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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 understanding the debt of a company, but for this article, I will look at Home Depot Inc.'s (HD) 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 Lowe's Inc. (LOW), you will be able see which company has the most debt, thus adding to the company's risk.

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

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.

  • 2008 - $11.383 billion + $2.047 billion = $13.430 billion
  • 2009 - $9.667 billion + $1.767 billion = $11.434 billion
  • 2010 - $8.662 billion + $1.020 million = $9.682 billion
  • 2011 - $8.707 billion + $1.042 million = $9.749 billion
  • 2012 - $10.758 billion + $30 million = $10.788 billion

Home Depot's total debt has decreased since 2008. In 2008, the company reported a total debt of $13.430 billion. In 2012, the company's total debt decreased to 10.788 billion. Over the past 5 years, Home Depot's total debt has decreased by 19.67%.

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.

  • 2008 - $26.610 billion
  • 2009 - $23.387 billion
  • 2010 - $21.484 billion
  • 2011 - $21.236 billion
  • 2012 - $22.620 billion

Home Depot's liabilities have also decreased over the past 5 years. In 2008, the company reported liabilities at $26.610 billion; in 2012, the company reported liabilities at $22.620 billion. Over the past 5 years, Home Depot's liabilities have increased by 14.99%.

In analyzing Home Depot's total debt and liabilities, we can see that the company currently has a total debt of $10.788 billion and liabilities at $22.620 billion. Over the past five years, the total debt has decreased by 19.67%, while total liabilities have decreased by 14.99%. As the company's amount of debt and amount of liabilities have decreased over the past 5 years, this indicates a strengthening of the company's financial health; the next step will reveal if the company has the ability to it.

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.

  • 2010 - $9.682 billion / $40.877 billion = 0.24
  • 2011 - $9.749 billion / $40.125 billion = 0.24
  • 2012 - $10.788 billion / $40.518 billion = 0.27

Over the past three years Home Depot's total-debt-to-total-assets ratio has increased. This indicates that since 2010 the company has been adding more total debt than assets. As the number is currently well below 1 but increasing, this states that the risk to the company regarding its debt to assets has increased slightly since 2010.

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.

  • 2010 - $21.484 billion / $40.877 billion = 0.53
  • 2011 - $21.236 billion / $40.125 billion = 0.53
  • 2012 - $22.620 billion / $40.518 billion = 0.56

In looking at Home Depot's total liabilities to total assets ratio over the past three years, we can see that the ratio has also increased. As the 2012 numbers are just above the 0.50 mark, this indicates that Home Depot has financed most of the company's assets through debt. As the number has increased compared to 2012, 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.

  • 2010 - $21.484 billion / $19.393 billion = 1.11
  • 2011 - $21.236 billion / $18.889 billion = 1.12
  • 2012 - $22.620 billion / $17.898 billion = 1.26

Over the past three years, Home Depot's debt-to-equity ratio has increased from a low of 1.11 to a high of 1.26. As the ratio is currently above 1, this indicates that suppliers, lenders, creditors and obligators have more invested than shareholders. 1.26 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.

  • 2010 - $8.662 billion / $28.055 billion = 0.31
  • 2011 - $8.707 billion / $27.596 billion = 0.32
  • 2012 - $10.758 billion / $28.656 billion = 0.38

Over the past three years, Home Depot's capitalization ratio has increased from 0.31 to 0.38. 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.

  • 2010 - $5.125 billion / $9.682 billion = 0.53
  • 2011 - $4.585 billion / $9.749 billion = 0.47
  • 2012 - $6.651 billion / $10.788 billion = 0.62

Over the past three years, the cash flow to total debt ratio has increased from 0.53 to 0.62. 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 debt ratios have increased but are still showing no red flags. As the debt and liabilities have increased over the past 3 years, 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.

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." Home Depot has a rating that meets this description.

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

  • 2008 - $2.410 billion / $6.620 billion = 36.40%
  • 2009 - $1.278 billion / $3.590 billion = 35.60%
  • 2010 - $1.362 billion / $3.982 billion = 34.20%
  • 2011 - $1.935 billion / $5.273 billion = 36.70%
  • 2012 - $2.185 billion / $6.068 billion = 36.01%

5-year average = 35.78%

Over the past five years, Home Depot has averaged a tax rate of 35.78%.

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.

  • .0403 x (1 - .3578) = Cost of debt after tax

The cost of debt after tax for Home Depot is 2.59%

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 = 1.76% (Bloomberg)
  • Average market return 1950 - 2012 = 7%
  • Beta = (Google Finance) Home Depot's beta = 0.82

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

  • 1.76 + 0.82 (7-1.76)
  • 1.76 + 0.82 x 5.24
  • 1.76 + 4.30 = 6.06%

Home Depot has a cost of equity or R Equity of 6.06%, so investors should expect to get a return of 6.06% 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 = 35.78% (Home Depot's five-year average Tax Rate)

Cost of Debt (before tax) or R debt = 4.03%

Cost of Equity or R equity = 6.06%

Debt (Total Liabilities) for 2011 or D = $22.620 billion

Stock Price = $61.32 (December 22nd, 2012)

Outstanding Shares = 1.50 billion

Equity = Stock price x Outstanding Shares or E = $91.980 billion

Debt + Equity or D+E = $114.600 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 - .3578) x .0403 x ($22.620/$114.600) + .0606 ($91.980/$114.600)

.6422 x .0403 x .1974 + .0606 x .8026

.0026 + .0486

= 5.12%

Based on the calculations above, we can conclude that Home Depot pays 5.12% on every dollar that it finances, or 5.12 cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0512 plus the cost of the investment for the investment to be feasible for the company.

Summary

In analyzing Home Depot's total debt and liabilities, we can see that the company currently has a total debt of $10.788 billion and liabilities at $22.620 billion. Over the past five years, the total debt has decreased by 19.67%, while total liabilities have decreased by 14.99%.

Based on the five debt ratios listed above, we can see the debt ratios have increased but are still showing no red flags. As the debt and liabilities have increased over the past 3 years, the ratios indicate that the company's growth has been slightly slower than the increase in debt and liabilities.

As Home Depot'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 6.06% 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 5.12% on every dollar that it finances. As the current WACC of Home Depot is currently 5.12% and the beta is below average at 0.82, this implies that the company needs at least 5.12% 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 Home Depot's debt and liabilities indicates a company that has been moderately increasing its total debt and liabilities over the past 3 years. The analysis also reveals that the company's growth rate is increasing at a slower rate than its 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 Home Depot has the ability to add future investments and assets at relatively low rates. Currently, Home Depot has the ability to pay for its debts and meet its obligations while adding growth.

All indications above reveal a strong company that has decreased its debt and liabilities over past 5 years but has increased its debt and liabilities over the past 3 years. When comparing the ratios over the past 3 years, they reveal that the debt levels have increased faster than the growth in assets. These ratios indicate some risk to the shareholder but the CAPM reveals that shareholders should expect to get 6.06% return, year over year, over the long term on their investment to get good value for their money.

For more articles on Home Depot please read: Home Depot: Customer Service Initiatives Increase Revenue and Home Depot: Inside The Numbers

Source: Analyzing Home Depot's Debt And Risk