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 Potash Corporation's (NYSE:POT) 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.
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 - $1.339 billion + $90 million = $1.429 billion
- 2008 - $1.740 billion + $1.324 billion = $3.064 billion
- 2009 - $3.319 billion + $729 million = $4.048 billion
- 2010 - $3.702 billion + $1.871 billion = $5.573 billion
- 2011 - $3.701 billion + $832 million = $4.533 billion
Potash Corp.'s total debt has increased significantly since 2007 but has decreased since 2010. In 2010, the company reported a total debt of $5.573 billion. In 2011, the company's total debt was decreased to 4.533 billion. Over the past 5 years, Potash Corp.'s total debt has increased by 317.21%.
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 - $3.698 billion
- 2008 - $5.660 billion
- 2009 - $6.422 billion
- 2010 - $8.815 billion
- 2011 - $8.410 billion
Potash Corporation's liabilities have been increasing over the past 5 years. In 2007, the company reported liabilities at $3.698 billion; in 2011, the company reported liabilities at $8.410 billion. Like the total debt the liabilities have decreased since 2010. Over the past 5 years, Potash Corp.'s liabilities have increased by 227.42%.
In analyzing Potash Corporation's total debt and liabilities, we can see that the company currently has a total debt of $4.533 billion and liabilities at $8.410 billion. Over the past five years, the total debt has increased by 317.21%, while total liabilities have increased by 227.42%. As the company's amount of debt and amount of liabilities have increased significantly over the past 5 years, the next step will reveal if the company has the ability to pay them.
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 - $4.048 billion / $12.922 billion = 0.31
- 2010 - $5.573 billion / $15.547 billion = 0.36
- 2011 - $4.533 billion / $16.257 billion = 0.28
In 2011 Potash Corp.'s total-debt-to-total-assets ratio decreased compared to 2010. This indicates that in 2011 the company has been adding more assets than total debt. As the number is currently below 1 and decreasing, this states that the risk to the company regarding its debt to assets has been decreased since 2009.
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 - $6.422 billion / $12.922 billion = 0.50
- 2010 - $8.815 billion / $15.547 billion = 0.57
- 2011 - $8.410 billion / $16.257 billion = 0.52
In looking at Potash Corp.'s total liabilities to total assets ratio, we can see that the ratio has increased slightly over the past three years. As these numbers are just over the 0.50 mark, this indicates that Potash Corp. has financed most of the company's assets through debt. As the number has increased slightly so has the risk to 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 - $6.422 billion / $6.440 billion = 0.99
- 2010 - $8.815 billion / $6.685 billion = 1.32
- 2011 - $8.410 billion / $7.847 billion = 1.07
Over the past three years, Potash Corp.'s debt-to-equity ratio has bounced around from a low of 0.99 to a high of 1.32. As the ratio is above 1, this indicates that suppliers, lenders, creditors and obligators have more invested than shareholders. 1.07 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 - $3.319 billion / $9.759 billion = 0.34
- 2010 - $3.702 billion / $10.387 billion = 0.36
- 2011 - $3.701 billion / $11.548 billion = 0.32
Over the past three years, Potash Corp.'s capitalization ratio has decreased from 0.34 to 0.32. 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 through its equity. As the ratio is decreasing and still very low financially, this implies a lowering 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 - $924 million / $4.048 billion = 0.23
- 2010 - $2.999 billion / $5.573 billion = 0.54
- 2011 - $3.485 billion / $4.533 billion = 0.77
Over the past three years, the cash flow to total debt ratio has been increasing. This indicates a strengthening of the company. Even though the ratio is increasing, the ratio is still below 1. 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 mixed results regarding the company's debt. The cash flow to total debt ratio shows increasing strength but the debt-to-equity ratio indicates that the company has been very aggressive in financing it's growth through debt. Even though the company has been aggressive in financing it's growth through debt the debt ratio indicates that the company's growth is keeping up with the debt. Even though the debt and liabilities have increased, the ratios indicate that the company's growth has been keeping up with the increase in debt and liabilities. 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.
- S&P rated Potash Corp.'s bonds "A- Outlook Stable"
- Current 20-year corporate bond Rate of "A" = 3.93%
- Current cost of Debt as of November 19th 2012 = 3.93%
According to the S&P rating guide, the "A" rating is - "Strong capacity to meet financial commitments but somewhat susceptible to adverse economic conditions and changes in circumstances." Potash Corp. has a rating that meets this description.
9. Current tax rate (Income Tax total / Income before Tax)
- 2007 - $416 million / $1.514 billion = 27.47%
- 2008 - $1.077 billion / $4.572 billion = 23.56%
- 2009 - $84 million / $1.071 billion = 7.84%
- 2010 - $643 million / $2.449 billion = 26.26%
- 2011 - $1.066 billion / $4.147 billion = 25.71%
5-year average subtract 2009 = 25.75%
Over the past five years subtract 2009, Potash Corp. has averaged a tax rate of 25.75%.
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.
- .0393 x (1 - .2575) = Cost of debt after tax
The cost of debt after tax for Potash Corp. is 2.92%
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 - 2012 = 7%
- Beta = (Google Finance) Potash Corp.'s beta = 1.02
Risk free rate + Beta equity (Average market return - Risk free rate)
- 1.62 + 1.02 (7-1.62)
- 1.62 + 1.02 x 5.38
- 1.62 + 5.49 = 7.11%
Potash Corp. has a cost of equity or R Equity of 7.11%, so investors should expect to get a return of 7.11% 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 - 2012 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 = 25.75% (Potash Corp.'s five-year average Tax Rate)
Cost of Debt (before tax) or R debt = 3.93%
Cost of Equity or R equity = 7.11%
Debt (Total Liabilities) for 2011 or D = $8.410 billion
Stock Price = $37.67 (November 19th, 2012)
Outstanding Shares = 861.63 million
Equity = Stock price x Outstanding Shares or E = $32.457 billion
Debt + Equity or D+E = $40.867 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 - .2575) x .0393 x ($8.410/$40.867) + .0711 ($32.457/$40.867)
.7425 x .0393 x .2058 + .0711 x .7942
.0060 + .0565
Based on the calculations above, we can conclude that Potash Corp. pays 6.25% on every dollar that it finances, or 6.25 cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0625 plus the cost of the investment for the investment to be feasible for the company.
In analyzing Potash Corporation's total debt and liabilities, we can see that the company currently has a total debt of $4.533 billion and liabilities at $8.410 billion. Over the past five years, the total debt has increased by 317.21%, while total liabilities have increased by 227.42%.
Based on the five debt ratios listed above, we can see mixed results regarding the company's debt. The cash flow to total debt ratio shows increasing strength but the debt-to-equity ratio indicates that the company has been very aggressive in financing it's growth through debt. Even though the company has been aggressive in financing it's growth through debt the debt ratio indicates that the company's growth is keeping up with the debt. Even though the debt and liabilities have increased, the ratios indicate that the company's growth has been keeping up with the increase in debt and liabilities.
As Potash Corporation's bond rating currently stands at "A-" this indicates that the company has a "Strong capacity to meet financial commitments but somewhat susceptible to adverse economic conditions and changes in circumstances."
The CAPM approach for cost of equity states that shareholders need 7.11% 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 2012 at 7%.
The WACC calculation reveals that the company pays 6.25% on every dollar that it finances. As the current WACC of Potash Corp. is currently 6.25% and the beta is above average at 1.02, this implies that the company needs at least 6.25% on future investments and will have 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 Potash Corporation's debt and liabilities indicates a strong company with vastly increasing debt and liabilities. The analysis also reveals that the company growth rate is increasing at the same rate as the company's debt and liabilities. This indicates approximately the same amount of risk to the company as three years ago. The Bond rating of "A- Stable Outlook" by S&P indicates that the company has a "Strong capacity to meet financial commitments but somewhat susceptible to adverse economic conditions and changes in circumstances." The WACC reveals that Potash Corp. has the ability to add future investments and assets at relatively low rates. Currently, Potash Corp. has the ability to pay for its debts meet its obligations while adding growth.
All indications above reveal a company with strong investment potential long term for the shareholder, as long as the above ratios maintain or improve on their current standards.
Disclosure: I am long POT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.