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 Lowe's Companies Inc.'s (NYSE:LOW) 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 Home Depot (NYSE:HD), 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 - $5.576 billion + $1.104 billion = $6.680 billion
- 2008 - $5.039 billion + $1.021 billion = $6.060 billion
- 2009 - $4.528 billion + $552 million = $5.080 billion
- 2010 - $6.537 billion + $36 million = $6.573 billion
- 2011 - $7.035 billion + $592 million = $7.627 billion
Lowe's total debt has increased since 2007. In 2007, the company reported a total debt of $6.680 billion. In 2011, the company's total debt increased to 7.627 billion. Over the past 5 years, Lowe's total debt has increased by 14.18%.
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 - $14.771 billion
- 2008 - $14.631 billion
- 2009 - $13.936 billion
- 2010 - $15.587 billion
- 2011 - $17.026 billion
Lowe's liabilities have also increased over the past 5 years. In 2007, the company reported liabilities at $14.771 billion; in 2011, the company reported liabilities at $17.026 billion. Over the past 5 years, Lowe's liabilities have increased by 15.27%.
In analyzing Lowe's total debt and liabilities, we can see that the company currently has a total debt of $7.627 billion and liabilities at $17.026 billion. Over the past five years, the total debt has increased by 14.18%, while total liabilities have increased by 15.27%. 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 - $5.080 billion / $33.005 billion = 0.15
- 2010 - $6.573 billion / $33.699 billion = 0.20
- 2011 - $7.627 billion / $33.559 billion = 0.23
Over the past three years Lowe's total-debt-to-total-assets ratio has increased. This indicates that since 2009 the company has been adding more total debt than assets. As the number is currently below 1 and but increasing, this states that the risk to the company regarding its debt to assets has increased 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 - $13.936 billion / $33.005 billion = 0.42
- 2010 - $15.587 billion / $33.699 billion = 0.46
- 2011 - $17.026 billion / $33.559 billion = 0.51
In looking at Lowe's total liabilities to total assets ratio over the past three years, we can see that the ratio has also increased. As the 2011 numbers are just above the 0.50 mark, this indicates that Lowe's Company has financed most of the company's assets through debt. As the number has increased 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 - $13.936 billion / $19.069 billion = 0.73
- 2010 - $15.587 billion / $18.112 billion = 0.86
- 2011 - $17.026 billion / $16.533 billion = 1.03
Over the past three years, Lowe's debt-to-equity ratio has increased from a low of 0.73 to a high of 1.03. As the ratio is currently above 1, this indicates that suppliers, lenders, creditors and obligators have more invested than shareholders. 1.03 indicates a moderate amount of risk for the company. As the ratio is above 1 and considered moderate, 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 - $4.528 billion / $23.597 billion = 0.19
- 2010 - $6.537 billion / $24.649 billion = 0.27
- 2011 - $7.035 billion / $23.568 billion = 0.30
Over the past three years, Lowe's capitalization ratio has increased from 0.19 to 0.30. This implies that the company has had less equity compared with its long-term debt. As this is the case, the company has had less equity to support its operations and add growth through its equity. As the ratio is increasing but still quite low, financially this implies a slight increase 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 - $4.054 billion / $5.080 billion = 0.80
- 2010 - $3.852 billion / $6.573 billion = 0.59
- 2011 - $4.349 billion / $7.627 billion = 0.57
Over the past three years, the cash flow to total debt ratio has been decreasing. 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 the results regarding the company's debt. As the debt and liabilities have increased, the ratios indicate that the company's growth has been slightly slower than 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 Lowe's bonds "A- Outlook NEGATIVE"
- Current 20-year corporate bond Rate of "A" = 4.01%
- Current cost of Debt as of December 8th 2012 = 4.01%
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." Lowe's has a rating that meets this description.
9. Current tax rate (Income Tax total / Income before Tax)
- 2007 - $1.702 billion / $4.511 billion = 37.73%
- 2008 - $1.311 billion / $3.506 billion = 37.39%
- 2009 - $1.042 billion / $2.825 billion = 36.88%
- 2010 - $1.218 billion / $3.228 billion = 37.32%
- 2011 - $1.067 billion / $2.906 billion = 36.72%
5-year average = 37.21%
Over the past five years, Lowe's has averaged a tax rate of 37.21%.
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.
- .0401 x (1 - .3721) = Cost of debt after tax
The cost of debt after tax for Lowe's is 2.52%
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) Lowe's beta = 1.05
Risk free rate + Beta equity (Average market return - Risk free rate)
- 1.62 + 1.05 (7-1.62)
- 1.62 + 1.05 x 5.38
- 1.62 + 5.65 = 7.27%
Lowe's has a cost of equity or R Equity of 7.27%, so investors should expect to get a return of 7.27% 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 = 37.21% (Lowe's five-year average Tax Rate)
Cost of Debt (before tax) or R debt = 4.01%
Cost of Equity or R equity = 7.27%
Debt (Total Liabilities) for 2011 or D = $17.026 billion
Stock Price = $35.11 (December 8th, 2012)
Outstanding Shares = 1.12 billion
Equity = Stock price x Outstanding Shares or E = $39.323 billion
Debt + Equity or D+E = $56.349 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 - .3721) x .0401 x ($17.026/$56.349) + .0727 ($39.323/$56.349)
.6279 x .0401 x .3022 + .0727 x .6978
.0076 + .0507
Based on the calculations above, we can conclude that Lowe's pays 5.83% on every dollar that it finances, or 5.83 cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0583 plus the cost of the investment for the investment to be feasible for the company.
In analyzing Lowe's total debt and liabilities, we can see that the company currently has a total debt of $7.627 billion and liabilities at $17.026 billion. Over the past five years, the total debt has increased by 14.18%, while total liabilities have increased by 15.27%.
Based on the five debt ratios listed above, we can see the results regarding the company's debt. As the debt and liabilities have increased, the ratios indicate that the company's growth has been slightly slower than the increase in debt and liabilities.
As Lowe'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 7.27% 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 5.83% on every dollar that it finances. As the current WACC of Lowe's is currently 5.83% and the beta is below average at 1.05, this implies that the company needs at least 5.83% 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 Lowe's debt and liabilities indicates a company that is moderately increasing it's total debt and liabilities. The analysis also reveals that the company growth rate is increasing at a slower rate than the company's debt and liabilities. This indicates a higher amount of risk to the company as three years ago. The Bond rating of "A-" 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 Lowe's has the ability to add future investments and assets at relatively low rates. Currently, Lowe's has the ability to pay for its debts meet its obligations while adding growth.
All indications above reveal a strong company with some questions regarding its debt and growth, as the debt levels have increased faster than the growth in assets of the company. If these ratios begin to levels off Lowe's would be good value for the money as the CAPM reveals that the investor needs 7.27% return, year over year over the long term to get value on their investment.