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Having some knowledge about 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 gaining knowledge about the debt of a company, but for this article, I will look at Transocean Limited's (NYSE:RIG) total debt, total liabilities, debt ratios and WACC.

In 2011, Transocean Limited completed it's acquisition of Aker Drilling ASA and reported a negative EPS. Due to the acquisition, a look at the company's debt and risk would be beneficial to see if the company could afford this and to estimate how much risk the shareholder is going take on from this point moving forward.

All material is sourced from Google Finance, Morningstar and the company webpage.

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 - $11.085 billion + $6.172 million = $17.257 billion
  • 2008 - $13.522 billion + $664 million = $14.186 billion
  • 2009 - $9.849 billion + $1.868 million = $11.717 billion
  • 2010 - $9.209 billion + $2.012 million = $11.221 billion
  • 2011 - $11.497 billion + $2.039 billion = $13.536 billion

Transocean's total debt has decreased since 2007. In 2007, the company reported a total debt of $17.257 billion. In 2011, the company's total debt decreased to $13.536 billion. Over the past 5 years, Transocean's total debt has decreased by 21.56%.

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 - $21.798 billion
  • 2008 - $18.647 billion
  • 2009 - $15.884 billion
  • 2010 - $15.428 billion
  • 2011 - $19.387 billion

Transocean's liabilities have also decreased over the past 5 years. In 2007, the company reported liabilities at $21.798 billion; in 2011, the company reported liabilities at $19.387 billion. Over the past 5 years, Transoceans's liabilities have decreased by 11.06%.

In analyzing Transocean's total debt and liabilities, we can see that the company currently has a total debt of $13.536 billion and liabilities at $19.387 billion. Over the past five years, the total debt has decreased by 21.56%, while total liabilities have decreased by 11.06%. As the company's amount of debt and amount of liabilities have decreased over the past 5 years, the next step will reveal if the company has the ability to pay them.

Debt Ratios

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 - $11.717 billion / $36.436 billion = 0.32
  • 2010 - $11.221 billion / $36.811 billion = 0.30
  • 2011 - $13.536 billion / $35.088 billion = 0.38

Over the past three years Transocean's total-debt-to-total-assets ratio has increased. In 2009 the ratio was 0.32 while in 2011 the ratio was 0.38. This indicates that since 2009 the company has been adding more total debt than assets. As the number is currently below 1, this indicates that the company has more assets than total debt. As the number has increased, 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 - $15.884 billion / $36.436 billion = 0.44
  • 2010 - $15.428 billion / $36.811 billion = 0.42
  • 2011 - $19.387 billion / $35.088 billion = 0.55

In looking at Transocean's total liabilities to total assets ratio over the past three years, we can see that the ratio has increased. As the 2011 numbers are above the 0.50 mark, this indicates that Transocean 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 - $15.884 billion / $20.552 billion = 0.77
  • 2010 - $15.428 billion / $21.383 billion = 0.72
  • 2011 - $19.387 billion / $15.701 billion = 1.23

Over the past three years, Transocean's debt-to-equity ratio has increased from 0.77 to 1.23. As the ratio is currently above 1, this indicates that suppliers, lenders, creditors and obligators have more invested than shareholders. 1.23 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 - $9.849 billion / $30.401 billion = 0.32
  • 2010 - $9.209 billion / $30.592 billion = 0.30
  • 2011 - $11.497 billion / $27.198 billion = 0.42

Over the past three years, Transocean's capitalization ratio has increased from 0.32 to 0.42. 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, 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 - $5.598 billion / $11.717 billion = 0.48
  • 2010 - $3.946 billion / $11.221 billion = 0.35
  • 2011 - $1.785 billion / $13.536 billion = 0.14

Over the past three years, the cash flow to total debt ratio has been decreasing. It has fallen from 0.48 in 2009 to 0.14 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 a slight increase in risk regarding the company's debt. As the debt and liabilities have decreased over the past 5 years and increased over the past 3 years the ratios indicate that the company's growth has been slightly behind the company's 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 Transocean's bonds "BBB- Negative Outlook"
  • Transocean issued bonds, 10 year notes at 6.375%
  • Current cost of Debt as of December 19th 2012 = 6.375%

According to the S&P rating guide, the "BBB-" rating is - "Considered lowest investment grade by market participants." Transocean has a rating that meets this description.

9. Current tax rate (Income Tax total / Income before Tax)

  • 2007 - $253 million / $3.384 billion = 7.48%
  • 2008 - $743 million / $4.943 billion = 15.03%
  • 2009 - $754 million / $3.924 billion = 19.21%
  • 2010 - $311 million / $1.299 billion = 23.94%
  • 2011 - $395 million / $(5.434) billion = -7.27%

2007 - 2010 4 year average = 16.42%

From 2007 - 2010, Transocean has averaged a tax rate of 16.42%.

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.

  • .06375 x (1 - .1642) = Cost of debt after tax

The cost of debt after tax for Transocean is 5.33%

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 = 1.83% (Bloomberg)
  • Average market return 1950 - 2012 = 7%
  • Beta = (Google Finance) Transocean's beta = 1.14

Risk free rate + Beta equity (Average market return - Risk free rate)

  • 1.83 + 1.14 (7-1.83)
  • 1.83 + 1.14 x 5.17
  • 1.83 + 5.89 = 7.72%

Currently, Transocean has a cost of equity or R Equity of 7.72%, so investors should expect to get a return of 7.72% 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 = 16.42% (Transocean's four-year average Tax Rate)

Cost of Debt (before tax) or R debt = 6.375%

Cost of Equity or R equity = 7.72%

Debt (Total Liabilities) for 2011 or D = $19.387 billion

Stock Price = $46.45 (December 19th, 2012)

Outstanding Shares = 359.43 million

Equity = Stock price x Outstanding Shares or E = $16.695 billion

Debt + Equity or D+E = $36.082 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 - .1642) x .06375 x ($19.387/$36.082) + .0772 ($16.695/$36.082)

.8358 x .06375 x .5373 + .0772 x .4627

.0286 + .0357

= 6.43%

Based on the calculations above, we can conclude that Transocean pays 6.43% on every dollar that it finances, or 6.43 cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0643 plus the cost of the investment for the investment to be feasible for the company.

Summary

In the analysis of Transocean's total debt and liabilities, we can see that the company currently has a total debt of $13.536 billion and liabilities at $19.387 billion. Over the past five years, the total debt has decreased by 21.56%, while total liabilities have decreased by 11.06%.

Based on the five debt ratios listed above, we can see a slight increase in risk regarding the company's debt. As the debt and liabilities have decreased over the past 5 years and increased over the past 3 years the ratios indicate that the company's growth has been slightly behind the company's increase in debt and liabilities.

As Transocean's bond rating currently stands at "BBB-" this indicates that the company bonds are "Considered lowest investment grade by market participants."

The CAPM approach for cost of equity states that shareholders need 7.72% 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 6.43% on every dollar that it finances. As the current WACC of Transocean is currently 6.43% and the beta is above average at 1.14, this implies that the company needs at least 6.43% on future investments and will have average volatility moving forward.

Based on the calculations above, the company has increased its debt and liabilities over the past 3 years but currently has the capacity to make its debt payments and meet its tax obligations.

The analysis of Transocean's debt and liabilities indicates a company that has increased it's total debt and liabilities over the past 3 years. The analysis also reveals that the company growth rate is increasing at a slightly slower rate than it's debt when compared to the past 3 years. This indicates slightly more risk to the company than three years ago. The Bond rating of "BBB-" by Standard and Poors indicates that the company's bonds are "Considered lowest investment grade by market participants." The WACC reveals that Transocean has the ability to add future investments and assets at around 6.43%. Currently, Transocean 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 are showing signs of strength but the Bond rating of "BBB-" is "Considered lowest investment grade by market participants." This analysis indicates a large amount of risk for the shareholder but the CAPM reveals that the investor needs 7.72% return, year over year over the long term on this investment for the investor to get good value on your investment. In my opinion, 7.72% is a reasonable expectation for a return year over year over the long term but be cautious as the analysis also reveals there is a large amount of risk associated with this stock.

Source: Analyzing Transocean's Debt And Risk