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 key component in understanding the risk of a company, thus helping aid in a 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 ABB LTD's (NYSE:ABB) 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, you will be able see which who has the most debt and the most risk.
Most of the financial numbers were used from MSN Money and are in U.S. dollars.
1. Total Debt = Long Term Debt + Short Term Debt
A debt is an amount of money borrowed by one party from another, and must be paid back. Total debt is the addition 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. The combination of the two is total debt.
- 2007 - $2.138 billion + $129 million = $2.267 billion
- 2008 - $2.009 billion + $354 million = $2.363 billion
- 2009 - $2.172 billion + $128 million = $2.300 billion
- 2010 - $1.139 billion + $124 million = $1.263 billion
- 2011 - $3.231 billion + $689 million = $3.920 billion
ABB's total debt has increased from $2.267 billion in 2007 to $3.920 billion in 2011, note the large increment of total debt added from 2010 to 2011.
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 are the addition of long-term liabilities, which are the liabilities that are due in one year or more, and short-term, or current liabilities, are any liabilities due within one year. The combination of the two equals the total liabilities.
- 2007 - $20.044 billion
- 2008 - $21.853 billion
- 2009 - $20.938 billion
- 2010 - $21.410 billion
- 2011 - $23.871 billion
ABB's liabilities have increased from $20.044 billion in 2007 to $23.871 billion in 2011, an increase of 19.09%.
In analyzing the company's total debt and liabilities, ABB's debt totals are quite low but the liabilities are much higher. Much of the company's debt was incurred through the purchase of assets. The next step will reveal if the company has the ability to pay for these assets.
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 - $2.300 billion / $34.728 billion = 0.07
- 2010 - $1.263 billion / $36.295 billion = 0.03
- 2011 - $3.920 billion / $39.648 billion = 0.10
As ABB's total debt to total assets ratio is well below 1, this indicates that ABB has many more assets than total debt, ensuring that the company is in good shape and currently not close to bankruptcy. ABB is in excellent shape in regards to the Total Debt to Total Assets Ratio.
4. Debt ratio = Total Liabilities / Total Assets
Total liabilities divided by total assets. The debt ratio shows the proportion of a company's assets which are 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 - $20.938 billion / $34.728 billion = 0.60
- 2010 - $21.410 billion / $36.295 billion = 0.59
- 2011 - $23.871 billion / $39.648 billion = 0.60
As the total liabilities to total assets ratio has increased compared to 2010, it indicates that the company's total liabilities in relation total assets have increased. As the ratio is over 0.50 in both years, this indicates that ABB's has financed most of the company's assets through debt, but as the ratio is below 1, currently the company is not in danger becoming insolvent and/or going bankrupt.
5. Debt to Equity Ratio = Total Liabilities / Shareholder's Equity
The debt to equity ratio is another leverage ratio that compares a company's total liabilities to its total shareholder's 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 - $20.938 billion / $13.790 billion = 1.52
- 2010 - $21.410 billion / $14.885 billion = 1.44
- 2011 - $23.871 billion / $15.777 billion = 1.51
ABB's 2011 debt to equity is moderate at 1.51. This indicates that suppliers, lenders, creditors and obligators have more equity invested than shareholders. This indicates a moderate amount of 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. The 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 - $2.172 billion / $15.962 billion = 13.60
- 2010 - $1.139 billion / $16.024 billion = 7.11
- 2011 - $3.231 billion / $19.008 billion = 16.99
As ABB's long-term debt increased, so did the company's capitalization ratio. This implies that the company has less equity compared to its long-term debt. As this is the case, the company had less equity to support its operations and add growth through its equity, thus adding to the company's risk.
7. Interest Coverage Ratio = EBIT (Earnings before interest and taxes) / Interest Expenses
The interest coverage ratio is used to determine how easily a company can pay interest expenses on outstanding debt. The ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by the company's interest expenses for the same period. The lower the ratio, the more the company is burdened by debt expense, the higher the ratio the better. When a company's interest coverage ratio is 1.5 or lower, its ability to meet interest expenses may be questionable.
- 2009 - $3.993 billion / $127 million = 31.41
- 2010 - $3.567 billion / $173 million = 20.62
- 2011 - $4.343 billion / $207 million = 20.98
As the company's Interest Coverage Ratio is very high at 20.98, ABB is not burdened by debt expense. ABB has the ability to meet its interest expenses.
8. Cash Flow to Total Debt Ratio = Operating Cash Flow / Total Debt
This coverage ratio compares a company's operating cash flow to 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 - $4.027 billion / $2.300 billion = 1.75
- 2010 - $4.197 billion / $1.263 billion = 3.32
- 2011 - $3.612 billion / $3.920 billion = 0.92
As the cash flow to debt ratio in 2011 ratio was below 100% or 1.0, it implies that in 2011 the company did not have the ability to cover its total debt with its yearly cash flow from operations.
Based on the above six debt ratios, we can see that ABB has purchased many of its assets through debt. The company's total debt management looks solid as well as the company's ability to manage its liabilities. There has been some increase in debt and liabilities but none to the point of raising any red flags. All indications above reveal that ABB has the ability to pay for its debt, and is not showing any signs of bankruptcy. The next step will reveal how much the company will pay for the debts that it has 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 to others. The higher the cost of debt the higher the risk.
9. Cost of debt (before tax) = Corporate Bond rate of company's bond rating.
- S&P rated ABB's bonds "A"
- Current 20 year corporate bond Rate of "A" = 3.76%
- Current cost of Debt = 3.76%
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". ABB has a rating that meets this description.
10. Current tax rate ( Income Tax total / Income before Tax)
- 2007 - $595 million / $3.913 billion = 15.20%
- 2008 - $1.119 billion / $3.399 million = 32.92%
- 2009 - $1.001 million / $3.119 million = 32.09%
- 2010 - $1.018 million / $2.722 million = 37.40%
- 2011 - $1.244 million / $3.306 million = 37.62%
4 year average = 35.01%
Over the past 4 years ABB has averaged a tax rate of 35.01%.
11. 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.
- .0376 x (1 - .3501) = Cost of debt after tax
- .0376 x .6499
The cost of debt after tax for ABB is 2.44%
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 = US 10 year bond = 1.46% (Bloomberg)
- average market return 1950 - 2011 = 7%
- Beta = (Google finance) Waste Managements beta = 1.49
Risk free rate + Beta equity(Average market return - Risk free rate)
- 1.46 + 1.49 (7-1.46)
- 1.46 + 1.49 x 5.54
- 1.46 + 8.25 = 9.71%
ABB has a cost of equity or R Equity of 9.71%. So investors should expect to get a return of 9.71% on their investment to compensate for the risk they undertake by investing in this company.
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 = 35.01% (ABB 4 year average Tax Rate)
Cost of Debt (before tax) or R debt = 3.76%
Cost of Equity or R equity = 9.71%
Debt (Total Liabilities) for 2011 or D = $23.871 billion
Stock Price = $16.97 (July 27th 2012)
Outstanding Shares = 2.290 billion
Equity = Stock price x Outstanding Shares or E = $38.861 billion
Debt + Equity or D+E = $62.732 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 - .3501) x .0376 x ($23.871/$38.861) + .0971 ($38.861/$62.732)
.6499 x .0376 x .6143 + .0971 x .6195
.0244 + .0602
Based on the calculations above we can arrive that ABB pays 8.46% on every dollar that it finances or .0846 on every dollar. From this calculation we understand that on every dollar the company spends on an investment the company must make $.0846, plus the cost of the investment for the investment to be feasible for the company.
In analyzing the company's total debt and liabilities over the past 5 years, we have seen an 72.92% increase in the total debt and an increase of 19.09% increase in the total liabilities when compared to 2007. The company has a very moderate amount of total debt at $3.920 billion, but sizeable liabilities at $23.871 billion.
As illustrated above, we can see that ABB has purchased many of its assets through debt. Even though some of the ratios have degraded slightly over the past year thus increasing the companies risk, all indications above reveal that the company has the ability to manage its debt and is currently not on the verge of bankruptcy.
As ABB's bond rating received a "A" rating, this indicates that the company has a "Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances".
As ABB can be a volatile stock, the cost of equity states that shareholders need 9.71% on their equity to make it worthwhile to invest in the company.
The WACC reveals that the company pays 8.46% on every dollar that it finances. As the current WACC of a ABB is currently moderate at 8.46%, this implies a moderate amount of risk on future investments for the company, with a current beta at 1.49 this implies above average volatility moving forward.
Overall, the company has a low amount of total debt but a large amount of liabilities. The company currently has the capacity to make its debts payments, meet its tax obligations and is showing no signs of being in danger of bankruptcy.
The analysis of ABB's debt and liabilities indicates a strong company with a large amount of liabilities but the ability to pay for them. The analysis reveals some degradation in some of the debt ratios, but It also reveals that ABB currently has the ability to pay for its debts, meet its tax obligations, is showing no signs of being in danger of bankruptcy and has the opportunity to capitalize on future investments at a moderate amount of risk.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.