Having an understanding of a company's debt and liabilities is a key component in understanding the risk of a company. An understanding of these factors will aid 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 Seadrill Limited's (NYSE:SDRL) total debt, total liabilities, debt ratios and WACC.
1. Total Debt = Long-Term Debt + Short-Term Debt
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 - $4.116 billion + $484 million = $4.600 billion
- 2008 - $6.691 billion + $746 million = $7.437 billion
- 2009 - $6.622 billion + $774 million = $7.396 billion
- 2010 - $8.611 billion + $981 million = $9.592 billion
- 2011 - $8.574 billion + $1.419 billion = $9.993 billion
Seadrill's total debt has increased since 2007. In 2007, the company reported a total debt of $4.600 billion. In 2011, the company's total debt increased to $9.993 billion. Over the past 5 years, Seadrill's total debt has increased by 217.24%.
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 - $5.670 billion
- 2008 - $9.675 billion
- 2009 - $9.652 billion
- 2010 - $12.100 billion
- 2011 - $12.327 billion
Seadrill's liabilities have also increased over the past 5 years. In 2007, the company reported liabilities at $5.670 billion; in 2011, the company reported liabilities at $12.327 billion. Over the past 5 years, Seadrill's liabilities have increased by 217.41%.
In analyzing Seadrill's total debt and liabilities, we can see that the company currently has a total debt of $9.993 billion and liabilities at $12.327 billion. Over the past five years, the total debt has increased by 217.24%, while total liabilities have increased by 217.41%. 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 - $7.396 billion / $13.831 billion = 0.53
- 2010 - $9.592 billion / $17.497 billion = 0.55
- 2011 - $9.993 billion / $18.304 billion = 0.55
Over the past three years Seadrill's total-debt-to-total-assets ratio has increased slightly. In 2009 the ratio was 0.53 while in 2011 the ratio was 0.55. This indicates that since 2009 the company has been adding just slightly more total debt than assets. As the number is currently below 1, this states that the risk to the company regarding its debt to assets has increased slightly 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 - $9.652 billion / $13.831 billion = 0.70
- 2010 - $12.100 billion / $17.497 billion = 0.69
- 2011 - $12.327 billion / $18.304 billion = 0.67
In looking at Seadrill's total liabilities to total assets ratio over the past three years, we can see that the ratio has decreased. As the 2011 numbers are above the 0.50 mark, this indicates that Seadrill has financed most of the company's assets through debt. As the number has decreased 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 - $9.652 billion / $4.179 billion = 2.31
- 2010 - $12.100 billion / $5.398 billion = 2.24
- 2011 - $12.327 billion / $5.977 billion = 2.06
Over the past three years, Seadrill's debt-to-equity ratio has decreased from a high of 2.31 to a low of 2.06. As the ratio is currently above 1, this indicates that suppliers, lenders, creditors and obligators have more invested than shareholders. 2.06 indicates a large 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 - $6.622 billion / $10.801 billion = 0.61
- 2010 - $8.611 billion / $14.009 billion = 0.61
- 2011 - $8.574 billion / $14.551 billion = 0.59
Over the past three years, Seadrill's capitalization ratio has decreased from 0.61 to 0.59. 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 slight decrease 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 - $1.452 billion / $7.396 billion = 0.20
- 2010 - $1.300 billion / $9.592 billion = 0.14
- 2011 - $1.816 billion / $9.993 billion = 0.18
Over the past three years, the cash flow to total debt ratio has been bounced around from 0.20 in 2009 to 0.18 in 2011 . 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 steady results regarding the company's debt. We can see that debt and liabilities have increased but the ratios indicate that the company's growth has been keeping up 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.
- Morningstar rated Seadrill's bonds "B"
- Seadrill's bonds Maturing on Sep 15, 2017, Rating of "B" = 5.625%
- Current cost of Debt as of December 12th 2012 = 5.625%
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." Seadrill Limited has a rating that meets this description.
9. Current tax rate (Income Tax total / Income before Tax)
- 2008 - $48 million / $(100) million = (48.00%)
- 2009 - $120 million / $1.473 billion = 8.15%
- 2010 - $159 million / $1.331 billion = 11.95%
- 2011 - $189 million / $1.671 billion = 11.31%
- 2012 TTM - $165 million / $1.265 billion = 13.04%
2010 - 2012 TTM 3 year average = 12.10%
Over the past three years, Seadrill limited has averaged a tax rate of 12.10%.
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.
- .05625 x (1 - .121) = Cost of debt after tax
The cost of debt after tax for Seadrill Limited is 4.94%
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 = 1.66% (Bloomberg)
- Average market return 1950 - 2012 = 7%
- Beta = (Google Finance) Seadrill's beta = 1.97
Risk free rate + Beta equity (Average market return - Risk free rate)
- 1.66 + 1.97 (7-1.66)
- 1.66 + 1.97 x 5.34
- 1.66 + 10.52 = 12.18%
Seadrill's has a cost of equity or R Equity of 12.18%, so investors should expect to get a return of 12.18% 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 = 12.10% (Seadrill's three-year average Tax Rate)
Cost of Debt (before tax) or R debt = 5.625%
Cost of Equity or R equity = 12.18%
Debt (Total Liabilities) for 2011 or D = $12.327 billion
Stock Price = $36.91 (December 12th, 2012)
Outstanding Shares = 469.12 million
Equity = Stock price x Outstanding Shares or E = $17.351 billion
Debt + Equity or D+E = $29.678 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 - .121) x .05625 x ($12.327/$29.678) + .1218 ($17.351/$29.678)
.879 x .05625 x .4154 + .1218 x .5846
.0205 + .0712
Based on the calculations above, we can conclude that Seadrill pays 9.17% on every dollar that it finances, or 9.17 cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0917 plus the cost of the investment for the investment to be feasible for the company.
In analyzing Seadrill's total debt and liabilities, we can see that the company currently has a total debt of $9.993 billion and liabilities at $12.327 billion. Over the past five years, the total debt has increased by 217.24%, while total liabilities have increased by 217.41%.
Based on the five debt ratios listed above, we can see steady results regarding the company's debt. We can see that debt and liabilities have increased but the ratios indicate that the company's growth has been keeping up than the increase in debt and liabilities.
As Seadrill's bond rating currently stands at "B" 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 12.18% 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 9.17% on every dollar that it finances. As the current WACC of Seadrill is currently 9.17% and the beta is above average at 1.97, this implies that the company needs at least 9.17% 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 Seadrill's debt and liabilities indicates a company that has increased it's total debt and liabilities significantly over the past 5 years. The analysis also reveals that the company growth rate is increasing at approximately the same rate. This indicates about the same amount of risk to the company as three years ago. The Bond rating of "B" by Morningstar 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 Seadrill has the ability to add future investments and assets at around 9.17%. Currently, Seadrill has the ability to pay for its debts meet its obligations while adding growth.
All indications above reveal a company with some questions regarding its debt and growth. The above ratio's show signs of strength but the Bond rating of "B" is "speculative". The analysis indicates a significant of risk for the shareholder but if above ratio's continue to show strength, Seadrill could be good value for the money. The CAPM reveals that the investor needs 12.18% return so if you believe that you can get 12.18% year over year over the long term on this investment then you will get good value on your investment.
To read more on Seadrill, read my article: Seadrill Limited: Inside The Numbers
An excellent article on Seadrill's debt is: Why there is no reason to panic about Seadrill's debt.