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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 Royal Dutch Shell's (NYSE:RDS.A) total debt, total liabilities, debt ratios and WACC.

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.

  • 2008 - $13.772 billion + $9.497 billion = $23.269 billion
  • 2009 - $30.862 billion + $4.171 billion = $35.033 billion
  • 2010 - $34.381 billion + $9.951 billion = $44.332 billion
  • 2011 - $30.463 billion + $6.712 billion = $37.475 billion
  • 2012 TTM - $28.078 billion + $8.280 billion = $36.358 billion

Shell's total debt has increased since 2008. In 2008, the company reported a total debt of $23.269 billion. In 2012 TTM, the company's total debt increased to $36.358 billion. Over the past 5 years, Shell's total debt has increased by 56.25%.

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 - $155.116 billion
  • 2009 - $155.750 billion
  • 2010 - $174.547 billion
  • 2011 - $175.740 billion
  • 2012 TTM - $176.565 billion

Shell's liabilities have also increased over the past 5 years. In 2008, the company reported liabilities at $155.116 billion; in 2012 TTM, the company reported liabilities at $176.565 billion. Over the past 5 years, Royal Dutch Shell's liabilities have increased by 13.83%.

In analyzing Shell's total debt and liabilities, we can see that the company currently has a total debt of $36.358 billion and liabilities at $176.565 billion. Over the past five years, the total debt has increased by 56.25%, while total liabilities have increased by 13.83%. 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.

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 - $44.332 billion / $322.560 billion = 0.14
  • 2011 - $37.475 billion / $345.257 billion = 0.11
  • 2012 TTM - $36.358 billion / $360.350 billion = 0.10

Over the past three years, Shell's total debt to total assets ratio has been decreasing. Over the past 3 years, the total debt to total assets ratio dropped from 0.14 in 2010 to 0.10 in 2012. This indicates that since 2010 the company has been adding assets while decreasing its total debt. As the number is currently well below 1, this indicates that the company has more assets than total debt. As the number has been declining, this states that the risk to the company regarding its debt-to-assets has been decreasing 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 - $174.547 billion / $322.560 billion = 0.54
  • 2011 - $175.740 billion / $345.257 billion = 0.51
  • 2012 TTM - $176.565 billion / $360.350 billion = 0.49

In looking at Shell's total liabilities to total assets ratio over the past three years, we can see that this ratio has also been declining. As the 2012 TTM numbers are just below the 0.50 mark, this indicates that Shell has not financed most of the company's assets through debt. As the number been declining, so is 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 - $174.547 billion / $148.013 billion = 1.18
  • 2011 - $175.740 billion / $169.517 billion = 1.04
  • 2012 TTM - $176.565 billion / $183.785 billion = 0.96

Over the past three years, Shell's debt-to-equity ratio has decreased. The ratio has dropped from 1.18 to 0.96. As the ratio is currently below 1, this indicates that shareholders have invested more than suppliers, lenders, creditors and obligators. 0.96 indicates a moderately low amount of risk for the company. As the ratio is below 1 and considered moderately low, 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 - $34.381 billion / $182.394 billion = 0.19
  • 2011 - $30.463 billion / $199.980 billion = 0.15
  • 2012 TTM - $28.078 billion / $211.863 billion = 0.13

Over the past three years, Shell's capitalization ratio has decreased from 0.19 to 0.13. 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.

  • 2010 - $27.350 billion / $44.332 billion = 0.61
  • 2011 - $36.771 billion / $37.475 billion = 0.98
  • 2012 TTM - $42.692 billion / $36.358 billion = 1.17

Over the past three years, the cash flow to total debt ratio has been increasing. The ratio has increased from 0.61 in 2010 to 1.17 in 2012 TTM. As the ratio is now above 1, this implies that the company has 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 the risk to the company has decreased over the past 3 years. Over the past 3 years, the ratios indicate that the company's growth in assets has exceeded 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 "AA" rating is - "Very strong capacity to meet financial commitments." Royal Dutch Shell has a rating that meets this description.

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

  • 2008 - $24.344 billion / $50.820 billion = 47.90%
  • 2009 - $8.302 billion / $21.020 billion = 39.50%
  • 2010 - $14.870 billion / $35.344 billion = 42.07%
  • 2011 - $24.475 billion / $55.660 billion = 43.97%
  • 2012 TTM - $23.122 billion / $49.731 billion = 46.49%

2008 - 2012 TTM 5-year average = 43.98%

From 2007 - 2012 TTM, Royal Dutch Shell has averaged a tax rate of 43.98%.

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.

  • .0368 x (1 - .4398) = Cost of debt after tax

The cost of debt after tax for Royal Dutch Shell is 2.06%

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 = 1.86% (Bloomberg)
  • Average market return 1950 - 2012 = 7%
  • Beta = (Google Finance) Royal Dutch Shell's beta = 1.01

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

  • 1.86 + 1.01 (7-1.86)
  • 1.86 + 1.01 x 5.14
  • 1.86 + 5.19 = 7.05%

Currently, Shell has a cost of equity or R Equity of 7.05%, so investors should expect to get a return of 7.05% 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 = 43.98% (Shell's five-year average Tax Rate)

Cost of Debt (before tax) or R debt = 3.68%

Cost of Equity or R equity = 7.05%

Debt (Total Liabilities) for 2011 or D = $176.565 billion

Stock Price = $69.20 (January 3rd, 2013)

Outstanding Shares = 3.13 billion

Equity = Stock price x Outstanding Shares or E = $216.596 billion

Debt + Equity or D+E = $393.161 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 - .4398) x .0368 x ($176.565/$393.161) + .0705 ($216.596/$393.161)

.5602 x .0368 x .4491 + .0705 x .5509

.0093 + .0388

= 4.81%

Based on the calculations above, we can conclude that Royal Dutch Shell pays 4.81% on every dollar that it finances, or 4.81 cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0481 plus the cost of the investment for the investment to be feasible for the company.

Summary

In analyzing Shell's total debt and liabilities, we can see that the company currently has a total debt of $36.358 billion and liabilities at $176.565 billion. Over the past five years, the total debt has increased by 56.25%, while total liabilities have increased by 13.83%.

Based on the five debt ratios listed above, we can see that the risk to the company has decreased over the past 3 years. Over the past 3 years, the ratios indicate that the company's growth in assets has exceeded the increase in debt and liabilities.

As Royal Dutch Shell's bond rating currently stands at "AA," this implies that the company has a "Very strong capacity to meet financial commitments."

The CAPM approach for cost of equity states that shareholders need 7.05% 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 4.81% on every dollar that it finances. As the current WACC of Royal Dutch Shell is currently 4.81% and the beta is below average at 1.01, this implies that the company needs at least 4.81% on future investments and will have average volatility moving forward.

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

The analysis of Royal Dutch Shell's debt and liabilities indicates a company that has slightly increased its liabilities over the past 3 years. The analysis also reveals that the company's growth rate is increasing at the faster rate than its liabilities, when compared to the past 3 years. This indicates a decreasing amount of risk to the company as compared to three years ago. The Bond rating of "AA" by Standard & Poor's indicates that the company has "Very strong capacity to meet financial commitments." The WACC reveals that Royal Dutch Shell has the ability to add future investments and assets at around 4.81%. Currently, Royal Dutch Shell has the ability to pay for its debts, meet its obligations, while adding growth.

All indications above reveal a company that is gaining strength. The company has reduced its total debt when compared to three years ago while adding assets. The company has increased its liabilities over the past three years but significantly less than the increase in assets. The Bond rating of "AA" states that the company has "Very strong capacity to meet financial commitments." The CAPM reveals that the investor needs 7.05% return, year-over-year over the long term on this investment for the investor to get good value on their investment. In my opinion, 7.05% is a reasonable expectation for a return year-over-year over the long term.

For another article on Royal Dutch Shell please read: Royal Dutch Shell: Inside The Numbers

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Analyzing Royal Dutch Shell's Debt And Risk