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 Devon Energy Corporation's (DVN) 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 such as Chesapeake Energy Corp (CHK) and Apache Corporation (APA) you will be able see which company has the most debt, thus adding to the company's 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 - $6.923 billion + $1.004 billion = $7.927 billion
- 2008 - $5.661 billion + $180 million = $5.841 billion
- 2009 - $7.265 billion + $1.527 billion = $8.792 billion
- 2010 - $3.819 billion + $1.811 billion = $5.630 billion
- 2011 - $5.969 billion + $3.811 billion = $9.780 billion
Devon Energy's total debt has increased since 2007. In 2007, the company reported a total debt of $7.927 billion. In 2011, the company's total debt increased to 9.780 billion. Over the past 5 years, Devon Energy's total debt has increased by 23.38%.
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 - $19.450 billion
- 2008 - $14.848 billion
- 2009 - $14.116 billion
- 2010 - $13.674 billion
- 2011 - $19.687 billion
Devon Energy's liabilities have been increasing very little over the past 5 years. In 2007, the company reported liabilities at $19.450 billion; in 2011, the company reported liabilities at $19.687 billion. Over the past 5 years, Devon Energy's liabilities have increased by 1.22%.
In analyzing Devon Energy's total debt and liabilities, we can see that the company currently has a total debt of $9.780 billion and liabilities at $19.687 billion. Over the past five years, the total debt has increased by 23.38%, while total liabilities have increased by 1.22%. 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 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 - $8.792 billion / $29.686 billion = 0.30
- 2010 - $5.630 billion / $32.927 billion = 0.17
- 2011 - $9.780 billion / $41.117 billion = 0.24
Over the past three years Devon Energy's total-debt-to-total-assets ratio has decreased. 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 - $14.116 billion / $29.686 billion = 0.48
- 2010 - $13.674 billion / $32.927 billion = 0.42
- 2011 - $19.687 billion / $41.117 billion = 0.48
In looking at Devon Energy's total liabilities to total assets ratio over the past three years, we can see that the ratio has the same. As these numbers are just below the 0.50 mark, this indicates that Devon Energy has not financed most of the company's assets through debt. As the number has remained the same compared to 2009 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 - $14.116 billion / $15.570 billion = 0.91
- 2010 - $13.674 billion / $19.253 billion = 0.71
- 2011 - $19.687 billion / $21.430 billion = 0.92
Over the past three years, Devon Energy's debt-to-equity ratio has bounced around from a low of 0.71 to a high of 0.92. As the ratio is below 1, this indicates that shareholders have more invested than suppliers, lenders, creditors and obligators. 0.92 indicates a moderately low amount of risk for the company. As the ratio is below 1 and considered moderately low, 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 - $7.265 billion / $22.835 billion = 0.32
- 2010 - $3.819 billion / $23.072 billion = 0.17
- 2011 - $5.969 billion / $27.399 billion = 0.22
Over the past three years, Devon Energy's capitalization ratio has decreased from 0.32 to 0.22. 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 - $4.737 billion / $8.792 billion = 0.54
- 2010 - $5.478 billion / $5.630 billion = 0.97
- 2011 - $6.224 billion / $9.780 billion = 0.64
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 strong results regarding the company's debt. Even though the debt and liabilities have increased, the ratios indicate that the company's growth has been keeping up with this increase. 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 Devon Energy's bonds "BBB+ Outlook Stable"
- Current 20-year corporate bond Rate of "BBB" = 6.69%
- Current cost of Debt as of November 22nd 2012 = 6.69%
According to the S&P rating guide, the "BBB" rating is - "Adequate capacity to meet financial commitments, but more subject to adverse economic conditions." Devon Energy has a rating that meets this description.
9. Current tax rate (Income Tax total / Income before Tax)
- 2007 - $1.078 million / $4.224 billion = 25.52%
- 2008 - $(954) billion / $(4.033) billion = 23.65%
- 2009 - $(1.773) million / $(4.526) billion = 39.17%
- 2010 - $1.235 million / $3.568 billion = 34.16%
- 2011 - $2.156 billion / $4.290 billion = 50.26%
5-year average subtract 2009 = 34.55%
Over the past five years, Devon Energy has averaged a tax rate of 34.55%.
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 - .3455) = Cost of debt after tax
The cost of debt after tax for Devon Energy is 4.38%
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 = 1.68% (Bloomberg)
- Average market return 1950 - 2012 = 7%
- Beta = (Google Finance) Devon Energy's beta = 1.15
Risk free rate + Beta equity (Average market return - Risk free rate)
- 1.68 + 1.15 (7-1.68)
- 1.68 + 1.15 x 5.32
- 1.68 + 6.12 = 7.80%
Devon Energy has a cost of equity or R Equity of 7.80%, so investors should expect to get a return of 7.80% 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 = 34.55% (Devon Energy's five-year average Tax Rate)
Cost of Debt (before tax) or R debt = 6.69%
Cost of Equity or R equity = 7.80%
Debt (Total Liabilities) for 2011 or D = $19.687 billion
Stock Price = $52.89 (November 22nd, 2012)
Outstanding Shares = 405.00 million
Equity = Stock price x Outstanding Shares or E = $21.420 billion
Debt + Equity or D+E = $41.107 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 - .3455) x .0669 x ($19.687/$41.107) + .0780 ($21.420/$41.107)
.6545 x .0669 x .4789 + .0780 x .5211
.021 + .0406
Based on the calculations above, we can conclude that Devon Energy pays 6.16% on every dollar that it finances, or 6.16 cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0616 plus the cost of the investment for the investment to be feasible for the company.
In analyzing Devon Energy's total debt and liabilities, we can see that the company currently has a total debt of $9.780 billion and liabilities at $19.687 billion. Over the past five years, the total debt has increased by 23.38%, while total liabilities have increased by 1.22%.
Based on the five debt ratios listed above, we can see strong results regarding the company's debt. Even though the debt and liabilities have increased, the ratios indicate that the company's growth has been keeping up with this increase.
As Devon 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 7.80% 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 6.16% on every dollar that it finances. As the current WACC of Devon Energy is currently 6.16% and the beta is above average at 1.15, this implies that the company needs at least 6.16% on future investments and will have slightly 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 Devon Energy's debt and liabilities indicates a strong company with increasing total debt but a stable increase in liabilities. The analysis also reveals that the company growth rate is increasing at a faster rate than the company's debt and liabilities. This indicates a lower amount of risk to the company as three years ago. The Bond rating of "BBB+ Stable Outlook" by S&P indicates that the company has a "Adequate capacity to meet financial commitments, but more subject to adverse economic conditions." The WACC reveals that Devon Energy has the ability to add future investments and assets at relatively low rates. Currently, Devon Energy has the ability to pay for its debts meet its obligations while adding growth.
All indications above reveal a very strong company with excellent investment potential long term for the shareholder, as long as the above ratios maintain or improve on their current standards.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.