debt contagion and financial issues at ahmad zaki

CUeJAR Volume 3 | Issue 2 | 2021

City University eJournal of Academic Research (CUeJAR)

e-ISSN : 2682-910X

CUeJAR Homepage: https://www.city.edu.my/CUeJAR

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Copyright © City University Press.

CUeJAR

Received: 9th March 2021

Revised: 30th March 2021

Accepted: 25th April 2021

Debt Contagion and Financial Issues at Ahmad Zaki Resources Berhad

Azizah Md Nor

Faculty of Business and Management, City University, Malaysia ([email protected])

Abstract

Introduction: The case study takes place at Ahmad Zaki Resources Berhad, (AZRB) which

is one of the construction companies in Malaysia. Purpose of the study is to evaluate the

capital structure of AZRB to understand the capital structure decisions of the company

and to know the impact of capital structure decisions on the profitability and performance

of the company.

Methodology: The author evaluated the composition of the capital structure used by

AZRB during the period of year 2014 to 2018 so as to understand the company’s planning

and its patterns of financing. The case study used Debt Ratio, Debt to Equity Ratio and

Interest Coverage Ratio on the company’s five years annual reports.

Result and Discussion: Results show that the increasing level of debt in the company

balance sheet was tremendous and it diminishing the company’s net worth and has taken

its debt-equity ratio to an unsustainable limit.

.

Conclusion and Recommendation: Theoretical and practical implications are introduced

as well as suggestions for future research.

Keywords: Capital Structure, Debt and Equity Financing, Leverage, Ownership Structure.

1.0 Introduction

Capital structure refers to a company’s outstanding debt and equity. It allows a

firm to understand what kind of funding the company uses to finance its overall

activities and growth. The financing policy chosen, most of times, refer to the

policy that has been specified by the management in financing their investments.

In other words, it shows the proportions of debt and equity (common or

preferred equity) in the funding. A company's proportion of short- and long-term

debt is considered when analyzing capital structure.

When analysts refer to capital structure, they are most likely referring to a

firm's debt-to-equity (D/E) ratio, which provides insight into how risky a company

is. Usually, a company that is heavily financed by debt has a more aggressive

capital structure and therefore poses greater risk to investors.

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Nor, 2021 89

The purpose of capital structure is to provide an overview of the level of the

company’s risk. As a rule of thumb, the higher the proportion of debt financing a

company has, the higher its exposure to risk will be. This risk, however, may be

the primary source of the firm's growth . Most companies will make effort to make

an optimal financing combination of debt and equity or better known as the target

capital structure.

The cost of capital which is the combined costs of all the company’s financing

resources is known as Weighted Average Cost of Capital (WACC). It is the

average cost after tax for each capital resources that is used by the company to

finance its projects (Rhyne & Brigham, 2006).

2 Literature review

Many empirical studies have looked into the factors that influence capital structure

choice from various perspectives and in various environments connected to

established and emerging economies (Lei et al., 2021; Khalifa et al., 2021;

Khalifa, Trung and Hossain, 2021; Alghfeli et al., 2021; Hossain et al., 2020;

Alneadi et al., 2020; Alharthi et al., 2020; Almatrooshi et al., 2020; Khalifa, 2020;

Khalifa, 2019; Jassem Al-Ameri, Bhaumik and Khalifa, 2019; Alghfeli et al.,

2019; El-Aidie, Alseiari and Khalifa, 2021; Almatrooshi et al., 2021). Miller and

Modigliani (1958) investigated whether the firm's value was independent of its

capital structure, and that the advantages and costs of debt were set off, with no

effect on the firm's value. The hypothesis is based on a number of unreasonable

assumptions, including neglecting the effects of taxes, equity transaction fees, and

bankruptcy expenses. However, it serves as a beginning point for understanding

the capital structure and the factors that influence financing mix decisions.

Titman and Wessels (1988) investigated the explanatory power of certain

current debt equity ratio ideas. They discovered that debt financing was negatively

associated to a firm's originality in terms of its type of operation. The results were

consistent with current ideas and suggested that transaction costs could be a

determining factor in capital structure decisions.

Cassar and Holmes (2003) conducted another study to test the static trade off

theory and pecking order theory on the attributes of size, tangibility of asset,

profitability of firm, growth, and risk.

The firm's debt funding was influenced less by size and risk. The static trade-

off, pecking order, and agency cost theories all agreed with these findings. While

Rajan and Zingales (1995) pointed out that parameters linked to firm leverage in

the United States by previous studies have a comparable association in other

countries.

D Vasiliou et al. (2003) found that enterprises with large fixed asset

investments had a greater leverage ratio than smaller firms in a subsequent

investigation. The study supported both the trade-off and pecking order theories. T.

Mitton (2007) elucidated the emerging market's proclivity towards debt financing.

Cespedes et al. (2009) explained the behaviour of enterprises in seven Latin

American nations in their study. They discovered that ownership-oriented


Debt Contagion and Financial Issues

90

businesses preferred equity financing, which had smaller tax benefits and higher

bankruptcy costs. According to Jong et al. (2008), the debt equity ratio is linked to

a number of country-specific characteristics such as bond market development,

creditor rights protection, and GDP growth rate. Although many international

scholars have looked into the factors that influence a company's decision on debt

and equity ratios in developed countries, few have looked into companies in

emerging countries.

2.1 Case Review

2.1.1 Business Activities and Development

Ahmad Zaki Resources Berhad (AZRB) is an investment holding company,

which engages in the civil and structural works contracting and provision of

management services. AZRB was incorporated on 26 May 1997, and was listed

on Bursa Malaysia since 1999. From its modest beginnings, established as Ahmad

Zaki Sdn Bhd (AZSB) in 1982, AZRB has earned its reputation as the Builder of

Award-winning Landmarks and Infrastructure Projects in Malaysia. AZRB

operates through the following segments:

Engineering and construction segment refers to the civil and structural

works.

Concession segment includes concession and assets managements.

Oil and gas segment deals with marine fuels, lubricants and petroleum

based-products.

Plantation segment refers to the production of crude palm oil and kernel.

Property segment which responsible for the property development, hotel

operation and facilities management.

AZRB consolidated annual revenue exceeded the Billion Ringgit mark for the

first time in 2016. Engineering and construction (E&C) contributed 93% of this

success. E&C project excellence spanning across various landmark projects such

as Menara Kerja Raya and Masjid Wilayah Persekutuan Kuala Lumpur. Other

E&C projects include on-going mega scale such as the MRT Sungai Buluh-

Serdang-Putrajaya line, Viaduct Package V202 and East Klang Valley

Expressway.

AZRB today is involved in business activities such as:

Oil and Gas – as the operator of Tok Bali Supply Base

Property development and facilities management (currently the concession

holder for IIUM teaching hospital in Kuantan for 21 ½ years period)

Oil Palm Plantation – spanning across a sizable 8,200 hectare in West

Kalimantan

Expressway – as the concession holder for East Klang Valley Expresswa


Nor, 2021 91

2.1.2 Company Results and Financial Highlights

The year 2018, has been a year of tremendous growth of the Group. The

Group showed significant growth in revenue recorded with an increase of 27.9%

from the financial year ended 2017 (Y2017). The recorded revenue of RM1.23

billion (compare Y2017: 960.6 million) is the highest ever recorded by the Group

in its 36-year history.

Unfortunately, the Group’s profitability did not increase in line with that of

revenue recorded. One of the significant impacts to the Group’s profitability was

the unrealized foreign exchange loss recorded by the Plantation Division of

RM19.7 million, which severely impacted its profitability and overall financial

performance. Adding further to the woes of the Plantation Division were the low

crude oil (CPO) prices during the whole 2018, especially when compared to 2017.

Whilst there was the continuous growth in revenue for the Plantation Division, the

loss before tax recognized was significantly worse in Y2018, with RM29.6 million

as compared to 2017 with 18.1 million losses before tax reported.

Another factor in the lower profits for the Group was the recognition of full

maintenance costs at its IIUM Medical Centre Concession (PenMedic) from May

2018 onwards following the expiry of the defect liability period for PenMedic.

Taking all this into account, the Group recorded a net profit of RM8.6 million in

2018 as compared to RM2.7 million in 2017.

As for in Y2016, It was a year where the construction division helped propel

the Group to reach a significant mark and milestones in the Group’s financial

history. Both the Group and construction division passed billion Ringgit mark in

terms of revenue with a recorded revenue of RM1.2 billion (2015: RM714.97

million and 2014: RM662,358 million).

The construction division retained its position as the Group’s primary

generator of revenue and profit, as is befitting for the core business since

inception. This segment accomplished a new milestone in 2016 with a record

RM1.6 billion in new contract wins, attesting AZRB competitiveness in tenders

and customers’ recognition of their strong expertise encompassing the full range of

design to development of iconic buildings and infrastructure.

The construction division’s year of achievement started off with the award by

the International Islamic University of Malaysia (IIUM) for the supply of

additional medical equipment for the IIUM Medical Centre. In the meantime, the

construction division successfully completed the construction of the IIUM Medical

Centre. In April 2016, the construction division has been awarded by MRT Corp

for the Mass Rapid Transit (MRT) Sungai Buloh-Serdang-Putrajaya (SSP) Line for

a project known as ‘Package V202’ for a total value of RM1.44 billion.

2.1.3 Capital Structure and Financial Performance

A company’s capitalization describes the composition of a company’s

permanent or long-term capital which consists of a combination of debt and

equity. From a technical perspective, the capital structure is defined as the careful



92

balance between equity and debt that a business uses to finance its assets, day to

day operations and future growth. Therefore, capital structure ratios are very

important to analyze the financial statements of any company.

There are four important effects of financial leverage:

1. Increases expected rates of return on equity and expected EPS

2. Increases risk of equity: both variance and beta

3. Increases the probability of bankruptcy and expected bankruptcy costs

4. Increases the interest tax shield

Below are two financial ratios that reflected the companies’ capital structures.

Debt to Equity Ratio

The debt to equity ratio is the most important of all capital adequacy ratios. It

shows the relation between the portion of assets financed by the creditors and the

portion of assets financed by shareholders. Hence, it would tell the shareholders as

well as debt holders the relative amounts they are contributing to the capital.

Debt Ratio

The debt ratio is the second important ratio when it comes to gauging the

capital structure and solvency of the company. It tells the investment community

the amount of funds that have been contributed by creditors instead of the

shareholders. According to the previous literature (see Rajan and Zingales (1995))

there are four factors that identifies as the major determinants of firms' debt ratios:

size, asset tangibility, growth, and profitability. In particular, size and the

proportion of tangible assets are highly significant and positively related to debt

ratios, while profitability and growth opportunities, as proxies by the ratio of

capital expenditures to total assets and growth in sales, are highly significant and

negatively related to debt ratios. (Margaritis & Psillaki, 2010)

2.1.4 Capital Structure in AZRB

After the analysis, I considered AZRB as a leveraged company because the

business relies more of long-term debt financing which are loans and also

borrowings. However, when the interest costs are high and the volume is much, it

is advisable for the company to avoid debts financing and instead go for equities

issuance.

Generally, in most construction sectors, plants and equipment are financed

under the leasing arrangements. This has obviously shown in AZRB financial

statements where its debts ratios are shown in below table.

Table 1 : Debt Ratio from year 2014 to 2018

Ratio Formula

2018

2017

2016

2015

2014

Debt Ratio

89%

88%

89%

80%

70%


Nor, 2021 93

For the past five years, it is seen that AZRB used debts as its capital financing

and only 11% of its capitals were financed by equities. The ratios were stagnant

from Y2016 to Y2018. Further analysis on the AZRB debt to equity ratio indicates

that AZRB debt to equity ratio keeps increasing from 126% in Y2014 to 311% in

Y2018.

Table 2 : Debt to Equity Ratio from 2014 to year 2018

Ratio Formula

2018

2017

2016

2015

2014


311% 248%

285%

184%

126%

This indicate that AZRB had invested huge amount in its capital using

leverage financing and only small percentage of amount through its equities

issuance. The increase in the leverage is back up by its billions of contracts won

over the years due to AZRB recognition on its strong expertise to most of their

customers.

According to Harris and Raviv (1991, page 334), the available studies

“generally agree that leverage increases with fixed assets, non-debt tax shields,

growth opportunities, and firm size and decreases with volatility, advertising

expenditures, research and development expenditures, bankruptcy probability,

profitability and uniqueness of the product.” (Frank & Goyal, 2009)

3. Case Analysis

AZRB is an investment holding company which engages in civil and

structural works contracting and provision of management services. It was

incorporated on 26 May 1997 and was listed on Bursa Malaysia Berhad since

1999. AZRB has earned its reputation as the Builder of Award-winning

Landmarks and Infrastructure Projects in Malaysia. AZRB’s engineering and

construction division contributed 93% of this success.

Other business activities involve are oil and gas, property development, oil

palm plantation and expressway. AZRB’s Group results in year 2016, had passed

billion Ringgit mark in terms of revenue. The construction division retained its

position as the Group’s primary generator of revenue and profit.

AZRB relies on long-term creditor supplied funds to run its construction

business. This is shown from the company debt to equity ratio. AZRB’s debt to

equity ratios from 2014 was greater than 100% and the figure kept increasing to

310% in Y2018. The industry ratio reads at 43% (Attachment 5). This indicate

that AZRB’s assets were mostly financed by debts and its frightening.

Besides getting loans from the private loans, for instance banks, AZRB plants

and equipment were mostly financed under the lease arrangements. This is one of

the reasons why the interest cost of AZRB is extremely high.



94

Another reason of this high interest costs was due to the public loan obtained

from public bonds example SUKUK. In January 2016, AZRB has made its first

issuance of RM1 billion SUKUK murabahah programme to fund the construction

of the East Klang Valley Expressway (EKVE). The proceeds raised from the

issuance would be used by EKVE to, among others, part-finance and reimburse all

costs associated with the development, design, construction and operations of the

EKVE.(Attachment 6)

Looking at its interest payment it shows that AZRB spent lots of its earnings

to pay the interest costs. In Y2018, over RM60 million was spent to the interest

expense and this figure is so alarming.

Table 3 : Interest payment expenses from year 2014 to 2018

Expenses Y2018

‘000

Y2017

‘000

Y2016

‘000

Y2015

‘000

Y2014

‘000

Interest payment 66,050 55,281 52,566 46,566 21,692

Further analysis on AZRB interest coverage ratio reveals the following result.

Table 4 : Interest Coverage Ratio from year 2014 to year 2018

Ratio Y2018

‘000

Y2017

‘000

Y2016

‘000

Y2015

‘000

Y2014

‘000

Interest Coverage Ratio 28,106/

66,050

=0.42

53,117/

55,281

=0.99

51,730/

52,566

=0.98

72,821/

46,566

=1.56

43,526/

21,692

=2.00

From the table we could summarize that AZRB capability to serve his interest

is decreasing from Y2014 to Y2018. In Y2018, it looks that AZRB EBIT could not

cover its interest payment for the year and this is one of the financial distress

indicators. The interest amount of RM66,050,000 for the year is too large and it’s a

signal that AZRB should think of a way to settle their loans fast. Having not

receive the finance income of RM62.761 million for the Y2018, AZRB is not

capable to pay its interest costs and would be on loss of (RM37,944).

Another reason on why AZRB maintaining its issuance of new share despite

being a public listed company is because AZRB does not want to lose its control

over the company. One fundamental difference between private and public firms is

their owner ship structure and hence the degree to which control is valued by their

shareholders. Where conflicts of interest exist, agency problems can arise and

control is valuable. Therefore, firms controlled by a major shareholder should be

reluctant to use equity financing when doing so causes the controlling shareholder

to risk losing control (Brav, 2009).


Nor, 2021 95

AZRB share capital for the Y2018 stood at 197.536 million, and not much

changes seen in its share capital in Y2017. In Y2017 the share capital was at

RM197,478 to compare with RM120.885 million in Y2016, where there was an

increase of 63% from Y2016 and Y2015.

Table 5 : Share Capital and Reserve year 2014 to year 2018

Capital 2018

‘000

2017

‘000

2016

‘000

2015

‘000

2014

‘000

Share capital

197,536

197,478

120.885

120,885

120,885

Reserve

263,945

248,252

244,031

217,900

207,863

Looking at the Directors indirect interest (deemed interest) as at 29/3/2019, we

noticed that Dato Sri Haji Wan Zaki holds RM321.927 million shares of AZRB.

He is the majority owner of AZRB. Issuing of new shares may result on the loss of

majority shares by Dato Sri Wan Zaki. Perhaps Dato Sri doesn’t want to dilute his

controlling interest by issuing new shares.

However, due to the high interest costs incurred, AZRB has no alternative

than to issue the new share issuance. Latest share issuance was done on 29/3/2019

and the paid up and issuance capital was then at RM600 million shares. With the

new share issuance, Dato Sri Wan’s interest in shares has reduced as tabulated

below:

Table 6 : Share Interest of Dato Sri Wan.

Date Direct Interest Deemed Interest %

30/3/2016 3,821,975 287,958,188 59.73

31/7/2017 3,821,975 285,958,188 59.32

30/3/2018 3,821,975 285,958,188 53.94

29/3/2019 4,747,471 321,927,959 53.82

Based on the above percentage hold above, we could summarize that despite

the burden on the interest costs payment, as much as possible, Dato Sri is ensuring

to hold on the majority interest and not to dilute its controlling to the public

shareholders.

Ideally, to get RM 1 billion fund by new share issuance, instead of borrowing

RM1 billion from public or private, AZRB has to issue 2.5billion shares (based on

today’s share price, 2/8/2019 @RM0.40 per share – Attachment 3&4).

For instance, taking the Y2016 capital record, Dato Sri interest will be reduced

to 9.63 i. e. 287m /(480m+2500m). As such, shares of Dato Sri will reduce from

59.73% to 50.1%% and that shows that he may not hold more than 51% of

majority shares anymore. (Attachment 8)



96

5. Conclusion

Managers of large firms are responsible to provide continuous service and

must refrain from using leverage to the point where the firm’s long-run viability is

endangered. In this case study, it is obvious that AZRB total debt leverage is so

alarming when the non-current liabilities were over RM2.5billion in Y2018 and its

interest expenses is RM66million. Trade Off Theory Modigliani and Miller

indicates that interest rates rise as debt/asset ratio increases.

One of the reasons of this high interest expense could be due to the SUKUK

bond they made to finance the EKVE construction, and anticipating that they will

get the payment back and pay back the interest when EKVE launch their highway

on 9 September 2019. However, latest news confirmed that EKVE was granted an

extension of time of 315 days, with a new completion date of 20 July 2020.

(Attachment 9). If this is going to happen, AZRB will suffer more in terms of its

interest expenses.

Analysis shows that the company’s debts keep on increasing and to one extend

we see that the private loans are no longer keep to offer them borrowings. This

could be seen in their almost stagnant volume of non-current liabilities from

Y2016 to Y2018 (RM2.136b, RM2.368b and RM2.533b). And perhaps that the

reason AZRB started to issued out its new shares in 30/3/2018 and 29/3/2019?

However, what actually refrain AZRB from quickly switch to the optimal capital

structure? Are they trying not to dilute their controlling to the public shareholders?

Further observation, we also noticed that AZRB shareholders are not happy

with the company. Shareholders started selling their shares and the shares price has

dropped even though AZRB managed to secure the EKVE highway contract from

the Government. Share price has dropped to RM0.39 cents as at 03/08/2019. In

January 2019, price drop to RM0.30 against the par value of RM0.25. This may

due to the public release that the EKVE highway completion date been extended to

September 2019. Something to ponder here is “what if the share price keep

dropping?”

Author is of the opinion that the management of AZRB had taken the action

that provides clues to the investors about how management views the firm’s

prospects and as a result the Reserve Borrowing Capacity increase. This can be

seen through-out their ability to borrow money at a reasonable cost with the public

loan (SUKUK bond), when the good investment opportunities arise on funding the

construction highway EKWE. (Signaling Theory)

The decision to issued out shares are good way to ease out the debt leverage

burden and to optimize their leverage structure, however, it should be done earlier

when the company is not too burden with its debt leverage. They should consider

re-structuring their capital and not just relying too much on debt long before they

issued the SUKUK bond.

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ATTACHMENT 1

Statement of Financial Position Group 2018

RM’000

Group 2017

RM’000

Group

2016

RM’000

Group

2015

RM’000

Group

2014

RM’000

Assets

Non Current Assets

:

Property, plant and

equipment

Prepaid lease

payments

Land held for

development

Biological assets

Intangible assets

Concession service

assets

Goodwill

Investment in

subsidiaries

Investment in

associates

Interests in joint

ventures

Available-for-sale-

investments

Deferred tax assets

Trade and other

receivables

570,113

22,577

56,995

77

20,995

1,238,196

41,781

-

2,805

34

116

35,474

640,992

306,870

23,869

36,130 198,665

22,620 829,873

41,781

-

165

34

116

27,294

625,536

285,064

20,860

38,630

173,055

41,060

398,071

36,490

-

165

34

116

22,712

704,236

114,671

7,800

24,228

140,457

-

39,920

6,158

-

165

3,104

116

31,517

108,306

96,274

8,046

8,958

124,969

16,410

-

6,158

-

165

448

116

24,695

87,591

Total non-current

assets

2,964,253 2,112,953 1,720,493 476,442 373,829

Current Assets

Inventories

Property

development costs

Current tax assets

Trade and other

receivables

Other investments

Cash and deposits

19,393

17,480

11,339

640,992

164,338

622,896

19,240 15,843

10,898 798,537

699,510

281,338

12,222

19,366

11,782

786,517

823,856

190,052

13,450

23,473

8,858

1,036,818

-

153,096

13,176

11,943

6,519

660,710

-

102,840

1,843,795


Nor, 2021 99

Total current assets 1,476,438 1,825,366 1,235,695 824,354

Total Assets 4,440,691 3,938,319 3,564,288 1,712,137 1,198,183

Equity

Share Capital

Reserves

197,536

263,945

197,478

248,252

120,885

244,031

120,885

217,900

120,885

207,863

Equity attributable

to owners of the

Company

461,481 445,730 364,916 338,785 328,748

Non-controlling

interests

11,521 16,941 23,431

2,324

3,994

Total equity 473,002 462,671 388,347

341,109

332,741

Liabilities

Loans and

borrowings

Employee benefits

Deferred tax

liabilities

Trade and other

payable

2,308,904

3,373

82,488

138,339

2,171,467 3,029

77,426 116,217

2,000,353

2,836

75,097

57,800

690,662

-

2,324

56,291

403,810

1,721

45,854

-

Total non-current

liabilities

2,533,104

2,368,139

2,136,086

749,277

451,385

Loans and borrowings

Trade and other payables

Current tax liabilities

317,491

1,098,072

19,022

257,260

831,187

19,062

187,424

852,127

304

159,149

457,442

5,160

82,757

325,954

5,345,532

Total current liabilities

1,434,585

1,107,509

1,039,855

621,751

414,056

Total liabilities

3,967,689

3,475,648

3,175,941

1,371,028

865,441

Total equity and liabilities

4,440,602

3,938,319

3,564,288

1,712,137

1,198,183

ATTACHMENT 2

Computation of Capital Structure Ratios

Ratio Formula

2018

2017

2016

2015

2014



100


= Long Term Liabilities / Total

Equity x 100

2,533,104/

473,033

=5.35

X 100

=535%

2,368,139/

462,671

= 5.12

X 100

= 512%

2,136,086/

388,347

= 5.5

x 100

= 550%

749,277/

341,109

= 2.19

x 100

= 219%

451,385/

332,741

= 1.35

x 100%

= 135%

Debt Ratio

= Total Liabilities / Total

Assets x 100

3,967,689/

4,440,691

=0.89

X 100

= 89%

3,475,648/

3,938,319

= 0.88

X100

= 88%

3,175,941/

3,564,288

= 0.89

x 100

= 89%

1,371,028/

1,712,137

= 0.80

x 100

= 80%

865,441/

1,198,182

= 0.7

x 100

= 70%

ATTACHMENT 3

ATTACHMENT 4


Nor, 2021 101

ATTACHMENT 5

ATTACHMENT 6



102

ATTACHMENT 7

ATTACHMENT 8

ATTACHMENT 9

debt contagion and financial issues at ahmad zaki

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