORTUNE OIL PLC: A BRIEF BACKGROUND

1.2.1 Historical Background

Fortune Oil PLC is registered in England and Wales (number 2173279, main board
symbol FTO)
and is subiect to UK Listing Rules and compliance regulations. The Company has its
operational
headquarters in Hong Kong. Fortune Oil Plc Iocuses on oil and gas
supply and inIrastructure
proiects in China. The largest shareholders in Fortune Oil are First
Level Holdings Limited
(36.4°), Vitol (7.44°) the public (45.63), Kerry Holdings Limited (4.62°) and
maior Chinese
state-owned corporations (5.91°), plus Willmar International Limited has a 15 per
cent interest
in the Company's gas business.

1.2.2 Fortune Oil`s Strategy

China is the world`s second largest energy market. Fortune Oil seeks to exploit
opportunities in
the oil and gas industry as the China market develops, with a particular emphasis
on the supply
oI gas as a premium clean Iuel. Our strategy in developing our
businesses and seeking new
opportunities is:
3

To become a leading integrated gas supplier in north and central China, with
annual gas
sales oI 1 billion cubic metres by 2012 (equivalent to 1 per cent oI
the proiected total
domestic market); and
To develop opportunities Ior the supply oI Iuels to China, in
particular exploiting our
unique position in oil products supply and terminals.

1.2.3 Structure of the Company

In 2008 the Company established Fortune Gas Investment Holdings Limited ('Fortune
Gas¨) as
the holding company Ior all oI the Group`s gas operations, including
both gas distribution and
coal bed methane (CBM). In November 2008 Wilmar International Limited
('Wilmar¨), one oI
the largest companies listed on the Singapore Stock Exchange, invested
US$36 million (£22.3
million) to acquire new shares in Fortune Gas representing 15 per cent
oI the enlarged capital.
Fortune Gas is a Hong Kong registered company and is owned 85 per cent
and controlled by
Fortune Oil. Wilmar has representation on the board oI Fortune Gas.

The operations extend to production and wholesaling oI LiqueIied Natural

Gas (LNG) and
Compressed Natural Gas (CNG), gas pipelines, retail CNG stations and city gas
supply, as well
as CBM development. The vision Ior Fortune Gas is to be a leading
integrated gas supplier in
north and central China with gas sale to exceed 1 billion cubic metres
per year by 2012 (1 per
cent oI the proiected market).In 2007 the Company acquired a 51 per cent
controlling interest in
Henan Fortune Green Energy Development Company ('Green Energy¨), which operates a
LNG
and CNG production and distribution business based in Puyang, Henan Province. The
remaining
49 per cent interest in Green Energy is held by the 500 employees, who
have signiIicant
expertise in LNG and CNG technology. Following the Company`s investment in
Green Energy
new compressors was installed to raise the throughput oI the Iirst
Puyang LNG plant and a
second parallel LNG train was commissioned in early 2009. Both trains
have the capacity to
liqueIy 150,000 m3/d oI natural gas, and this LNG is then transported by road to
over 50 cities.

In 2008 the Company established Fortune Gas Investment Holdings Limited ('Fortune
Gas¨) as
the holding company Ior all oI the Group`s gas operations, including
both gas distribution and
coal bed methane (CBM). Fortune Gas has a controlling interest in Fortune Liulin
Gas Company
4

(FLG), which is the Ioreign contractor in the PSC with CUCBM Ior the
Liulin CBM block in
Shanxi Province. The PSC has recently been extended Ior a Iurther two years to 29
March 2012.
The Liulin block achieved a maior recognition and advancement in February
2009 when the
block was designated a State Science and Technology SigniIicant Proiect
under a scheme
administered by the State Council, the nation`s chieI administrative authority.

In November 2009 the Company acquired the 26.1 per cent interest in FLG
held by Molopo
Energy Ltd. ('Molopo¨) in exchange Ior US$4 million cash and US$2
million in new Fortune
Oil shares. The Iollowing month the Company agreed an alliance with
Arrow Energy
International Pte Ltd oI Australia ('Arrow International¨), wherein as a
Iirst step Arrow
International acquired a 35 per cent interest in FLG in a series oI transactions
which completed
aIter year-end Iollowing the renewal oI the PSC.

1.2.4 Recent Trading Development

Fortune Oil plc announced that a conditional subscription agreement has
been signed Ior an
investment in Fortune Gas Investments Holdings Limited (Fortune Gas), a newly
created holding
company Ior Fortune Oil's gas business, Ior $72 million (GBP39 million). Wilmar
International
Limited and Star Medal, a wholly owned subsidiary oI Kerry Holdings
Limited, have each
agreed to invest $36 million to acquire new shares in Fortune Gas representing 15°
each oI the
enlarged share capital oI Fortune Gas.

1.2.5 Financial Accounts and Reporting Standards

The Company prepares its Iinancial accounts and reports in compliance
with the International
Financial Reporting Standards (IFRS) adopted by the European Union. In
this regard, the
independent auditor`s (Deloitte LLP) opinions Ior the accounts and reports Ior the
year 2009 are
as Iollows:
"Opinion on financial statements
In our opinion the group financial statements.
give a true and fair view of the state of the groups affairs as at
31
December 2009 and of its profit for the vear then ended,
5

have been properlv prepared in accordance with IFRSs as adopted bv the

European Union, and
ave been prepared in accordance with the requirements of the
Companies Act 2006 and Article 4 of the IAS Regulation.`

$eparate opinion in relation to IFR$s as issued bv the IA$

As explained in Note 1 to the group Iinancial statements, the group in addition to
complying with
its legal obligation to apply IFRSs as adopted by the European Union, has also
applied IFRSs as
issued by the International Accounting Standards Board (IASB).

In our opinion the group Iinancial statements comply with IFRSs as issued by the
IASB.

Opinion on other matter prescribed bv the Companies Act 2ôôô

In our opinion the inIormation given in the Directors` Report Ior the Iinancial
year Ior which the
Iinancial statements are prepared is consistent with the group Iinancial
statements.

1.2.6 The Company`s Treasury Risk Management

Ceneral usiness Risks

The business oI the Fortune Oil Group is Iocused on the distribution in
mainland China oI
hydrocarbon Iuels with recent expansion into coal bed methane, and it is
subiect to a variety oI
business risks. These risks have not changed since the date oI the Annual Report
2008, where the
principal risks and uncertainties are detailed on pages 21 and 22.

The general business risks Iacing Fortune Oil's operations in China

include: country risk; the
regulatory regime; relationship risks; attraction and retention oI
employees; speed oI
development; current and Iuture Iinancing; uninsured risks; Ioreign
exchange risks; liquidity
risk; commodity price risk; and health, saIety and environment (HSE)
risks. SpeciIic risks
pertaining to the Group's Iuel distribution business include: the level oI energy
demand; technical
risk; physical security; and gas availability. SpeciIic risks and
uncertainties Ior the Group's
upstream gas business include: general exploration, development and
production risks;
6

estimation oI gas resources; and the work programme under the Group's
Production Sharing
Contract.
Currencv Risk
The Iunctional and presentation currency oI Fortune Oil Plc is pounds
sterling. The Iunctional
currencies oI overseas operations are the Hong Kong dollar and Chinese
renminbi. In the
accounts oI individual Group companies, the Group translates Ioreign currency
transactions into
the Iunctional currency at the rate oI exchange prevailing at the transaction date.
Monetary assets
and liabilities denominated in Ioreign currency are translated into the
Iunctional currency at the
rate oI exchange prevailing at the balance sheet date. Exchange diIIerences
arising are taken to
proIit and loss.

Exchange gains or losses on monetary items receivable Irom or payable to

a Ioreign operation
Ior which settlement is neither planned nor likely to occur, which Iorm part oI the
net investment
in a Ioreign operation, are recognised in the translation reserve.

As at the reporting date, the assets and liabilities oI overseas operations are
retranslated into the
presentation currency oI Fortune Oil Plc at the rate oI exchange ruling at the
balance sheet date
and their income statements are translated at the average exchange rate
Ior the year. The
exchange diIIerences arising on the retranslation are taken directly to a
separate component oI
equity. On disposal oI a Ioreign operation, the cumulative amount recognised in
equity relating
to that particular Ioreign operation shall be recognised in the income statement.

The Group has elected not to record cumulative translation diIIerences

arising prior to the
transition date as permitted by IFRS 1. In utilising this exemption, all
cumulative translation
diIIerences are deemed to be zero as at 1 January 2004 and all subsequent disposals
shall exclude
any transaction diIIerences arising prior to the date oI transition.

1.3 FINANCIAL ANALYSIS AND VALUATION APPROACH

For a complete analysis and valuation oI Fortune Oil Plc, available Iinancial and
operational data
and metrics were gathered. These were then used to derive measures and
compared to
7

benchmarks Irom similar businesses. Interpretation oI the analysis

accounted Ior diIIerences in
markets and business models. Methodology oI Iinancial analysis includes
variety oI speciIic
instruments like ratios, indicators and coeIIicients suitable Ior their own
purposes. The analysis
also implies researching oI changes over time. It is true that business
and Iinancial analysis
means thorough explanation oI each received result. All Iinancial ratios
in this proiect report
were calculated using MicrosoIt Excel environment, based on Iormulas presented
herein under.
All results were gathered in summary tables as shown in the Iollowing sections and
appendices.

There are many advantages oI this approach such as convenience, stability and
popularity oI the
soItware and relative accessibility (or easiness oI use). Additionally,
special analysis templates
have been created especially Ior this research proiect. With the help oI
these templates, the
calculation routine has been literally reduced. Nevertheless, regardless oI
the amount oI
calculations, all results have been grouped in the most compact resulting
tables as possible and
included in the Appendices.

We mostly used secondary data in conducting the analysis on valuation

and Iinancial
perIormance oI Fortune Oil Plc. These data were obtained through various
sources including
Annual Reports and Accounts, Fortune Oil Plc`s website, London Stock Exchange
website and
other Iinancial markets trading analysis news and research websites.

CHAPTER TWO
FINANCIAL PERFORMANCE AND POSITION OF THE COMPANY

2.1 INTRODUCTION
Company Iinancial perIormance assessment is mainly conducted through the
use oI Iinancial
statements. However, Iinancial statements by themselves do not provide adequate oI
inIormation
about how well a company perIorms year to year or in comparison to
other businesses in its
industry. One oI the reasons why it is diIIicult to make comparisons is
that companies rarely
have exactly the same revenue.
Another reason is that companies have varying Iinancing structures. Ratios
and other
perIormance measures and techniques have been developed to make Iinancial
inIormation
comparable Irom company to company. These tools Iorm three broad
categories: estimation oI
operating perIormance, evaluation oI Iinancial perIormance and deIining level oI
Iinancial risk.
Operating perIormance deals with eIIiciency oI management. In other words,
it is important to
know iI a company uses its assets in an eIIicient and proIitable
manner. Financial perIormance
deals with issues related to a company`s Iinancial structure and ability
to meet its Iinancial
obligations. Analysis oI Iinancial risk is important to banks, suppliers, and
investors. The general
obiective oI Iinancial analysis is to evaluate the eIIectiveness in each oI these
areas.
2.2 FINANCIAL PERFORMANCE ANALYSIS

2.2.1 Overview
The inIormation contained in the main Iinancial statements has maior
signiIicance to various
interested parties who regularly need to have relative measures oI the
company`s business
eIIiciency. Financial analysis conducted Ior the need oI third parties is external
by its nature and
oIten called 'analysis oI Iinancial statements¨. The analysis oI Iinancial
statements is based on
the use oI ratios also known as relative values. Ratio analysis involves
methods oI calculating
and interpreting Iinancial ratios to analyze and monitor the Iirm`s perIormance.

There are as many diIIerent Iinancial ratios as there are possible combinations oI
items appearing
on the balance sheet, income statement and cash Ilow statement, and their
application is deIined
Irom an analyst point oI view. Financial management practitioners use
various approaches
depending on the goal oI analysis or business issue. Despite oI the
number oI ratios, they all
cohere through their classiIication.

Furthermore, it is worth noting that ratio analysis is not iust the

calculation oI a given ratio.
Ratios, alone, are not suIIicient to understand a company`s past perIormance or to
Iorecast Iuture
perspectives in business. Most important is the interpretation oI the ratio value.
However it is not
an easy work to do and there is no single correct value Ior a ratio.
Correct conclusion, that the
value oI a particular ratio is too high, too low, or iust right depends on
perspective oI the analyst
and on company's strategy. A Iinancial ratio is meaningIul only when it is compared
with some
standard, a norm, such as an industry trend, ratio trend, or a planned management
obiective. This
is called benchmarking and it can be used as a measure. According to
Vance (2003),
benchmarking 'involves analyzing the Iinancial statements oI the best companies in
an industry
and using their Iinancial ratios as a basis Ior evaluation oI a company`s
perIormance.¨

As a result, to make correct conclusions on ratio analysis, two types oI ratio

comparisons should
be made: cross-sectional approach and trend-analysing method. Cross-sectional
analysis involves
comparison oI diIIerent Iirms` Iinancial ratios over the same period in time. It
usually concerns
two or more companies in similar lines oI business. One oI the most
popular Iorms oI cross-
sectional analysis compares a company's ratios to industry averages
published by statistical
agencies. In trend analysis, ratios are compared over a periods,
typically years. Year-to-year
comparisons can highlight trends and point up possible need Ior action.
Trend analysis works
best with three to Iive years oI ratios. Certainly, the most inIormative approach
to ratio analysis
combines both cross-sectional and trend analyses. A combined view makes it
possible to assess
the trend in the behaviour oI the ratio in relation to the trend Ior the industry.
2.2.2 Financial Performance Analysis of Fortune Oil Plc
As Ior Iinancial analysis, the set oI tools shown in Figure 2.1
corresponds to a sequence oI
operations (or applied methods so to say) oI the report. Whenever required,
readers can reIer to
this scheme.
10

Figure 2.1 Logical Scheme of the Discussion of Financial Results and Analysis

The Iirst logical step in the analysis sequence includes studying oI

structure and changes in
Iinancial reports. This allows evaluating the structure oI assets and
liabilities oI a company
according to its balance sheet. It gives the possibility not only to
estimate the capital owned or
controlled by organization, but also to allocate current and Iixed assets in its
structure oI capital.
In addition, this method deIines sources oI Iormation oI the company`s
capital. Studying oI
changes oI proIit allows answering such questions as: 1) changes oI net proIit Ior
a period (both
in absolute and in relative values); 2) sources oI its Iormation; 3) alterations in
operational proIit;
4) changes in tax burden. The complementary Fig.2.2 shows data presentation oI
the paragraph
'structure and changes in Iinancial reports¨.

11

Figure 2.2 Structure of Data Presentation

iquiditv of balance sheet is a Iirst step in measuring company`s

liquidity. According to this
method, ability oI assets to cover balance sheets obligations deIines
liquidity oI a company,
which in terms oI transIormation into the money also corresponds to a degree oI
maturity oI the
company`s obligations. Studying oI changes and structure oI balance sheets
and income
statements is important, because it gives an idea about the company`s
business development.
Yet, this method is very basic, as it does not go deep into details and
answer only to questions
'what¨ and not to questions 'why¨. It is impossible to evaluate a
company`s Iinancial
12

perIormance by analysing its balance sheet changes and assets structure only, as
well as there is
no way oI doing it by iust looking at a balance sheet. Only ratio analysis is
suitable.

Ratios are capable oI revealing many patterns oI relationship in Iinancial reports.

Four groups oI
ratios have been calculated and analyzed Ior Fortune Oil Plc in this
report: liquidity ratios,
proIitability ratios, activity ratios and debt ratios (or Iinancial
leverage ratios) as shown in Fig.
2.3.

Figure 2.3 Financial Analysis Ratios

The term 'analyzed period¨ means an interval in Iive years (Irom 2005
until 2009) that
corresponds with obtained Iinancial reports (see Appendix 2).

13

Structure and Changes in Fortune Oil Plc`s Financial Reports

Table 2.1 presents the balance sheet Ior Fortune Oil Plc covering the analyzed
period. It provides
useIul inIormation about assets and liabilities oI the company and the balance
sheets structure.

Table 2.1 Fortune Oil Plc`s Balance Sheet Structure (2005 - 2009)

No.

VALUE
illion C! (£)
2005 2006 2007 2008 2009
1 Total Assets 70,198 64,756 114,297 228,996 219,242
1.1a on-current Assets 50,062 49,182 77,211 137,564 143,399
1.1b In º to balance 71.32° 76° 68° 60° 65°
1.2a Current Assets 20,136 15,574 37,086 91,432 75,843
1.2b In º to balance 28.68° 24° 32° 40° 35°
2 Shareholders` Equity and
Liabilities

2.1a Shareholders Equitv 39,012 38,678 45,150 86,666 90,086

2.1b In º to balance 56° 60° 40° 38° 41°
2.2a Long-term Liabilities 19,188 17,119 47,976 87,133 65,480
2.2b In º to balance 27° 26° 42° 38° 30°
2.3c Current Liabilities 11,998 8,959 21,171 55,197 63,676
2.4d In º to balance 17° 14° 19° 24° 29°

In addition, it is necessary to create additional analytical table

showing changes oI all Iigures
listed in the previous table. Table 3.2 helps to visualise changes
occurred with balance sheet
values during the analyzed period. This table contains such inIormation
as the Iollowing: 1)
'A2006¨, 'A2007¨, 'A2008¨, 'A2009¨, absolute changes Ior the periods; 2) '°2006
to 2005¨
'°2007 to 2006¨ '°2008 to 2007¨ '°2009 to 2008¨ relative changes Ior
last period; 3)
VALUE main balance sheet accounts.

14

The inIormation gained Irom analysis Tables 2.1 and 2.2 allows estimating
capital structure oI
the balance sheets horizontally and vertically.

Distribution oI total assets (to current assets and non-current assets)

can also be studied Irom
Table 2.1. A good proportion between Iixed and current assets is required Ior
successIul business
operations. While it depends on type oI activities oI a company, percentage oI
current and non-
current assets should be equal approximately to 60-70 ° oI non-current
assets and 30-40 ° oI
current assets in the total balance. Excesses oI current assets may be
result oI wrong Iinancial
policy.

Formation oI a company`s capital can be IulIilled both at expense oI

its own and at borrowed
Iunds. For deIinition oI Iinancial stability and degree oI dependence on
loan proceeds, it is
necessary to analyze structure oI liabilities oI the balance sheets. In general,
the less a company
owes to others, the more stable Iinancial position it has. Table 3.1 provides
useIul insights on this
matter.

There is no 'universal¨ rule regarding proportion between owned and

borrowed Iunds a
company operates as shown in its balance sheet. However, a company whose assets
are Iormed
Irom its own capital is usually considered more Iinancially stable than a Iirm
relying on external
Iinances is. With Fortune Oil Plc, we see that during the analysed period, the
company`s capital
structure (a combination oI shareholders equity and liabilities) was
maintained at shareholders`
equity oI between 40° and 60° (see Table 3.1 above), which indicate
that it is Iinancially
stable.

Analysis of Profit Changes

Analyzing oI changes in the accounting reports includes studying not only
balance sheets, but
also other important sources oI Iinancial inIormation - income statements.
For this paragraph,
Fortune Oil Plc income statements were transIormed into reports similar to the IFRS
statements.
You can compare income statements in Appendix 3.

15

Another important issue to mention here is the possibility oI correct

interpretation oI Iinancial
statements analysis results. UnIortunately, it is not easy to analyze
Fortune Oil Plc income
statements. Due to their 'tax nature¨, these Iinancial reports give iust
rough picture oI what
really happened with a company`s incomes and losses during a period. They do not
answer why
these changes occurred. Only studying oI internal Iinancial accounts,
records and business
documents may clariIy alterations oI such Iactors as prices, sold
quantities, tax speciIications,
and interest rates etc. all that can explain changes oI main income statement
articles.

Financial Results of Fortune Oil !lc for the !eriod from 2ôô5 to 2ôô9
According to Table 2.3, net sales Ior the analyzed period increased Irom
£9.8 billion to £ 11
billion (¹11.8 °). At the same time, costs oI sales changed Irom £ 7.6 billion to £
8.2 billion (¹7
°). SpeciIic weight oI costs in net sales reduced Irom 77.7° to 74.3°.
Total amount oI gross
proIit increased in 2009 by 29.2 °.

Comparison oI sales and costs change rates in 2009 indicates eIIiciency

growth oI main
operations. The base Ior this statement is signiIicant increase in
operating proIit Irom £ 748
million to £ 1.6 billion or by 109 °. Sums oI tax expense increased at the end oI
the period by
45.7 ° that may be connected with growth oI proIit beIore tax on £722.2 million
or by 131 °.
At the end oI the analyzed period, Fortune Oil Plc gained net proIit at the level
oI £ 905 million
(increase by 203.7 ° in comparison with previous year). This means that
own capital oI the
company was Iormed Irom Iinancial and economic activities. In the
structure oI incomes, the
greatest share was provided by proIit Irom main operational activity that
signiIies normal
commercial strategy oI the company. Fig.3.4 represents trends oI all main
income statement
accounts oI Fortune Oil Plc in the analyzed period. This diagram shows
certain level oI
expansion in main activities oI the company due to the positive tendency oI net
sales and costs oI
sales.

16

Figure 2.3 Changes of Main Income Statement Accounts (2005 - 2009)

Source: Developed Irom Financial Statements Data using MicrosoIt Excel

Fortune Oil Plc Ratio Analysis

This part oI the report contains ratios calculated and presented. All ratios were
arranged in tables
to make them easier to understand. All ratios were patterned to make easier
evaluation oI critical,
32.50%
22.87%
25.10%
65.87%
10.70%
0.00%
20.00%
40.00%
60.00%
80.00%
2005 2006 2007 2008 2009
%

C
h
a
n
g
e
Periods
Growth in Net Sales
Growth in Net Sales
29.00%
-7.98%
82.33%
64.42%
54.45%
-50.00%
0.00%
50.00%
100.00%
2005 2006 2007 2008 2009
%

C
h
a
n
g
e
Periods
Cost of Goods Sold
Cost of Goods Sold
2.90%
8.71%
-10.94%
0.34%
-15.27%
-20.00%
-10.00%
0.00%
10.00%
2005 2006 2007 2008 2009
%
C
h
a
n
g
e
Periods
Growth in Gross Profits
Growth in Gross
Profits
33.50%
78.07%
-5.22%
72.82%
7.75%
-50.00%
0.00%
50.00%
100.00%
2005 2006 2007 2008 2009
%

C
h
a
n
g
e
Periods
Growth in Net Ìncome
Growth in Net Ìncome
17

negative, satisIactory and good values. It is now possible to explain

methodology oI this
approach. Without a doubt, the method oI results visualization is intended Iirst
Ior the readers to
keep their attention on important Iindings.
Table 2.2 Ratio Analysis for Fortune Oil Plc

Annual Annual Annual Annual Annual

!eriod !eriod !eriod !eriod !eriod

Title of Ratio 2ôô5 2ôôô 2ôô7 2ôô8 2ôô9
Acid Test Ratio 1.50 1.62 1.70 1.57 1.11
Current Ratio 1.68 1.74 1.75 1.66 1.19
Operating Cash Flow to Net Income 1.00 1.18 (0.13) (0.43) 2.58
iquiditv Index:

Receivables - Days Removed 34 146 137 218 232

Inventory - Days Removed 79 17 6 10 12
Other - Days Removed 16 22 26 21 19
Liquidity Index (Days) 19 60 33 46 46
$core:

1.2 x (working capital / total assets) 0.14 0.12 0.17 0.19 0.07
1.4 x (retained earn / total assets) (0.36) 0.51 0.35 0.23 0.30
3.3 x (EBIT / total assets) 0.28 0.50 0.29 0.27 0.31
.6 x (market value equity / debt) 0.00 0.00 0.00 0.00 0.00
.999 x (sales / total assets) 2.04 2.71 1.92 1.59 1.84
Z Score 2.09 3.85 2.73 2.28 2.52
Receivable 1urnover:

Receivable Turnover 10.9 2.5 2.7 1.7 1.6

Days Required to Collect A/R 34 146 137 218 232
Inventorv 1urnover:

Inventory Turnover 4.6 21.1 57.9 35.4 31.6

Days in Inventory 79 17 6 10 12
Total Asset Turnover 2.0 2.7 1.9 1.6 1.8
Operating Assets Ratio 0.67 0.62 0.70 0.79 0.78
Gross ProIit Margin 74º 81º 72º 72º 61º
Operating Margin 2º 3º 3º 3º 3º
Net ProIit Margin 11º 20º 11º 11º 8º
Direct Cost to Operating Revenues 82º 78º 85º 85º 88º
Capitalization Rate / Asset Return:

Capitalization Rate / Return 6.18º 10.55º 6.09º 4.84º 5.92º

Return on Shareholder Equity 15º 14º 18º 8º 19º
Debt to Total Assets 0.28 0.23 0.44 0.40 0.39
Debt to Common Equity 0.52 0.35 1.09 1.40 1.10
Times Interest Earned 13 21 8 7 8
Source: Developed Irom Financial Statements Data using A Financial Model developed
in MicrosoIt Excel

The above iust give an overview oI the ratios. As it was mentioned earlier, ratios
themselves do
not provide enough inIormation without correct explanation. ThereIore,
ratio evaluation is the
18

subiect oI next section. It is also a good idea to speciIy in which

year the company had better
results.

Financial iquiditv
Calculated liquidity ratios conIirm results obtained with balance sheet liquidity
method discussed
above. Absolute liquidity value is associated with monetary assets
available Ior covering
immediate liabilities. Many experts agree that the 6uick ratio is the most
inIormative measure oI
Iinancial liquidity oI companies. The normal value that is internationally accepted
Ior quick ratio
is '1¨. This ratio is similar to the absolute liquidity ratio and
includes Iinancial instruments
besides cash and cash equivalents. Throughout the analysed period, Fortune Oil Plc
had good or
satisIactory values oI this ratio. The good quick ratio values during
the analyzed period most
probably have been creating a 'Iinancial cushion¨ Ior settlement oI the
company`s Iuture
liabilities.

Current ratio characterizes solvency oI a company in backing oI immediate

obligations and is
used in this thesis as main criterion Ior deIining Iinancial stability. During
the analysed period,
Fortune Oil Plc has current ratios in the range oI 1.8 2.5. This
means that in case oI a Iorce-
maieure, the company`s current assets were able to cover all obligations
immediately and even
leave 50 percent oI the current assets. This is an excellent state oI stable
Iinancial position.

et working capital (NWC) characterizes amount oI capital in a company`s

turnover. This
indicator is Iree Irom current obligations. In other words, it consists
oI current assets Iinanced
Irom long-term sources, which will not be used Ior debt settlement but
only Ior Iinancing oI
current operations. II amount oI the company`s NWC is positive, it means
basic possibility oI
settlement oI any debts by means oI current assets. Another important criterion
Ior the NWC is
steadiness oI its changes. As it can be seen Irom Table 3.3, net
working capital oI Fortune Oil
Plc, was higher than zero and sometimes had positive trend. Hence it is evaluated
positively too
Irom point oI view oI increased liquidity and solvency oI the company.
Any potential creditor
that observes similar trends will increase its conIidence in Fortune Oil Plc as a
credible borrower.

19

The net working capital to sales (NWC/S) ratio represents share oI the
most Iinancially stable
capital in total amount oI net sales. The higher it is - the better Ior Iinancial
stability.

!rofitabilitv
ProIitability indicators allow giving perIormance evaluation oI a company`s
management by
study oI how well they use corporate assets. An overall managerial
perIormance is deIined by
parity oI proIit, identiIied in various ways, with assets used Ior earning this
proIit.

ross profit margin (GPM) shows how much money is leIt in revenues aIter accounting
Ior the
cost oI goods sold. During the analyzed period, Fortune Oil Plc had
gross proIit margin in the
range oI 6064°. It is high value, especially Ior a company operating in
the tobacco sector,
which is mostly governed by legal trade restrictions. Still, there is an
opinion among top-
managers that 20-30° oI gross proIit margin is acceptable in current economic
conditions. It is
also obvious, that negative GPM means absence oI any proIit Ior company.

perating profit margin (OPM) is associated with proportion oI the company's

revenues that is
leIt aIter paying Ior variable production costs such as wages, raw materials and so
on. This value
is closely connected with capability oI the company`s management to work
eIIiciently while
keeping production costs low. The reduction oI the OPM in the other
years can most likely be
connected with high variable production costs.

%he net profit margin (NPM) ratio tells how much proIit Fortune Oil Plc
made Ior every £.1
generated in revenue. This is comparative indicator. The year 2006 has the
best perIormance in
terms oI NPM at 20°. The year 2009 was the worst with NPM dropping down to8°.

Return on assets (ROA) and complimentary ratios Return on fixed assets (ROFA) and
Return on
current assets (ROCA) are the most important proIitability indicators in
the thesis. They show
how eIIectively has been used each monetary unit involved in the
business cycle i.e. how a
company`s assets were allocated Ior earning its proIit. Fortune Oil Plc ROA ranged
Irom 28° to
40°, which indicates good perIormance. The ROA ratio is logically
connected with net proIit
margin and assets turnover.
20

Earnings before interest and taxes (EBIT) include all proIits Irom operations,
beIore interest and
income taxes are deducted. Normally, non-operating proIits and non-operating
expenses are not
included in the EBIT.

Return on equitv (ROE) deIines eIIectiveness oI using a company`s own

capital. It shows how
much money per £1 oI shareholder`s equity was earned during the analyzed
period. Being the
comparative indicator, there is no normal value Ior this ratio. Fig.3.4
provides visual
representation oI these ratios.

Another important measure oI proIitability is the Return on capital emploved ratio

(ROCE). This
indicator shows how much money in the EBIT has been generated by the
Net working capital
(i.e. by the most stable and Iinancially independent sources oI
Iinancing). In two years oI the
analysed period, Fortune Oil Plc achieved good Iigures oI this ratio.

Activitv Ratios
Activity ratios measure a Iirm's ability to convert diIIerent accounts
(current assets and current
liabilities) Iound in their balance sheets (or in internal accounting
books) into cash or sales.
Companies will normally try to turn their production into cash or sales as Iast as
possible because
this leads to higher revenues.

Inventorv turnover (IT) is used Ior estimation oI how Iast a company's stock is
sold and replaced
over the period. There is no generally accepted Iigure Ior this ratio, but the
main idea is to turn
inventories as Iast as possible. During the analysed period, Fortune Oil
Plc demonstrated good
integrity oI this indicator with an average oI 34 times.

21

Figure 2.4 Fortune Oil Plc`s Inventory Turnover

Source. Ms Excel Financial Model utput

The Davs in Inventorv (DI) ratio is the opposite indicator Ior the
inventory turnover. It is
measured in days. It shows how many days were needed Ior companies to
convert their stocks
into products. Fewer days in inventories are better and conclusions are
the same as with the
previous ratio.

Figure 2.5 Fortune Oil Plc`s Inventory Days Comparison with Green Dragon Gas

0.00
10.00
20.00
30.00
40.00
50.00
60.00
70.00
2005 2006 2007 2008 2009
%
:
r
n
o
v
e
r

R
a
t
e
Periods
Inventory %:rnover
Ìnventory Turnover -
Company
0
10
20
30
40
50
60
70
80
90
100
2005 2006 2007 2008 2009
D
a
y
s

H
e
I
d

i
n

I
n
v
e
n
t
o
r
y
Periods
Inventory Days Comparison
Days in Ìnventory -
Green Dragon Gas
Days in Ìnventory -
Fortune Oil
22

Source. Ms Excel Financial Model utput

The Average Collection Period (ACP) ratio measures average number oI days
that company`s
customers took to pay their bills, indicating eIIectiveness oI credit and
collection policies oI the
businesses. As it was mentioned earlier, the average collection period should not
be exceeding 30
days. Acceptable value oI this ratio Ior the industry is equal to one quarter (120
days) even iI it is
substantially longer than thirty days. Figure 3.5 shows the analysis.

Figure 2.6 Fortune Oil Plc`s Receivable Collection Period

Source. Ms Excel Financial Model utput

As Figure 2.6 indicates, Fortune Oil Plc takes relatively long time to collect
its receivables and
this may not be a good sign. The reason Ior that includes many Iactors
starting Irom poor
perIormance oI the industry and Iinishing by geographical speciIicity such as
distances between
business partners and their Iacilities. More than 120 days Ior this indicator
may cause delays in
receiving payments and considerably increases risk oI Iinancial Iailure.

Accounts receivable turnover (ART) is connected with the average collection period
ratio within
one-year business cycle. It shows how many times the studied companies
collected their
0
50
100
150
200
250
2005 2006 2007 2008 2009
D
a
y
s

t
o

C
o
I
I
e
c
t

A
/
R
Periods
ReceivabIe CoIIection Comparison
Days to Collect A/R -
Green Dragon Gas
Days to Collect A/R -
Fortune Oil
23

receivables during Iinancial period. High average collection period means

slow receivables
turnover. As shown in Figure 2.7 below, Fortune Oil Plc ART averaged at
4.9 during the
analysed period.

Figure 2.7 Fortune Oil Plc`s Receivable Turnover Comparison with Green Dragon Gas

Source. Ms Excel Financial Model utput

The accounts pavable turnover (APT) is short-term liquidity measure used

to quantiIy rate at
which the companies paid oII their suppliers. Generally, the Iaster company pays to
its partners,
the higher Iinancial liquidity it has. High turnover rate also indicates
production development
and possible business expansion.

That is critically low Ior any businesses. It is required to mention here

that external analysis oI
assets and liabilities turnovers has approximate nature and can be
substituted by studying oI
accounts and books. For Iigures that are more precise it is necessary
using oI managerial
accounting data iI possible.

0.00
2.00
4.00
6.00
8.00
10.00
12.00
2005 2006 2007 2008 2009
%
:
r
n
o
v
e
r

R
a
t
e
Periods
ReceivabIe %:rnover Comparison
Receivable
Turnover - Green
Dragon Gas
Receivable
Turnover - Fortune
Oil
24

The %otal assets turnover (TAT) measures a company`s operating eIIiciency by

estimation oI its
assets use in generating sales or revenues - the higher it is the
better. It also indicates pricing
strategy: companies with low proIit margins tend to have high asset
turnover, while those with
high proIit margins have low asset turnover. This ratio diIIers Irom industry to
industry. During
the analysed period, the TAT Ior Fortune Oil Plc was stably above 1.5 and at an
average oI 2.0,
which is good Ior the company (see Figure 2.8).

Figure 2.8 Fortune Oil`s Asset Turnover Comparison with Green Dragon Gas

The fixed assets turnover (FAT) ratio is similar to the previous indicator. It is
narrower measure
and determines eIIectiveness oI sales generated by investments in Iixed
assets. It does not
include current assets. This ratio is most likely to be useIul in such capital-
intensive industry as
oil and gas exploration and distribution.

Financial everage Ratios

Leverage indicators have mission to show degree oI possible risk oI
business collapse in
connection with use oI borrowed Iinancial resources. Indeed, iI a company
does not use loan
proceeds the risk oI bankruptcy is insigniIicant. This group oI Iinancial
ratios is interesting Ior
existing and potential creditors oI Fortune Oil Plc.
0.00
0.50
1.00
1.50
2.00
2.50
3.00
2005 2006 2007 2008 2009
%
:
r
n
o
v
e
r

R
a
t
e
Periods
Asset %:rnover Comparison
Asset Turnover -
Green Dragon
Gas
Asset Turnover -
Fortune Oil
25

The financial leverage (FL) ratio characterizes company`s dependencies Irom

loans and
borrowings. The lower this ratio, the higher is risk oI potential
insolvency Ior the company.
Fortune Oil Plc can be deIined to be Iinancially stable Ior the analyzed
period according to the
Iinancial leverage ratios.

The debt ratio (D/A) shows share oI company`s assets that is Iinanced
at the expense oI loan
proceeds, irrespective oI their sources. Some Iinancial experts commend keeping
this indicator at
stably at good levels. During the analyzed period, Fortune Oil Plc had good
values oI this ratio
although it was steadily increasing Irom 52° in 2005 (see Figure 2.9).
And Fortune Oil had
highest debt-to-equity ratio indicates that the company is mostly Iinanced
by debt than internal
sources oI Iinance (retained earnings).

Figure 2.9 Fortune Oil`s Debt to E6uity Comparison with Green Dragon Gas

The last calculated indicator in this group oI leverage ratios is the gearing ratio
(GR). Gearing is
a measure oI Iinancial leverage, demonstrating degree to which a Iirm`s activities
are Iunded by
owner`s Iunds versus creditor's Iunds. The higher degree oI leverage, the
more the company is
considered risky. Fortune Oil Plc`s leverage was mostly above 50° during the
analysed period,
keeping its Iinancial risk at high levels and this is not good Ior the company.
0%
20%
40%
60%
80%
100%
120%
140%
160%
2005 2006 2007 2008 2009
D
e
b
t

t
o

E
q
:
i
t
y

R
a
t
i
o
Periods
Debt to Eq:ity Comparison
Debt to Equity -
Ìndustry
Debt to Equity -
Fortune Oil
26

2.2.3 Limitations on Using Ratios in Financial Analysis

Financial ratios have certain limitations in their use and are not meant to be
applied as deIinitive
answers. They are usually used to provide additional details in the determination
oI the results oI
Iinancial and managerial decisions. They can provide clues to the
company`s perIormance or
Iinancial situation. However, on their own, they cannot explain whether perIormance
is good or
bad. As Ior the external Iinancial analysis, ratios also play a role oI basic
indicators, showing iust
an overview oI studying business entity.

Ratios have to be interpreted careIully. Gitman (2004) points out some

cautions about using
ratios in Iinancial analysis. He deIines six oI them:
Ratios with large deviations from the norm onlv indicate svmptoms of a
problem. It is
essential always to carry out additional analysis based on internal data
to isolate the
causes oI the problem. Ratio analysis iust directs attention to potential weak
spots. It does
not provide conclusive evidence and only shows the existence oI a problem;

A single ratio does not provide enough information sufficient to iudge

the overall
performance of a firm. Only a group oI ratios can practically play key role in it;

%he ratio comparison should be made using ratios calculated with

financial statements
dated at the same point in time. Otherwise, the eIIects oI seasonality
may produce
incorrect conclusions. (For example, it is especially important while
comparing
agricultural companies where seasonality is crucial);
%he use of audited financial statements for ratio analvsis is preferable. Using
an audited
Iinancial statement guarantees a certain level oI trust both Ior analyst
and Ior the end-
user. II the statements have not been audited, the data contained in them may not
reIlect
true Iinancial situation;
%he financial data being compared should have been developed in the same wav. The
use
oI diIIering accounting practices is especially relative to inventory and
depreciation and
can distort the results oI ratio analysis. This limitation is very important Ior
the thesis. It
narrows the possibility Ior comparison oI results oI Russian Iorest
product companies
27

with European analogues since the analysis is perIormed on the diIIerent data
basis. It is
true, that the diIIerences oI accounting policies may distort inter-company
comparisons;
Results can be distorted bv inflation. which can cause the book values
oI inventory and
depreciable assets to diIIer greatly Irom their true (replacement) values.
Additionally,
inventory costs and depreciation write-oIIs can diIIer Irom their true
values, thereby
distorting proIits. Without adiustment, inIlation tends to cause older
Iirms (older assets)
to appear more eIIicient and proIitable than newer Iirms (newer assets).
Ratio analysis is a useIul tool, but a person who deals with it has
to be always aware oI these
limitations and make adiustments as necessary and whenever possible. First, the
ratio analysis is
not iust a mechanical process, as it seems to be. It involves an accurate results
interpretation. For
instance, a correct conclusion about Iinancial ratio value is impossible
without analysis oI
economical situation both in the industry and in the country. Knowing oI
environment where
studied companies operate helps to make better conclusions Ior an analyst.

Analysis oI Iinancial ratios can provide useIul insights about company`s

operations, but
preIerably, it should be used together with other methods such as
potential bankruptcy
prediction, liquidity oI a balance sheet, evaluation oI proIit changes
and its composition and
studying oI structure oI assets and liabilities.

2.3 CAPITAL STRUCTURE ANALYSIS

2.3.1 Overview
The capital structure oI companies has been a Iocus by Iinancial
researchers Ior some decades
since the proposition by Miller and Modigliani (1958). As we analyse the
capital structure oI
Fortune Oil Plc, it is imperative that we review and apply the key
methods oI analysis Ior
company capital structure. In this regard, we review Miller and Modigliani`s
irrelevance theory,
the trade-oII theory and the pecking order theory. This provides a guide
Ior analysing Fortune
Oil Plc`s capital structure.

28

2.3.2 The Miller and Modigliani Irrelevance Theory

The ModiglianiMiller capital structure irrelevance theory states that, in
the absence oI taxes,
bankruptcy costs, and asymmetric inIormation, and in an eIIicient market, a
company`s value is
unaIIected by how it is Iinanced, regardless oI whether the company`s capital
consists oI equities
or debt, or a combination oI these, or what the dividend policy is. The theory is
interchangeably
also known as the capital structure irrelevance principle.

A number oI principles underlie the theorem, which holds under the assumption oI
both taxation
and no taxation. The two most important principles are that, Iirst, iI there are no
taxes, increasing
leverage brings no beneIits in terms oI value creation, and second, that
where there are taxes,
such beneIits, by way oI an interest tax shield, accrue when leverage
is introduced and/or
increased. The theory compares two companies: one un-levered (i.e. Iinanced purely
by equity)
and the other levered (i.e. Iinanced partly by equity and partly by debt)and
states that iI they
are identical in every other way the value oI the two companies is the same.

2.3.3 Capital Structure: The Trade-off Theory

This theory oI capital structure suggests that a Iirm`s a Iirm`s target leverage
is driven by three
components: corporate taxes, bankruptcy costs and agency conIlicts. Capital
structure trade oII
involves balancing the corporate tax advantage oI debt against the present
value oI bankruptcy
costs (Kraus and Litzenberger, 1973) and agency costs (Jensen and Meckling,
1976). Trade-oII
Theory also states that debt-equity ratio varies Irom one Iirm to another
depending on its risks,
number oI assets held (collateral) and number oI assets which are source oI taxable
income Irom
their shield. The theory explains that, industry diIIerences lead to diIIerences in
capital structure
oI companies. High technology industries tend to use very little debt
because oI its risks on
assets, since their assets are intangible, unlike retailers who borrow
heavily because oI the
presence oI tangible assets they hold.

2.3.4 The Pecking Order Theory

The Pecking Order Theory depicts the hierarchy or mix oI Iirm`s sources oI Iinance.
It explains
how Iirms choose to Iinance their operations and investments between
internal and external
29

Iinancing, basing on companies` policies, priorities and prospective. The

hierarchy implies that
there is preIerence in Iinancing Iirm`s operations. Retained earnings are
preIerred Iollowed by
debt iI there is a short Iall and equity being the last option. Under this theory,
the optimal capital
structure is not well deIined.

Meyers (1984) and Meyers and MailuI (1984) contended that there are three sources
oI Iunding
available to Iirms, which are retained earnings, debt and equity.
Retained earnings have no
adverse selection problem; equity is subiect to serious adverse selection problem
while debt has
only a minor adverse selection problem. Due to adverse selection problems, Iirms
preIer internal
to external Iinance. But when outside Iunds are necessary, Iirms preIer debt to
equity because oI
the lower inIormation costs associated with debt issue.

From the point oI view oI the outside investors, equity is strictly riskier than
debt. However, both
have an adverse selection risk premium, but the premium is larger on
equity, which inIluences
the outside investors to demand a high rate oI return on equity than on debt.
Whereas Irom the
perspective oI those inside the Iirm, retained earnings are a better source oI
Iunds than debt and
debt is better than equity.

2.3.5 Fortune Oil Plc`s Capital Structure

During 2009, Fortune Oil market capitalization remained largely unchanged
at approximately
£11.4 billion. The impact oI a 4 pence decrease in the share price during the year
to 546 pence at
31 December 2009 (550 pence at 1 January 2009) was oIIset by the
issuance oI 10.7 million
shares to satisIy employee share awards. Net debt decreased during the year Irom
£3,900 million
at the end oI 2008 to £2,909 million at the end oI 2009.
The company continues to proactively manage the capital structure to
maximize shareowner
value, whilst maintaining Ilexibility to take advantage oI opportunities which
arise, to grow the
business. One element oI the strategy is to make targeted, value
enhancing acquisitions. It is
intended that these will, where possible, be Iunded Irom cash Ilow and
increased borrowings.
30

The availability oI suitable acquisitions, at acceptable prices is,

however, unpredictable.
Accordingly, in order to maintain Ilexibility to manage the capital
structure, the company has
sought, and been given, shareholders approval to buy back shares as and
iI appropriate. This
authority has only been used once, in 1999, when 24 million shares (representing
approximately
1° oI the Company's equity) were purchased. Additionally, many oI the obligations
under share
plans will be satisIied by existing shares purchased in the market by the
Fortune Oil Employee
Trust (Employee Trust) rather than by newly issued shares. The Employee Trust
purchased £50
million shares during 2009 (none in 2008) and held 19 million shares at
the end oI 2009,
representing approximately 0.9° oI the company's issued share capital.

Fortune Oil authorized ordinary share capital is 3,200,000,000 ordinary

shares oI 12.5 pence
each (2005-2009). The allotted, Called-up and Iully paid up ordinary
share capital as at 31
st
,
December, 2002, 2003,2004, 2005 and 2006 shows £ million 257, £ million 258, £
million 259, £
million 260, and £ million 262(2,095,000 at 12.5p shares in 2009)
respectively. The Company
has one class oI ordinary shares which carry no right to Iixed income.

During 2009, 10,682,192 ordinary shares oI 12.5p were allotted and issued upon the
exercise oI
share options. The nominal value oI ordinary shares issued during the
year was £1.3 million.
There were no other changes in the issued ordinary share capital oI the
Company during 2009.
During 2008, 11,528,687 ordinary shares oI 12.5p were allotted and issued upon the
exercise oI
share options .The nominal value oI ordinary shares issued during the
year was £1.4 million.
There were no other changes in the issued ordinary share capital oI the
Company during 2008.
During 2007, 8,446,409 ordinary shares oI 12.5p were allotted and issued
upon the exercise oI
share options. The nominal value oI ordinary shares issued during the year was £1.1
million.

The company committed both long and short term debt / borrowings at
Iixed and Iloating rate
iust to maintain its debt capital program Ior the period under review. The Gross
debt as at 31
st
,
December, 2002, 2003, 2004, 2005 and 2006 shows £2,318 million, £4,644
million£4,216
million, £4,279 million and £3,304 million respectively. Generally the
company is highly
Iinanced through borrowings and these borrowings were secured by the
company group
properties.
31

CHAPTER THREE
VALUATION OF THE COMPANY

3.1 OVERVIEW
This chapter presents the valuation oI Fortune Oil Plc by applying diIIerent
valuation methods.
There are several valuation methods. However, this proiect uses the
methods in the Iollowing
sections. To Iully understand the application oI the valuation models to Fortune
Oil plc, we start
with a review oI the literature on the selected valuation models.

3.2 VALUATION MODELS

3.2.1 Dividend Valuation Models
Is the discounted cash Ilow model used to value stock, or equity i.e. the cash Ilow
the shareowner
in a company really stands to receive is dividends plus the proceeds Irom the sale
oI the shares at
some Iuture time. The dividend is the cash payment made by the company
to the investors. In
most cases, companies pay out part oI their earnings in the Iorm oI dividends and
retain a part Ior
reinvestment. Dividends are paid Irom earnings, and consequently it is
the potential earning
power oI a company which is the most important determinant oI its market value.
This had been
most convincingly argued by Miller and Modigliani (1961) who contended,
assuming perIectly
competitive capital market, that values are determined by real considerations the
earning power
oI the company`s assets and its investment policy and not by how the Iruits oI the
earning power
are packaged Ior distribution¨. A company can use either or all oI the
Iollowing Iactors to
inIluence dividend policy; ProIitability, Company Size, Leverage, Agency Costs,
Business Risk,
Ownership Structure, Maturity, Tangibility, and Growth Opportunities.

The Gordon Dividend Valuation Model (1959)

Gordon (1959) established the model and the calculation bases on dividends growth
and required
rate oI return. Always the value oI the company is the same with earnings based
valuation model
to that oI the dividend model. This model states that, the share price given by
discounted value
Ior the dividend per share is what expected to be received by the shareholders. The
shares will be
32

held Ior a given time period and then sold at the expected price
(based on the payoII expected
Irom holding stocks in present value terms).

The cash Ilow consists oI the dividends expected by shareholders and the
process predictable
Irom the sale oI the share at the end oI holding period. Increase in dividend
payout increases the
value oI company. Current dividends are preIerable to Iuture dividends as the
Iuture ones that are
associated with uncertainties.

Graham and Dodd (1934) commended that, the typical investor would most
certainly preIer to
have his dividend today and that let tomorrow take care oI it. There
seems to be a natural
clientele Ior high payout shares because dividends are regarded as payout income
where capital
gains are additions to capital. Gordon (1961) and Lintner (1962) cited that
investors view current
dividends as less risky than Iuture dividends or capital gains.

The expected rate oI return on a share bought in the market comprises dividends
paid until share
sold and the price on sale`. In order to make a purchase decision, the
shareholder must believe
that the current price is below the value oI the receipts, i.e. Current price. P
o
Dividends to sale
¹ Sale price Discount rate i. Algebraically, iI the share is held Ior n years then
sold at a price Pn
and annual dividends to year n are D1, D2, D3,...Dn.

Then:
Po · D1/(1¹i)' ¹ D2/(1¹i)· ¹ D3/(1¹i)³ ¹ (Dn ¹ Pn)/(1¹i)·

The model tells us that the price oI a share oI stock should equal the present
value oI all Iuture
dividends paid by the share.

By similar logic, the seller oI the share must believe that;

Po ~ D1/(1¹i)' ¹ D2/(1¹i)· ¹ D3/(1¹i)³ ¹ (Dn ¹ Pn)/(1¹i)·

These diIIerent views will occur Ior two reasons.

 DiIIerent proiects Ior D1, D2, etc and Ior Pn by the diIIerent investors.
33

DiIIerent discount rates being used by diIIerent investors.

However, the price oI share is usually in equilibrium, Ior the maiority oI

investors who are not
actively trading in that asset. Dividend policy oI the company is
thereIore depending on what
type oI the investors the company has and the tax rate in Iorce at the time. II
investors demand
their dividend currently, then the company will Iund its business by using the
external Iunding or
otherwise. The Company can try to decrease the problem oI providing high dividend
payout ratio
by convincing its investors to make out their own dividends by selling some oI
their shares iI the
dividends provided by the company are contrary to their expectation.

Table 2.4 Value of the Fortune Oil Plc using Dividend Valuation Models
Dividend Valuation Model 2007 2008 2009
Po÷D/r D÷ dividend(million) 247 260 272
r ° 23 23 23
Po 10.739 11.3043 11.826
No(million) 2,027 2,051 2,072
Vo ÷ Po*No (million) 21,767.953 23,185.1193 24,503.472
Note: 'r¨ assumed to be constant Irom 2005 to 2009

This study Iocussed on the Iollowing key assumptions governing the Gordon Valuation
Model:
O Dividends continue to grow at a constant rate Ior an extended period oI time.
O The growth rate is assumed to be less than the required return on equity, ke.

Gordon demonstrated that iI this were not so, in the long run the Iirm
would grow impossibly
large. Theoretically, the best method oI stock valuation is the dividend valuation
approach. But,
iI a Iirm is not paying dividends or has an erratic growth rate, the
approach will not work.
Consequently, other methods are required.

34

3.2.2 Gordon`s Growth Model

Gordon Growth Model is a variant oI the discounted cash Ilow model, a
method Ior valuing
shares or business. OIten used to provide diIIicult-to-resolve valuation
issues Ior litigation, tax
planning, and business transactions that are currently oII market.

Assumptions of the Model

It assumes that the company issues a dividend that has a current value
oI D that grows at a
constant rate g. It also assumes that the required rate oI return Ior the stock
remains constant at k
which is equal to the cost oI equity Ior that company. It involves
summing the inIinite series
which gives the value oI price current P.
The model also assumes that the earnings growth is constant Ior
perpetuity. In practice a very
high growth rate cannot be sustained Ior a long time. OIten it is
assumed that the high growth
rate can be sustained Ior only a limited number oI years. AIter that only a
sustainable growth rate
will be experienced. This corresponds to the terminal case oI the Discounted Cash
Flow model.
Gordon's model is thus applicable to the terminal case. Gordon established that iI
this was not so,
in the long run the company would impossibly grow large.

The problem with the model is that it requires one perpetual growth rate greater
than negative 1
and less than the cost oI capital.

P
0
÷ (D
0
(1¹g)
1
(1¹r)
1
) (D
0
(1¹g)
2
(1¹r)
2
) ... (D0 (1¹g)
·
(1¹r)
·)

Where:
D0 ÷ the most recently paid dividend.
g ÷ the expected growth rate in dividends
r ÷ the required return on equity investments
·
÷ inIinite time.

Predicting Iuture dividends Ior two or three periods is hard enough; the equation
above needs an
estimate oI dividends perpetually. A pragmatic approach oI providing such
estimates is to
presume that the dividend will grow steadily evenly hence high dividend policy is
the best.
35

Algebraicallv model ÷ P0 ÷ D0 (1 ¹ g) (r - g) ÷ D1 (r g)

3.2.3 Earnings Valuation Model

Modigliani and Miller (1961), developed M & M model and argued that, dividend
is paid Irom
earnings. Earnings power oI the company is the most signiIicant Ieature in the
whole course oI
determining the market value oI the company. All investments in respect
oI this model are
Iunded Irom retention. Earnings based valuation model uses Net Present Value (NPV),
earnings
required rate oI return and growth rate.

They argued that dividend policy is irrelevant given the perIect capital
market and Irictionless
world. The value oI the company depends only on the proIitable
investment strategies to be
undertaken by a company and working decisions that produce cash Ilows. M&M study
based on
the assumptions that there are perIect capital markets, no transaction
costs, no taxes/tariIIs, no
brokerage/commission Iees, inIormation is costless and the market has
homogeneous belieIs.
Modigliani and Miller relaxed some oI their assumptions such that
transaction costs and tax.
Dividends are more certain than retentions as they increase payout ratio. Expected
dividends are
generally perceived to be critical determinants oI the value on the share price but
dividend policy
is somehow controversial.

In developing a dividend policy, there must be a proper approach to deal with,

because, when a
company decides to increase investment by using retained earnings, investor`
current income in
the Iorm oI dividends will decreases. On the other hand, when dividends
are increased,
shareholders` current income will increase, but the company may have to
give up some
investment opportunities Ior want oI Iunds and as a result, the Iuture earnings may
decrease.

Management should thereIore develop a dividend policy that apportion the

net earnings into
dividends and retained earnings in the best possible way to achieve the obiective
oI maximizing
the wealth oI investors. The obiective oI a dividends policy is to maximize the
inventor`s return
so that the value oI his investment is maximized. Investor` return
comprises dividends and
capital gain and dividend policy has a direct impact on these components oI return.
36

A high pay out dividend policy means more dividends and less retained
earnings, which may
accordingly leads to slower growth and perhaps lower share price. Low
pay out policy means
less dividends, more retained earnings, higher capital gains, and perhaps
higher share price.
Capital gains are Iuture earnings while dividends are current earnings. Dividends
in most cases
are taxed more than capital gains. ThereIore, it is somewhat reasonable
that some investors
would preIer high-payout companies while others may preIer low-payout companies.

Earnings valuation model, assumes value is based upon the sum oI Net
present value Irom
contribution obtained on the expected earnings and the expected returns oI the
company.

'÷E/r¹P',

Where:
P' ÷

P't¹P'/(r-g) (1¹r)
t
,
G ÷retention times rate oI return Irom investment, and
NPV ÷ Eb (k/r-1) ÷ Eb (k/r-1),
V0 ÷ stands Ior the value oI the company
E ÷ expected earnings,
R ÷ Ior required rate oI return,
g ÷ Ior growth rate,
b ÷ Ior retention,
k ÷ Ior investment rate oI return and
PVGO ÷ Present Value oI Growth Opportunity

Earnings Valuation of Fortune Oil Plc (2009 to 2014)

Let g ÷ growth oI the Fortune Oil oI the revenue generated, assumed to
be 23° evenly Irom
2009 to 2014.

37

Let b÷ Retention ÷ the earnings aIter interest and tax Ior six years subtracts
dividend paid, hence
average retentions rate obtained and get 77° and (1-b)÷dividend payout ÷23°.

According to the theory g bk assumed that earnings is anticipated to grow at

constant rate.
From assumed b is 77° and g is 23° hence k ÷ g/b ÷0.23/0.77 ÷ 0.2987÷29.87°÷k÷30°

The company-required rate oI return also assumed to be constant ÷ the

average rate oI
shareholders Iunds ÷ r ÷ 23°.
Year 2005 2006 2007 2008 2009 Average(2005-2009)
ROSF÷r÷ 19.26° 13.16° 25.5° 25.43° 31.7° r÷23º

Earning model:
V0 ÷ E/r ¹ PVGO, but PVGO ÷ NPV
1
/ (1¹r)
1
¹ NPV
2
/ (1 ¹ r)
2
¹ ......NPV
n
/ (1¹r)
n
Amount in £ million
V0 ÷ 1,169 ¹ 273.95 ¹ 337.23 ¹ 415.25 ¹ 511.17 ¹ 629.25
¹ 774.60
0.23 1.23 (1.23)
2
(1.23)
3
(1.23)
4
(1.23)
5
(1.23)
6

÷£6,421.91 million

3.2.4 Net Assets Valuation

Book-value ÷ Assets - Liabilities i.e. the book value oI the company is
the cost oI assets less
accumulated depreciation, i.e. it is the sum value net asset oI the
company. Book value can be
deIined as total value oI the company`s assets that investors would notionally
receive in case oI
company`s liquidation. The book value can show whether the inventory is over
or under priced
when compared to market value. It is the same as net assets value
taking the cost oI tangible
assets less accumulated depreciation add working capital less long-term liability.
The book value
may be aIIected by the management decisions on the provisions made on
depreciation and
debtors hence some companies may decide to have large amount oI provision on bad
debts.

38

Table 2.5 Fortune Oil`s Book Value

Year 2005
(£million)
2006
(£million)
2007
(£million)
2008
(£million)
2009
(£million)
Book value 70,198 64,756 114,297 219,242 228,996
° change in
book value
13° -9° 76.5° 91.8° 4.4°

The Fortune Oil`s book value grew to 13° in 2005 beIore Ialling by 9° in 2006 and
the growth
shoot up to 76.5° and 91.8° in 2007 and 2008 respectively with a marginal growth oI
4.4° in
2009(see Table 40 above).
Figure 2.11 Fortune Oil Book Value Trend

3.2.5 Price-Earnings Model

The price earnings ratio (PE) is a widely method used to measure how
much the market is
willing to pay Ior a unit oI earnings Irom a company. It shows how
much shareowners are
willing to pay per a unit oI currency oI the reported proIits. P/E ratios are
higher Ior companies
with high growth prospects, all else being equal, but they are lower Ior riskier
companies.
2003 2006 2007 2008 2009
70ţ198
64ţ736
114ţ297
219ţ242
228ţ996
8ook Va|ue 1rend (|n £¯||||on) Ŵ
Iortune C||
39

A high PE has two interpretations:

A higher than average PE may mean that the market expects earnings to rise in the
Iuture.
A high PE may indicate that the market thinks the company`s earnings are very low
risk
and is thereIore willing to pay a premium Ior them.

Assumptions of the P/E model:

The price earnings ratios are expected to remain constant over time.
A number oI inIerences are drawn based on results oI the analysis.
The expected rate oI return (k) is constant over time.

Market 'alue ('o) ÷ Earnings *P/E ratio

Table 2.6 Fortune Oil`s Price Earnings Valuation Model

2005 2006 2007 2008 2009
Earnings Per Share 0.16 0.24 0.25 0.49 0.47
Market Share price (GBP) 6.5p 5.7p 6.4p 8.7p 6.8p
P/E 40.625 23.75 25.6 17.7551 14.4681
Earnings (£million) 2,792 4,307 4,487 8,897 8,842
Vo(£million)
113,425 102,291 114,867 157,967 127,927

From Table 2.6, Fortune Oil`s earnings Ior 2009 were £8,842 million and P/E ratio
oI 14.468, the
lowest compared to the company`s perIormance in the preceding Iour years
and this gives the
value Ior the company to be £127,927 million in 2009.

3.2.6 Market Valuation Method

The market capitalization reIers to the value oI the outstanding shares oI
company. The market
value is equal to the total number oI shares multiplying by the market
share price. The market
40

capitalization depends on the share price and on occasion may misinIorm

users as they believe
that the higher the market share price the larger the value oI the company.

Market value
The method assumes that shareowners will buy investments oI equal value
interchangeably and
the company value is determined in the Iollowing way:

Market value per share ÷ dividend per share divided bv dividend vield

Assumptions of market value method:

A constant ratio oI earnings is reserved in each time.
All investment is Iunded by retentions
The rate oI return on investment is constant over time (The earlier a shareholder
receives
his or her Iunds the more value it has).
The cash Ilow generated Irom investment are constant in inIinity
The rate oI return on existing assets remains constant over time
A constant ratio oI dividends is paid out.

Market Prospects
Market measures are valuable Ior analyzing companies registered in stock exchange.
The market
measures use share prices, which reIlect the market`s prospects oI both company
return and risk
as the market perceives it.

Fair Market Value

'Fair market value¨ is deIined as the price, expressed in terms oI cash
equivalents, at which
assets would change hands between a theoretical willing and able
purchaser and a theoretical
willing and able broker, acting at arm`s length in an open and unrestricted market,
when neither
is under Iorce to acquire or sell and when both have rational knowledge oI the
relevant Iacts. The
Iair market value standard incorporates deIinite assumptions, including the
assumptions that;
the theoretical buyer is rationally prudent and logical but is not
stimulated by any
synergistic or planned inIluences;
41

the business operates as a going concern the theoretical transaction will be

conducted in
cash or equivalents;
The parties are willing and able to consummate the transaction.

These assumptions might not, and probably do not, reIlect the actual
situation oI the market in
which the business might be sold. However, these conditions are assumed because
they yield the
same standards oI value, aIter applying generally-accepted valuation
methods, which allows
meaningIul comparison between businesses which are similarly situated.
The market approach to business valuation is rooted in the economic
principle oI competition:
that in a Iree market the market Iorces will drive the price oI
business assets to certain
equilibrium. Buyers would not pay more Ior the business, and the sellers
will not accept less,
than the price oI a comparable business enterprise. It is alike in many
respects to the
'comparable sales¨ technique that is regularly used in real estate evaluation. The
market price oI
the shares oI publicly traded companies engaged in the same or a similar line oI
business, whose
shares are actively traded in a Iree and open market, can be a valid indicator
oI value when the
transactions in which shares are traded are adequately similar to allow meaningIul
comparison.

The problem lies in identiIying public companies that are adequately comparable to
the company
Ior this purpose. Also, as Ior a private company, the equity is less
liquid (in other words its
shares are less easy to buy or sell) than Ior a public company, its value is taken
to be somewhat
lower than such a market-based valuation would give.

3.3 SUMMARY OF VALUATION OF FORTUNE PLC

Based on the calculations and discussion oI the valuation models presented above,
the valuation
oI the Fortune Plc can be summarized as shown in Table 3.7 below. The
summary Iocuses on
Fortune Plc`s valuation Ior years 2007, 2008 and 2009.

42

Table 3.7 Summary Valuation of Fortune Plc

Valuation Model 2009
(£Millions)

Gordon Dividend
Valuation Model
24,503
Earnings Valuation 6,421
Net Assets Valuation 228,996
Price Earnings Model 127,927
Market Value

43

CHAPTER FOUR
CONCLUSION
Financial analysis through various techniques including balance sheet
structure and income
statement structure analysis and the use oI ratios has been Iound to be very
helpIul in evaluating
the company perIormance, compared to previous years and to competitors
and the industry,
setting benchmarks or standards Ior perIormance, highlighting areas that need to be
improved, or
areas that oIIer the most hopeIul Iuture potential and enable external parties,
such as investors or
lenders, to measure the creditworthiness and proIitability oI the company.
The Iinancial statements oI Fortune Oil show that it was doing some how
good in terms oI
revenue, gross proIit, operating proIits as well as proIit aIter tax and
interest, especially Ior the
years under review. However, the Iinancing structure is set to be against the
shareholders oI the
company as its Iinancial leverage hangs above 50°. This puts the company
at higher Iinancial
risk.

The analysis also evaluated the company`s capital structure and this
involved a review oI the
irrelevancy theory propounded by Modigliani and Miller (1958). The
irrelevancy theory oI
capital structure by Modigliani and Miller (1958) argued that the value
oI the company is
independent with its capital structure. Friend and Puckett (1964) and Black and
Scholes (1974)
were incapable to Iind any considerable relationship between dividend policy and
total returns on
a risk-adiusted basis. Barnes, Haugen and Senbet (1981) concluded that as
the level oI gearing
increases, the agency costs increase as well. The conIlicting interest
between shareowners and
debt owners arise due to this agency costs. There are two assumptions presented by
researchers
'the principle and the agent motivated by selI-interest and they are
capable oI Iorming rational
anticipation concerning the likely outcomes and the actions oI the decision takers.

Modigliani and Miller (1995) explained that the dividend policy is

irrelevant in company
valuation. Gordon and Lintner model explained that high dividend policy
is the best one. The
results show that there are some general Iactors that determine dividend policy Ior
both Iinancial
and non-Iinancial companies and there are other Iactors that aIIect only non-
Iinancial companies.
44

SpeciIically, there are six determinants oI dividend policy Ior non-

Iinancial companies, while
there are only three Iactors that inIluence the dividend policy oI
Iinancial companies. The
general Iactors are proIitability, company size, and business risk, government
inIluence, gearing
level, and the company age have a strong inIluence on the dividend
policy oI non-Iinancial
companies but no eIIect on Iinancial companies. Agency costs, tangibility,
and growth do not
appear to have any eIIect on the dividend policy oI either Iinancial or non-
Iinancial companies.
The Iact that agency costs is not an important determinant oI dividend
policy is not surprising
given that Arab companies are highly geared on bank debt where the role
oI dividends in
alleviating the agency problems is less important.

With respect to the stability oI dividend policy, we Iind that the

speed oI adiustment diIIers
substantially between Iinancial and non-Iinancial companies. While we Iind
that non-Iinancial
companies adopt a policy oI smoothing dividends, this is not the case Ior Iinancial
companies. In
Iact, Iinancial companies do not have stable dividend policies. It was
Iound that shareholders
have a strong Iavourite to receive dividends. II the company cannot pay
cash dividends, they
preIer to receive stock dividends compared to not receiving dividends at all. This
clearly shows
that they are certainly not neutral towards the dividend policy. We do not Iind
much support Ior
the 'irrational¨ explanations oI the existence oI dividends, i.e. the uncertainty
solution theory oI
Gordon (1961, 1962) and the behavioural explanation oI SheIrin and
Statman (1984). We only
Iind support Ior the latter in case oI stock dividends. Furthermore, it was Iound
that shareholders
partly want dividends because oI transaction costs. The results strongly reiect the
agency theories
oI Easterbrook (1984) and Jensen (1986). On the other hand a strong
support is Iound Ior the
signalling theories oI Bhattacharya (1979) and Miller and Rock (1985).

45

REFERENCES

Brealey, Richard A., Stewart C. Myers, and Franklin Allen (2008)

Principles of Corporate
Finance. 9th ed., McGraw-Hill/Irwin, Boston

Gitman, L. J. (2004) Principles of Managerial Finance. 10

th
Edition, Pearson Education, London

Vance, D. I. (2003) Financial Analvsis and Decision Making. %ools and %echniques to
Solve
Financial Problems and Make Effective Business Decisions. McGraw Hill, Chicago

Modigliani and Miller (1958) 'The Capital Corporate Finance and the
Theory oI Investment,¨
American Economic Review, Vol. 48, 261-297
Gordon (1959) 'Dividends, Earnings and Stock prices,¨ Review of Economics
and Statistics.
Vol. 99-105
Lintner (1956) 'Distribution oI Incomes oI Corporations among Dividends,
Retained earnings
and Taxes,¨ %he American Economic Review Journal, Vol.46, No 2, 97-113
Myers S, (1984) 'The Determinants oI Corporate Borrowing,¨ Journal of Finance,
Vol.32, 147-
175

46

APPENDIX 1: BALANCE SHEETS (2005 - 2009) - FORTUNE OIL PLC

Millions of GBP

Annual Annual Annual Annual Annual

Period Period Period Period Period

Description 2005 2006 2007 2008 2009

Cash and Cash Equivalents 11,713 8,202 27,263 67,823 55,766

Short Term Marketable Securities 0 0 0 0 0
Accounts Receivable 6,272 6,302 8,759 18,937 14,817
Ìnventory 2,151 1,070 1,064 4,672 5,260
Other Current Assets 0 0 0 0 0
%otaI C:rrent Assets 20,136 15,574 37,086 91,432 75,843

Property, Plant and Equipment 26,747 24,539 43,283 90,086 94,126

Accumulated Depreciation 0 0 0 0 0
Net Fixed Assets 26,747 24,539 43,283 90,086 94,126
Long-term Ìnvestments 1,917 2,394 5,425 8,136 5,593
Ìnvestments in Other Companies 19,410 21,083 22,593 27,405 31,326
Ìntangibles and Other Assets 1,988 1,166 5,910 11,937 12,354
%otaI Non C:rrent Assets 50,062 49,182 77,211 137,564 143,399
%otaI Assets 70,198 64,756 114,297 228,996 219,242

Trade and Other Payables 9,813 5,362 15,410 26,572 32,458

Borrowings 1,944 3,427 5,212 27,593 30,192
Short Term Portion of LT Debt 0 0 0 0 0
Other Current Liabilities 241 170 549 1,032 1,026
%otaI C:rrent LiabiIities 11,998 8,959 21,171 55,197 63,676

Long-term Debt / Borrowings 7,126 5,567 27,976 34,633 18,346

Other Long-term Liabilities 336 264 1,527 2,556 3,024
%otaI Non C:rrent LiabiIities 7,462 5,831 29,503 37,189 21,370
%otaI LiabiIities 19,460 14,790 50,674 92,386 85,046

Non-controlling Ìnterests 11,726 11,288 18,473 49,944 44,110

Ordinary Shares 18,351 18,363 18,363 19,282 19,875
Share Premium 37,344 22 22 8,932 10,129
Retained Earnings (17,985) 23,805 28,291 37,618 47,157
Translation Reserves 2,062 (2,717) (932) 21,428 13,854
Treasury Shares (760) (795) (594) (594) (929)
%otaI SharehoIder Eq:ity 50,738 49,966 63,623 136,610 134,196

%otaI LiabiIities & Eq:ity 70,198 64,756 114,297 228,996 219,242

47

APPENDIX 2: INCOME STATEMENTS (2005 - 2009) - FORTUNE OIL PLC

Millions of GBP

Annual Annual Annual Annual Annual

Period Period Period Period Period

Description 2005 2006 2007 2008 2009

Net Sales 143,057 175,771 219,887 364,722 403,745

Other Operating Revenues -98,068 -132,500 -147,199 -232,586 -211,714
%otaI Reven:es 44,989 43,271 72,688 132,136 192,031
Cost of Goods Sold (36,851) (33,912) (61,831) (101,660) (157,013)
Other Operating Expenses 0 0 0 (11,192) (12,000)
%otaI Direct Expenses (36,851) (33,912) (61,831) (112,852) (169,013)
Selling, General & Administrative (4,617) (4,444) (5,169) (8,483) (9,522)
Operating Income 3,521 4,915 5,688 10,801 13,496

Ìnterest Expenses (454) (471) (1,243) (2,722) (2,532)

Foreign Exchange (Loss) Gain 0 0 0 0 0
Associated Company (Loss) Gain 2,966 3,110 4,376 (1,051) 6,228
Other Non-Operating (Loss) Gain 0 0 0 0 0
Ìncome Tax Expense (544) (617) (619) (1,501) (2,784)
Reserve Charges 0 (834) 0 0 0
Income Before Extra Ord. Items 5,489 6,103 8,202 5,527 14,408

Extra Ordinary Ìtems (Loss) Gain (629) 2,551 0 8,648 865

Tax Effects of Extraordinary Ìtems 0 0 0 0 0
Minority Ìnterests 0 0 0 0
Net Income 4,860 8,654 8,202 14,175 15,273