The current report would focus from the perspective of a foreign institutional investor planning to invest in the Australian market. Therefore, the two organisations that have been selected for this assignment operate in the banking sector of Australia. They include Westpac Banking Corporation and Bank of Queensland. The first section of the report would provide an insight of the business operations of the two banks along with comparative advantages. The second section would concentrate on analysing and contrasting the profitability and liquidity positions of the two chosen banks for the past three years by extracting the financial information from their published annual reports. The next part would emphasise on analysing the share price movement analysis of the two banks to determine the volatility of their stock prices in the ASX index. In addition, the weighted average cost of capital of the two companies has been analysed as well as their capital structures. Based on all the above aspects, recommendation letter would be provided to the concerned investor regarding the investment opportunities in the two banks.
Westpac Banking Corporation is involved in providing different financial and banking services in Australia, New Zealand, the Pacific region and global nations. The bank operates in five divisions, which include Business Bank, Consumer Bank, Westpac Institutional Bank and Westpac New Zealand. Moreover, the bank offers particular treasury and banking services, telephone banking, ATMs, travel centre, margin lending and emergency cash. Furthermore, it is involved in serving micro, small and medium enterprises, individuals, government customers and others by providing fund management and capital advisory services, which are the main comparative advantages of the bank. The bank has been established in 1817 with an employee base of around 35,029 employees (Westpac.com.au 2019).
Bank of Queensland is one of the leading regional banks in Australia and the local owner-managers run majority of its branches. The bank focuses on maintaining long-term customer relationships, which are dependent on mutual understanding and respect. The bank has above 180 branches in Australia and it has developed easy, simple and understandable banking products for supporting the financial needs of its customers. These products and services are rendered to the businesses as well as individuals. It falls under the top 100 Australian firms in terms of market capitalisation in ASX, which has assisted the bank in gaining comparative advantage in the market (Boq.com.au 2019).
For evaluating the profitability and liquidity position of the two selected banks, the following ratios are taken into consideration:
In order to analyse profitability position of Westpac Banking Corporation and Bank of Queensland, the ratios considered include operating margin, net margin, return on assets and return on equity.
In accordance with the above table and figure, it could be observed that the operating margin of both the banks after witnessing steady increase in 2017 has fallen in 2018 due to the reduction in the deposits of the customers leading to fall in interest income. This ratio helps in gauging the ability of an organisation to determine the profit earned after deduction of all its operating costs (Brown and Jones 2015). However, the margin is observed to be higher for Westpac due to increased interest income in 2018, which is denoted as revenue in the above table.
As commented by Gitman, Juchau and Flanagan (2015), net margin is the percentage of profit left for an organisation after deduction of all relevant expenses including operating expenses, interest expense and tax expense. In case of Westpac, the net margin is observed to increase from 23.44% in 2016 to 25.61% in 2017; however, it has fallen again to 24.87% in 2018. The trend is similar in case of Bank of Queensland, which after increasing in 2017 has declined again in 2018. The ratio is observed to be higher for Westpac; thus, it is placed in more a competitive position in the Australian banking industry.
The return on assets gauges the effectiveness of an organisation in earning a return on its investment in assets (Halili, Saleh and Zeitun 2015). For both the banks, return on assets after experiencing increase in 2017 has fallen slightly in 2018 due to increase in assets funded by debt. In this situation, the position is deemed to be favourable for Westpac, as its return on assets has been higher in all three years compared to Bank of Queensland. Finally, return on equity gauges the efficiency of an organisation in utilising money from the shareholders for profit generation and business expansion (Hatfield 2014). In case of Westpac, the return of assets after increasing in 2017 has declined slightly in 2018; however, the ratio is observed to be falling for the Bank of Queensland over three years. Thus, in this aspect as well, Westpac is enjoying competitive supremacy over the Bank of Queensland in the Australian banking sector.
Considering all the above-discussed points, Westpac is observed to be placed in a better position in terms of profitability position than the Bank of Queensland in the Australian market.
For assessing the long-term liquidity or solvency position of Westpac Banking Corporation and Bank of Queensland, the ratios considered include debt ratio, equity ratio, debt to equity ratio and interest cover ratio.
Debt ratio is considered as a solvency measure that gauges the proportion of total liabilities of an organisation as a percentage of total assets (Henderson et al. 2015). It is observed from the above figure that both banks have same debt ratio of 0.93 in all the three years, which denote that 93% of the assets of the banks are funded by debt. On the other hand, equity ratio denotes the percentage of equity out of the total asset base of an organisation (Hirshleifer 2015). The situation is similar like debt ratio, as 7% of the overall assets of the two banks are funded by equity.
Debt to equity ratio helps in denoting the proportion of company financing coming from investors and creditors (Hoyle, Schaefer and Doupnik 2015). This ratio has remained identical for both the banks, as most of its assets are funded by public deposits and thus, the banks are prone to increased financial leverage risk. Finally, interest cover ratio helps in denoting the capability of an organisation to settle off its interest expense with the help of operating profit (Kaplan and Atkinson 2015). In terms of this ratio, both banks have the ability to clear its interest expense efficiently due to higher positive operating income; however, the ratio is found to be slightly higher for Westpac Banking Corporation.
Therefore, in terms of long-term liquidity or solvency, Westpac is placed in a favourable position in the Australian banking sector compared to the Bank of Queensland.
The above figure mainly assists in representing the monthly share price movements of Westpac Banking Corporation compared to the All Ordinaries Index for three-year period starting from 2016 to 2018. The analysis directly points out the fact that the entire performance of Westpac has been declining over the three years. Along with this, the share price of the bank has failed to complement the rise in share price of the All Ordinaries Index, in which the index has increased exponentially, while the share price of Westpac has fallen; thus, depicting between negative correlation between the share price of the bank and the index. The price action of Westpac has indicated an unfavourable trend, which is expected to fall further in future and thus would minimise the overall return on investment for the investors. The correlation between the share price of Westpac and All Ordinaries Index is observed to be -0.211, which indicates that if the share price of the index rises, there would be fall in the stock price of Westpac Banking Corporation and vice-versa.
After careful evaluation of the monthly share price movement of the Bank of Queensland and that of the All Ordinaries Index, it could be witnessed that there has been deterioration in the stock performance of the bank starting from the mid of 2017. Along with this, the value of share price of the organisation fails to take into account the change in stock price of the All Ordinaries Index, which depicts the entire issues in the existing demand among potential investors. Hence, the contrast between the share price of the Bank of Queensland and All Ordinaries Index directly represents a low chance of future rise in the stock value of the bank. Negative correlation is deemed to be observed between the share price of the Bank of Queensland and that of the All Ordinaries Index, which imply that rise in the value of All Ordinaries Index would lead to fall in the stock value of the Bank of Queensland.
The above table mainly helps in depicting the calculation of WACC of Westpac from 201 to 2018. The changes in WACC of the bank could be witnessed over the years from 5.60% in 2016 to 5.64% in 2018. Such increase in cost of capital is owing to the increasing equity weights of Westpac Banking Corporation in contrast to the debt weights. The composition of capital structure of Westpac has changed over the three-year period, in which the depth exposure has fallen from 93.07% in 2016 to 92.66% in 2018, while there has been rise in exposure of equity from 6.93% in 2016 to 7.34% in 2018 (Westpac.com.au 2019). Based on the valuation, it could be understood that the cost of equity of the bank is comparatively high for the organisation, which is the reason that the composition of the weights of equity has raised the overall cost of capital of the bank (Lee and Parker 2014). Therefore, Westpac utilises equity capital to support its operations by minimising the debt exposure and due to this, there has been decline in cash outflow or interest expense of the organisation. As mentioned by Maynard (2017), WACC assists the organisations in undertaking suitable decisions about investments and accordingly, projects are selected that would maximise overall return on investment.
The computations carried out in the above table mainly influence the WACC for the Bank of Queensland. It could be witnessed that the WACC of the concerned bank after increasing slightly from 5.61% in 2016 to 5.64% in 2017 has remained the same in 2018. There has been slight decline in debt combination of the bank from 92.95% in 2016 to 92.72% in 2018 owing to which increase in cost of capital could be observed over the years. Along with the decline in debt weight of the bank in three years, slight increase could be observed in equity from 7.05% in 2016 to 7.28% in 2018. Moreover, the changes in the debt position and equity values of the bank have lead to relative change in its cost of capital. The increasing cost of capital has been minimising the financial ability of the bank in acquiring additional investment projects. In this context, Beatty and Liao (2014) advocated that with the assistance of WACC, it becomes possible for the investors in identifying the minimum required rate of return, which an organisation has to achieve for ensuring sustainable growth in future.
In case, the WACC of an organisation is found to be high, it indicates that the organisation has increased risk associated with its business operations. In this regard, McLaney and Atrill (2014) stated that the investors always desire for favourable and increased returns at the time risky investments are undertaken by them. WACC performs a key role in determining the projected cost related to financing the overall resources. The main elements constitute of the payments related to debt obligations or the amount engaged in debt financing along with the rate of return (McLean and Zhao 2014). This is deemed to be important for the management ownership as well as cost involved in equity funding.
The capital structure policy of Westpac Banking Corporation could be identified from the long-term liquidity section, which implies that the bank earns adequate profit that helps in covering up its interest expenses. The bank has raised its overall equity exposure by minimising the overall composition of debt. As a result, debt ratio is observed to fall over the years for the bank. On the contrary, slight increase in equity ratio could be observed over the years for the bank, which has resulted in increased weighted average cost of capital. Finally, the interest cover ratio is above 1, which indicates that the bank has stable capital position and the interest payments would be lower compared to its earnings before interest and taxes.
In case of the Bank of Queensland, both positive and negative attributes could be observed in its capital structure position. Since it is a bank, it is quite obvious that the debt to equity ratio would be extremely high. However, a slight minimisation in debt to equity ratio is considered as a positive attribute, while the increase in interest cover ratio is deemed to be favourable for the bank as well. Due to the fall in debt weight of the bank, the interest cover ratio represents has increased coupled with fall in interest payments. Along with this, the operating income of the bank has risen over the years.
Therefore, it could be stated that both the banks have increased financial leverage, since the debt weights are considerably high. Moreover, the issuance of mew equity shares would not have adequate negative effects on the capital structure combination of the two banks.
After taking into account the financial performance, stock price performance, weighted average cost of capital, capital structure and leverage position of Westpac Banking Corporation and the Bank of Queensland, the former option seems to be feasible for the concerned investor. The Australian banking sector is deemed to be experiencing increased profits over the years, which would assist in providing increased level of return to the shareholders and the investors. Westpac Banking Corporation is selected, since its financial performance has improved more compared to that of the Bank of Queensland. Positive attributes could be found more in the profitability and liquidity aspects of Westpac compared to the Bank of Queensland. This is because Westpac in comparison to the Bank of Queensland has ensured favourable financial growth in the accounting periods. As a result, it has assisted in undertaking sound investment decision of choosing an appropriate investment option generating greater returns in the long-run. The stock price performance of Westpac is not adequate compared to the All Ordinaries Index, as negative correlation could be found between the index performance and the stock performance of Westpac. The situation is deemed to be similar for the Bank of Queensland, as its stock performance is negatively correlated with the performance of the index.
The capital structure of both the banks is found to be funded by debt and thus, it implies that the financial leverage risk is high for both. In this aspect, Westpac Banking Corporation is deemed to be more capable than the Bank of Queensland in covering its interest expense with the help of operating income. Thus, it could be stated that choosing Westpac Banking Corporation would be the better alternative from the perspective of the investors, since it would increase the relevant portfolio returns related to the investment of the concerned investor.
Conclusion:
From the above discussion, it has been analysed that Westpac is observed to be placed in a better position in terms of profitability position than the Bank of Queensland in the Australian market. In terms of long-term liquidity or solvency, Westpac is placed in a favourable position in the Australian banking sector compared to the Bank of Queensland. The composition of capital structure of Westpac has changed over the three-year period, in which the depth exposure has fallen over the three-year period, while there has been rise in exposure of equity. Based on the valuation, it could be understood that the cost of equity of the bank is comparatively high for the organisation, which is the reason that the composition of the weights of equity has raised the overall cost of capital of the bank. In case of the Bank of Queensland, both positive and negative attributes could be observed in its capital structure position. Since it is a bank, it is quite obvious that the debt to equity ratio would be extremely high. However, a slight minimisation in debt to equity ratio is considered as a positive attribute, while the increase in interest cover ratio is deemed to be favourable for the bank as well. Therefore, the investor is recommended to invest in the shares of Westpac Banking Corporation for maximising the overall return on investment.
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