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A company's debt, liabilities and risk are very important factors in understanding the company. Having an understanding of a company's debt and liabilities is a key component in understanding the risk of a company, thus aiding in the decision to invest, not to invest, or to stay invested in a company. There are many metrics involved in understanding the debt of a company, but for this article, I will look at Valero Energy's (VLO) total debt, total liabilities, debt ratios and WACC.

Through the above-mentioned four main metrics, we will understand more about the company's debt, liabilities and risk. If this summary is compared with other companies in the same sector, you will be able see which has the most debt and the most risk.

All material is sourced from Google Finance, Morningstar and the company webpage.

1. Total Debt = Long-Term Debt + Short-Term Debt

Debt is an amount of money borrowed by one party from another, and must be paid back. Total debt is the sum of long-term debt, which is debt that is due in one year or more, and short-term debt, which is any debt that is due within one year.

  • 2007 - $6.470 billion + $392 million = $6.862 billion
  • 2008 - $6.264 billion + $312 million = $6.576 billion
  • 2009 - $7.163 billion + $237 million = $7.400 billion
  • 2010 - $7.515 billion + $822 million = $8.337 billion
  • 2011 - $6.732 billion + $1.009 billion = $7.741 billion

Valero's total debt has been increasing slightly over the past five years. In 2007, Valero reported a total debt of $6.862 billion. In 2011, the company reported a total debt of $7.741 billion. Over the past 5 years Valero's total debt has increased by 12.81%.

2. Total Liabilities

Liabilities are a company's legal debts or obligations that arise during the course of business operations, so debts are one type of liability, but not all liabilities. Total liabilities is the combination of long-term liabilities, which are the liabilities that are due in one year or more, and short-term or current liabilities, which are any liabilities due within one year.

  • 2007 - $24.215 billion
  • 2008 - $18.797 billion
  • 2009 - $20.904 billion
  • 2010 - $22.596 billion
  • 2011 - $26.360 billion

Valero's liabilities have also slightly increased over the past 5 years. In 2007, the company reported liabilities at $24.215 billion; in 2011, the company reported liabilities at $26.360 billion. This is an increase of 8.86% .

In analyzing Valero's total debt and liabilities, we can see that the company currently has debt at $7.741 billion and liabilities at $26.360 billion. Over the past five years, the total debt has increased by 12.81%, while total liabilities have increased by 8.86%. The increase is not significant compared to Terso Corporation (TSO) who's liabilities have increased by 22.62% over the past 5 years and Hollyfrontier (HFC) who's liabilities have increased by 477.66% over the past 5 years. As the company's amount of debt and amount of liabilities have increased over the past 5 years, the next step will reveal if the company has the ability to pay for their them.

Debt Ratios

3. Total Debt to Total Assets Ratio = Total Debt / Total Assets

This is a metric used to measure a company's financial risk by determining how much of the company's assets have been financed by debt. It is calculated by adding short-term and long-term debt and then dividing by the company's total assets.

A debt ratio of greater than 1 indicates that a company has more total debt than assets; meanwhile, a debt ratio of less than 1 indicates that a company has more assets than total debt. Used along with other measures of financial health, the total- debt-to-total-assets ratio can help investors determine a company's level of risk.

  • 2009 - $7.400 billion / $35.629 billion = 0.21
  • 2010 - $8.337 billion / $37.621 billion = 0.22
  • 2011 - $7.741 billion / $42.783 billion = 0.18

As Valero's total-debt-to-total-assets ratio has been decreasing over the past 3 years and is well below 1, this states that Valero's assets have been increasing faster than the company's total debt. As the number is currently below 1, this states that the risk to the company regarding its debt to assets has been relatively the same over the past three years.

4. Debt ratio = Total Liabilities / Total Assets

Total liabilities divided by total assets. The debt ratio shows the proportion of a company's assets that is financed through debt. If the ratio is less than 0.5, most of the company's assets are financed through equity. If the ratio is greater than 0.5, most of the company's assets are financed through debt. Companies with high debt/asset ratios are said to be "highly leveraged." A company with a high debt ratio or that is "highly leveraged" could be in danger if creditors start to demand repayment of debt.

  • 2009 - $20.904 billion / $35.629 billion = 0.59
  • 2010 - $22.596 billion / $37.621 billion = 0.60
  • 2011 - $26.360 billion / $42.783 billion = 0.62

In looking at Valero Energy's total liabilities to total assets ratio, we can see that the ratio has increased over the past three years. As these numbers are above the 0.50 mark, this indicates that Valero has financed most of the company's assets through debt. This ratio increases so does the level of risk for the company.

5. Debt to Equity Ratio = Total Liabilities / Shareholders' Equity

The debt-to-equity ratio is another leverage ratio that compares a company's total liabilities with its total shareholders' equity. This is a measurement of how much suppliers, lenders, creditors and obligators have committed to the company versus what the shareholders have committed.

A high debt-to-equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in the company reporting volatile earnings. In general, a high debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations, and therefore is considered a riskier investment.

  • 2009 - $20.904 billion / $14.725 billion = 1.42
  • 2010 - $22.596 billion / $15.025 billion = 1.50
  • 2011 - $26.360 billion / $16.423 billion = 1.61

Over the past three years, Valero Energy's debt-to-equity ratio has increased from 1.42 to 1.61. As the ratio is above 1, this indicates that suppliers, lenders, creditors and obligators have more equity invested than shareholders. 1.61 indicates a moderately high amount of risk for the company. As the ratio is above 1 and considered moderately high, so is the risk for the company.

6. Capitalization Ratio = LT Debt / LT Debt + Shareholders' Equity

(LT Debt = Long-Term Debt)

The capitalization ratio tells the investors about the extent to which the company is using its equity to support its operations and growth. This ratio helps in the assessment of risk. Companies with a high capitalization ratio are considered to be risky because they are at a risk of insolvency if they fail to repay their debt on time. Companies with a high capitalization ratio may also find it difficult to get more loans in the future.

  • 2009 - $7.163 billion / $21.888 billion = 0.33
  • 2010 - $7.515 billion / $22.540 billion = 0.33
  • 2011 - $6.732 billion / $23.155 billion = 0.29

Over the past three years, Valero's capitalization ratio has decreased from 0.33 to 0.29. This implies that the company has had slightly more equity compared with its long-term debt. As this is the case, the company has had more equity to support its operations and add growth. As the ratio is lower this implies a lower amount of risk to the company.

7. Cash Flow to Total Debt Ratio = Operating Cash Flow / Total Debt

This coverage ratio compares a company's operating cash flow with its total debt. This ratio provides an indication of a company's ability to cover total debt with its yearly cash flow from operations. The higher the percentage ratio, the better the company's ability to carry its total debt. The larger the ratio, the better a company can weather rough economic conditions.

  • 2009 - $1.823 billion / $7.400 billion = 0.25
  • 2010 - $3.045 billion / $8.337 billion = 0.37
  • 2011 - $4.038 billion / $7.741 billion = 0.52

Over the past three years, the cash flow to total debt ratio has been increasing. The ratio has increased from 0.25 to 0.52. As the ratio is below 1, this implies that the company does not have the ability to cover its total debt with its yearly cash flow from operations.

Based on the five debt ratios listed above, we can see that Valero Energy's ratios indicate a company that does carry some risk due to its debt. The Debt to Equity Ratio and the Debt ratio both indicate an increasing amount of risk moving forward. Even though these ratios indicate increasing risk the company's Total Debt ratio indicates that the company's total debt has kept up with the company's growth. The five ratios above indicate a slight increase in risk to the company compared to 3 years ago. The next step will reveal how much the company will pay for the debt incurred.

Cost of Debt

The cost of debt is the effective rate that a company pays on its total debt.

As a company acquires debt through various bonds, loans and other forms of debt, the cost of debt metric is useful, because it gives an idea as to the overall rate being paid by the company to use debt financing.

This measure is also useful because it gives investors an idea as to the riskiness of the company compared with others. The higher the cost of debt the higher the risk.

8. Cost of debt (before tax) = Corporate Bond rate of company's bond rating.

According to the S&P rating guide, the "BBB" rating is - "Adequate capacity to meet financial commitments, but more subject to adverse economic conditions." Valero Energy has a rating that meets this description.

9. Current tax rate ( Income Tax total / Income before Tax)

  • 2007 - $2.161 billion / $6.726 billion = 32.13%
  • 2008 - $1.467 billion / $336 million = 0.43%
  • 2009 - $(97) million / $(449) million = 21.60%
  • 2010 - $575 million / $1.498 billion = 38.38%
  • 2011 - $1.226 billion / $3.322 billion = 36.91%

5-year average subtracting 2009 and 2010 = 35.81%

Over the past five years subtracting 2009 and 2010, Valero Energy has averaged a tax rate of 35.81%.

10. Cost of Debt (After Tax) = (Cost of debt before tax) (1 - tax rate)

The effective rate that a company pays on its current debt after tax.

  • .0669 x (1 - .3581) = Cost of debt after tax

The cost of debt after tax for Valero Energy is 4.29%

Cost of equity or R equity = Risk free rate + Beta equity (Average market return - Risk free rate)

The cost of equity is the return a firm theoretically pays to its equity investors, for example, shareholders, to compensate for the risk they undertake by investing in their company.

  • Risk free rate = U.S. 10-year bond = 1.62% (Bloomberg)
  • Average market return 1950 - 2011 = 7%
  • Beta = (Google Finance) Valero Energy's beta = 1.48

Risk free rate + Beta equity (Average market return - Risk free rate)

  • 1.62 + 1.48 (7-1.62)
  • 1.62 + 1.48 x 5.38
  • 1.62 + 7.96 = 9.58%

Valero Energy's has a cost of equity or R Equity of 9.58%, so investors should expect to get a return of 9.58% per-year average over the long term on their investment to compensate for the risk they undertake by investing in this company.

(Please note that this is the CAPM approach to finding the cost of equity. Inherently, there are some flaws with this approach and that the numbers are very "general." This approach is based off of the S&P average return from 1950 - 2011 at 7%, the U.S. 10-year bond for the risk free rate which is susceptible to daily change and Google finance beta.)

Weighted Average Cost of Capital or WACC

The WACC calculation is a calculation of a company's cost of capital in which each category of capital is equally weighted. All capital sources such as common stock, preferred stock, bonds and all other long-term debt are included in this calculation.

As the WACC of a firm increases, and the beta and rate of return on equity increases, this states a decrease in valuation and a higher risk.

By taking the weighted average, we can see how much interest the company has to pay for every dollar it finances.

For this calculation, you will need to know the following listed below:

Tax Rate = 35.81% (Valero Energy's five-year average Tax Rate)

Cost of Debt (before tax) or R debt = 6.69%

Cost of Equity or R equity = 9.58%

Debt (Total Liabilities) for 2011 or D = $26.360 billion

Stock Price = $29.22 (November 14th, 2012)

Outstanding Shares = 553.54 million

Equity = Stock price x Outstanding Shares or E = $16.174 billion

Debt + Equity or D+E = $42.534 billion

WACC = R = (1 - Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 - Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 - .3581) x .0669 x ($26.360/$42.534) + .0958 ($16.174/$42.534)

.6419 x .0669 x .6197 + .0958 x .3803

.0266 + .0364

= 6.30%

Based on the calculations above, we can conclude that Valero Energy pays 6.30% on every dollar that it finances, or 6.30 cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0630 plus the cost of the investment for the investment to be feasible for the company.

Summary

In analyzing Valero's total debt and liabilities, we can see that the company currently has debt at $7.741 billion and liabilities at $26.360 billion. Over the past five years, the total debt has increased by 12.81%, while total liabilities have increased by 8.86%.

Based on the five debt ratios listed above, we can see that Valero Energy's ratios indicate a company that does carry some risk due to its debt. The Debt to Equity Ratio and the Debt ratio both indicate an increasing amount of risk moving forward. Even though these ratios indicate increasing risk, the company's Total Debt ratio indicates that the company's total debt has kept up with the company's growth. The five ratios above indicate a slight increase in risk to the company compared to 3 years ago.

As Valero Energy's bond rating currently stands at "BBB" this indicates that the company has a "Adequate capacity to meet financial commitments, but more subject to adverse economic conditions."

The CAPM approach for cost of equity states that shareholders need 9.58% average per year over a long period of time on their equity to make it worthwhile to invest in the company. This calculation is so based on the average market return between 1950 and 2011 at 7%.

The WACC calculation reveals that the company pays 6.30% on every dollar that it finances. As the current WACC of Valero Energy is currently 6.30% and the beta is above average at 1.48, this implies that the company needs at least 6.30% on future investments and will have above average volatility moving forward.

Based on the calculations above, the company has increased its debt and liabilities but currently has the capacity to make its debt payments and meet its tax obligations.

The analysis of Valero Energy's debt and liabilities indicates a good company with increasing debt and liabilities. The analysis also reveals that the company's total debt has kept up with the company's growth but the liabilities have fallen behind. The Bond rating of "BBB" by S&P indicates that a company has a "Adequate capacity to meet financial commitments, but more subject to adverse economic conditions." The WACC reveals that Valero Energy has the ability to add future investments and assets at relatively low rates. Currently, Valero Energy has the ability to pay for its debts meet its obligations while adding growth.

Indications above reveal a good company with a slight increase in risk moving forward.

For another article on Valero Energy please read: Valero Energy: Inside The Numbers

Source: Analyzing Valero Energy's Debt And Risk