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 Emerson Electric's (NYSE:EMR) 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.
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 - $3.372 billion + $0 million = $3.372 billion
- 2008 - $3.297 billion + $0 million = $3.297 billion
- 2009 - $3.998 billion + $0 million = $3.998 billion
- 2010 - $4.586 billion + $409 million = $5.066 billion
- 2011 - $4.324 billion + $598 million = $5.201 billion
Emerson Electric's total debt has increased from $3.372 billion in 2007 to $5.201 billion in 2011, an increase of 54.24%.
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 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 - $10.908 billion
- 2008 - $11.927 billion
- 2009 - $11.208 billion
- 2010 - $13.051 billion
- 2011 - $13.462 billion
Emerson Electric's liabilities have increased from $10.908 billion in 2007 to $13.462 billion in 2011, an increase of 23.41%.
In analyzing the company's total debt and liabilities, we have seen a steady increase over the past 5 years. The total debt has increased by 54.24% since 2007 while the liabilities has increase by 23.41%. Much of this debt was incurred through the purchase of assets such as Chloride Group PLC in 2010, EIM Controls Inc , Turbine Control Service and others. 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 - $3.998 billion / $19.763 billion = 0.20
- 2010 - $5.066 billion / $22.843 billion = 0.22
- 2011 - $5.201 billion / $23.861 billion = 0.22
As Emerson Electric's total debt to total assets ratio is well below 1, this indicates that Emerson Electric has many more assets than total debt, ensuring that the company is in good shape and currently not close to bankruptcy.
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 - $11.208 billion / $19.763 billion = 0.57
- 2010 - $13.051 billion / $22.843 billion = 0.57
- 2011 - $13.462 billion / $23.861 billion = 0.56
As the total liabilities to total assets ratio has been essentially the same over the past 3 years and is slightly above .5 this indicates that Emerson Electric 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 - $11.208 billion / $8.555 billion = 1.31
- 2010 - $13.051 billion / $9.792 billion = 1.33
- 2011 - $13.462 billion / $10.399 billion = 1.29
Emerson Electric's 2011 debt to equity is moderately low at 1.29. Even though the ratio is quite low this still indicates that suppliers, lenders, creditors and obligators have more equity invested than shareholders. This indicates a moderately low 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 - $3.998 billion / $12.553 billion = 0.32
- 2010 - $4.586 billion / $14.378 billion = 0.32
- 2011 - $4.324 billion / $14.723 billion = 0.29
Over the past 3 years Emerson Electric's capitalization ratio has been very consistent. This implies that the company has had relatively the same amount equity compared to its long-term debt. As this is the case, the company had the same amount of equity to support its operations and add growth through its equity, thus maintaining 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.
- 2010 - $2.661 billion / $244 million = 10.91
- 2010 - $3.159 billion / $280 million = 11.28
- 2011 - $3.877 billion / $246 million = 15.76
As the company's Interest Coverage Ratio is very high at 15.76, Emerson Electric is not burdened by debt expense. Emerson Electric 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 - $2.450 billion / $3.998 billion = 0.61
- 2010 - $2.879 billion / $5.066 billion = 0.57
- 2011 - $3.631 billion / $5.201 billion = 0.70
As the cash flow to debt ratio in the previous 3 years below 100% or 1, it implies that 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 Emerson Electric has been very consistent in regards to its debt ratios. There has been an increase in debt and liabilities over the past few years but has also shown very consistent results in the ratios listed above. All indications above reveal that Emerson Electric has the ability to pay for its debt, and is not on the verge of bankruptcy. 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 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 Emerson Electric bonds "A"
- Current 20 year corporate bond Rate of "A" = 4.08%
- Current cost of Debt as of August 8, 2012 = 4.08%
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." Emerson Electric has a rating that meets this description".
10. Current tax rate ( Income Tax total / Income before Tax)
- 2007 - $964 million / $3.093 billion = 30.59%
- 2008 - $1.125 billion / $3.645 million = 30.68%
- 2009 - $688 million / $2.450 million = 28.08%
- 2010 - $848 million / $2.879 million = 29.45%
- 2011 - $1.127 billion / $3.631 million = 31.04%
5 year average = 29.97%
Over the past 5 years Emerson Electric has averaged a tax rate of 29.97%.
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.
- .0408 x (1 - .2997) = Cost of debt after tax
The cost of debt after tax for Emerson Electric is 2.86%
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 = 1.62% (Bloomberg)
- average market return 1950 - 2011 = 7%
- Beta = (Google finance) Emerson Electrics beta = 1.22
Risk free rate + Beta equity (Average market return - Risk free rate)
- 1.62 + 1.22 (7-1.62)
- 1.62 + 1.22 x 5.38
- 1.62 + 6.60 = 8.22%
Emerson Electric has a cost of equity or R Equity of 8.22%. So investors should expect to get a return of 8.22% over the long term 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 = 29.97% (Emerson Electrics 5 year average Tax Rate)
Cost of Debt (before tax) or R debt = 4.08%
Cost of Equity or R equity = 8.22%
Debt (Total Liabilities) for 2011 or D = $13.462 billion
Stock Price = $49.79 (August 8, 2012)
Outstanding Shares = 733.61 Million
Equity = Stock price x Outstanding Shares or E = $ 36.526 billion
Debt + Equity or D+E = $49.988 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 - .2997) x .0408 x ($13.462/$49.988) + .0822 ($36.526/$49.988)
.7003 x .0408 x .2693 + .0822 x .7307
.0077 + .0601
Based on the calculations above we can arrive that Emerson Electric pays 6.78% on every dollar that it finances or .0678 on every dollar. From this calculation we understand that on every dollar the company spends on an investment the company must make $.0678, plus the cost of the investment for the investment to be feasible for the company.
In analyzing the company's total debt and liabilities, we have seen a steady increase in these areas over the past 5 years. The total debt has increased by 54.24% since 2007 while the liabilities has increase by 23.41%. The company does have a sizeable amount of total debt at $5.201 billion and liabilities at $13.462 billion, but much of this debt was incurred by the purchase of assets in the anticipation of growing and improving the company.
As illustrated above, we can see that Emerson Electric Company has purchased many of its assets through debt. The listed ratios above indicate that the company has been very consistent in the amount of debt incurred relative to the company's equity and assets. All indications above reveal that the company has the ability to manage its debt and is currently not in danger of bankruptcy.
As Emerson Electric's bond rating received a "A" rating through S&P, 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 Emerson Electric is a very consistent stock that has been slightly more volatile than the S&P 500, the cost of equity states that shareholders need 8.22% 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 to 2011 at 7%.
The WACC reveals that the company pays 6.78% on every dollar that it finances. As the current WACC of a Emerson Electric Company is currently moderately low at 6.78% while the beta is moderate at 1.22, it implies a moderately lower risk on future investments for the company and moderate volatility moving forward.
Overall, the company has a sizeable amount of debt but currently has the capacity to make its debts payments, meet its tax obligations and is not in danger of bankruptcy.
The analysis of Emerson Electric's debt and liabilities indicates a strong company with a sizeable amount of debt but the ability to pay for it. The analysis also reveals the company has been very consistent is its debt ratios and has the ability to add future investments at relatively moderate risk. Currently Emerson Electric has the ability to pay for its debts, meet its tax obligations, is not in danger of bankruptcy and has the opportunity to capitalize on future investments with relatively moderate risk.
To read more fundamental analysis on Emerson Electric please read my articles:
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.