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 Sandridge Energy's (NYSE:SD) 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 (NYSE:CHK) and Concho Resources (NYSE:CXO) 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 - $1.067 billion + $15 million = $1.082 billion
- 2008 - $2.375 billion + $17 million = $2.392 billion
- 2009 - $2.579 billion + $12 million = $2.591 billion
- 2010 - $2.909 billion + $7 million = $2.916 billion
- 2011 - $2.814 billion + $1 million = $2.815 billion
Sandridge Energy's total debt has increased since 2007. In 2007, the company reported a total debt of $1.082 billion. In 2011, the company's total debt increased to 2.815 billion. Over the past 5 years, Sandridge Energy's total debt has increased by 260.16%.
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 - $1.864 billion
- 2008 - $2.862 billion
- 2009 - $2.986 billion
- 2010 - $3.695 billion
- 2011 - $4.594 billion
Sandridge Energy's liabilities have also been increasing over the past 5 years. In 2007, the company reported liabilities at $1.864 billion; in 2011, the company reported liabilities at $4.594 billion. Over the past 5 years, Sandridge Energy's liabilities have increased by 246.45%.
In analyzing Sandridge Energy's total debt and liabilities, we can see that the company currently has a total debt of $2.815 billion and liabilities at $4.594 billion. Over the past five years, the total debt has increased by 260.16%, while total liabilities have increased by 246.45%. 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 - $2.591 billion / $2.780 billion = 0.93
- 2010 - $2.916 billion / $5.231 billion = 0.56
- 2011 - $2.815 billion / $6.220 billion = 0.45
Over the past three years Sandridge 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 - $2.986 billion / $2.780 billion = 1.07
- 2010 - $3.695 billion / $5.231 billion = 0.71
- 2011 - $4.594 billion / $6.220 billion = 0.74
In looking at Sandridge Energy's total liabilities to total assets ratio over the past three years, we can see that the ratio has decreased over the past 3 years. As these numbers are still above the 0.50 mark, this indicates that Sandridge Energy has financed most of the company's assets through debt.
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 - $2.986 billion / $-206 billion = -14.49
- 2010 - $3.695 billion / $1.536 billion = 2.41
- 2011 - $4.594 billion / $1.626 billion = 2.83
Over the past three years, Sandridge Energy's debt-to-equity ratio has bounced around from -14.49 to 2.41. As the ratio is above 1, this indicates that suppliers, lenders, creditors and obligators have more invested than shareholders. 2.83 indicates a higher amount of risk for the company. As the ratio is above 1 and considered 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 - $2.579 billion / $2.373 billion = 1.09
- 2010 - $2.909 billion / $4.445 billion = 0.65
- 2011 - $2.814 billion / $4.440 billion = 0.63
Over the past three years, Sandridge Energy's capitalization ratio has decreased from 1.09 to 0.63. This implies that the company has had 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, 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 - $312 million / $2.591 billion = 0.12
- 2010 - $390 million / $2.916 billion = 0.13
- 2011 - $475 million / $2.815 billion = 0.17
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 well below 1. As the ratio is well 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 financially the company is getting stronger. Even though the company is gaining strength, there is still a large amount of risk associated with Sandridge Energy based on the above ratios. As most of the ratios are gaining strength, the numbers are still very low and indicate a large amount of risk. The numbers above indicate that debt and liabilities have increased, but 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 Sandridge Energy's bonds "B Outlook Stable"
- SD bonds maturity date of 03/15/2021, Rating of "B" = 7.50%
- Current cost of Debt as of December 1st 2012 = 7.50%
According to the S&P rating guide, the "B" rating is - "More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments." Sandridge Energy has a rating that meets this description.
9. Current tax rate (Income Tax total / Income before Tax)
- 2007 - $30 million / $80 million = 37.50%
- 2008 - $(38) million / $(1.480) billion = 2.57%
- 2009 - $(9) million / $(1.782) billion = 0.5%
- 2010 - $(447) million / $(252) million = 177.38%
- 2011 - $(6) million / $157 million = -3.82%
Due to the volatile numbers of the corporate tax rates, I have used the numbers posted in the article: SandRidge Energy, Inc. Reports Financial and Operational Results for Third Quarter and First Nine Months of 2012 which states that so far in 2012 the company has a corporate tax rate of 0%
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.
- .0750 x (1 - .0) = Cost of debt after tax
The cost of debt after tax for Sandridge Energy is 7.50%
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) Sandridge Energy's beta = 2.10
Risk free rate + Beta equity (Average market return - Risk free rate)
- 1.62 + 2.10 (7-1.62)
- 1.62 + 2.10 x 5.38
- 1.62 + 11.30 = 12.92%
Sandridge Energy has a cost of equity or R Equity of 12.92%, so investors should expect to get a return of 12.92% 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 = 0% (Sandridge Energy's five-year average Tax Rate)
Cost of Debt (before tax) or R debt = 7.50%
Cost of Equity or R equity = 12.92%
Debt (Total Liabilities) for 2011 or D = $4.594 billion
Stock Price = $5.68 (December 1st, 2012)
Outstanding Shares = 490.48 million
Equity = Stock price x Outstanding Shares or E = $2.785 billion
Debt + Equity or D+E = $7.379 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 - .0) x .0750 x ($4.594/$7.379) + .1292 ($2.785/$7.379)
1 x .0750 x .6226 + .1292 x .3774
.0467 + .0488
Based on the calculations above, we can conclude that Sandridge Energy pays 9.55% on every dollar that it finances, or 9.55 cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0955 plus the cost of the investment for the investment to be feasible for the company.
In analyzing Sandridge Energy's total debt and liabilities, we can see that the company currently has a total debt of $2.815 billion and liabilities at $4.594 billion. Over the past five years, the total debt has increased by 260.16%, while total liabilities have increased by 246.45%.
Based on the five debt ratios listed above, we can see that financially the company is getting stronger. Even though the company is gaining strength, there is still a large amount of risk associated with Sandridge Energy based on the above ratios. As most of the ratios are gaining strength, the numbers are still very low and indicate a large amount of risk. The numbers above indicate that debt and liabilities have increased, but the ratios indicate that the company's growth has been keeping up with the increase in debt and liabilities.
As Sandridge Energy's bond rating currently stands at "B". According to Standard and Poor's this is a "Speculative Grade" quality rating. This indicates that the company is "More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments."
The CAPM approach for cost of equity states that shareholders need 12.92% 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 9.55% on every dollar that it finances. As the current WACC of Sandridge Energy is currently 9.55% and the beta is above average at 2.10, this implies that the company needs at least 9.55% on future investments and will have well 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 Sandridge Energy's debt and liabilities indicates a company with increasing total debt and increasing 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 "B Stable Outlook" by S&P indicates that the company is "More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments.". The WACC reveals that Sandridge Energy has the ability to add future investments and assets at around 9.55%. Currently, Sandridge Energy has the ability to pay for its debts meet its obligations while adding growth.
All indications above reveal a company that is gaining strength but has a considerable amount of risk associated with it. As the CAPM states, if you think you can get 12.92% per-year average over the long term on this investment to compensate for the risk you would undertake by investing in this company then this would be a good investment.
For a comparative analysis read my article on Chesapeake Energy Corp Analyzing Chesapeake Energy's Debt And Risk.