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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 Cummins Incorporation's (CMI) 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 has the most debt and the most risk.

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

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 - $555 million + $13 million = $568 million
  • 2008 - $629 million + $39 million = $668 million
  • 2009 - $637 million + $37 million = $674 million
  • 2010 - $709 million + $82 million = $791 million
  • 2011 - $658 million + $28 million = $686 million

Cummins total debt has increased from $568 million in 2007 to $686 million in 2011, an increase of 20.77%.

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 - $4.786 billion
  • 2008 - $5.285 billion
  • 2009 - $5.043 billion
  • 2010 - $5.732 billion
  • 2011 - $6.176 billion

Cummins liabilities have increased from $$4.786 billion in 2007 to $6.176 billion in 2011, an increase of 29.08%.

In analyzing the company's total debt and liabilities, we can see that the company's total debt is quite low in relation to the size of the company. Even though the total debt amount is quite low, the total debt has increased by 20.77% since 2007. The liabilities have also increased by 29.08% over the past 5 years. As most of the debt and liabilities was acquired in the acquisition of assets, the next step will reveal if the company has the ability to pay for these assets.

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 - $674 million / $8.816 billion = 0.076
  • 2010 - $791 million / $10.402 billion = 0.076
  • 2011 - $686 million / $11.668 billion = 0.059

As Cummins total debt to total assets ratio is well below 1, this indicates that Cummins Inc. has many more assets than total debt, ensuring that the company is currently in good shape and 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 - $5.043 billion / $8.816 billion = 0.57
  • 2010 - $5.732 billion / $10.402 billion = 0.55
  • 2011 - $6.176 billion / $11.668 billion = 0.53

In looking at Cummins total liabilities to total assets ratio we can see that the ratio has been slowly declining over the past 3 years. As these numbers are above .50 this indicates that Cummins Inc. 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 - $5.043 billion / $3.773 billion = 1.33
  • 2010 - $5.732 billion / $4.670 billion = 1.23
  • 2011 - $6.176 billion / $5.492 billion = 1.12

Cummins 2011 debt to equity is quite low at 1.12. 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. As the ratio has been declining over the past 3 years so has 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. 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 - $637 million / $4.410 billion = 0.14
  • 2010 - $709 million / $5.379 billion = 0.13
  • 2011 - $658 million / $6.150 billion = 0.11

Over the past 3 years Cummins Inc.'s capitalization ratio has been decreasing. This implies that the company has had more equity compared to 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, thus lowering 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 - $675 million / $35 million = 19.29
  • 2010 - $1.657 billion / $40 million = 41.43
  • 2011 - $2.715 billion / $44 million = 61.70

As the company's Interest Coverage Ratio is extremely high at 61.70, this indicates that Cummins Inc. is not burdened by debt expense. Cummins Inc. 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 - $1.137 billion / $674 million = 1.69
  • 2010 - $1.006 billion / $791 million = 1.27
  • 2011 - $2.073 billion / $686 million = 3.02

As the cash flow to debt ratio in the previous 3 years above 100% or 1, this implies that the company had 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 Cummins Inc has excellent results in regards to its debt ratios. All indications above reveal that Cummins Inc. 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.

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." Cummins Inc. has a rating that meets this description."

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

  • 2007 - $381 million / $1.169 billion = 32.59%
  • 2008 - $360 million / $1.178 billion = 30.56%
  • 2009 - $156 million / $640 million = 24.38%
  • 2010 - $477 million / $1.617 million = 29.50%
  • 2011 - $725 million / $2.671 million = 27.41%

5 year average = 28.89%

Over the past 5 years Cummins Inc. has averaged a tax rate of 28.89%.

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.

  • .0407 x (1 - .2889) = Cost of debt after tax

The cost of debt after tax for Cummins Inc. is 2.89%

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 = 1.70% (Bloomberg)
  • average market return 1950 - 2011 = 7%
  • Beta = (Google finance) Cummins Inc. beta = 2.01

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

  • 1.70 + 2.01 (7-1.70)
  • 1.70 + 2.01 x 5.30
  • 1.70 + 10.65 = 12.35%

Cummins Inc. has a cost of equity or R Equity of 12.35%. So investors should expect to get a return of 12.35% 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 - 2011 at 7%, the US 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 = 28.89% (Cummins Inc. 5 year average Tax Rate)

Cost of Debt (before tax) or R debt = 4.07%

Cost of Equity or R equity = 12.35%

Debt (Total Liabilities) for 2011 or D = $6.176 billion

Stock Price = $101.00 (August 9th 2012)

Outstanding Shares = 190.41 Million

Equity = Stock price x Outstanding Shares or E = $ 19.231 billion

Debt + Equity or D+E = $25.407 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 - .2889) x .0407 x ($6.176/$25.407) + .1235 ($19.231/$25.407)

.7111 x .0407 x .2431 + .1235 x .7569

.0070 + .0935

= 10.05%

Based on the calculations above we can arrive that Cummins Inc pays 10.05% on every dollar that it finances or .1005 on every dollar. From this calculation we understand that on every dollar the company spends on an investment the company must make $.1005, plus the cost of the investment for the investment to be feasible for the company.

Summary

In analyzing the company's total debt and liabilities, we can see that the company's total debt is quite low in relation to the size of the company. Even though the total debt amount is quite low, the total debt has increased by 20.77% since 2007. The liabilities have also increased by 29.08% over the past 5 years. Even though the debt and liabilities have increased by 20.77% and 29.08%, 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 Cummins Inc. 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 Cummins Inc.'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 Cummins Inc. is quite a volatile stock, the CAPM approach for cost of equity states that shareholders need 12.35% 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 calculation reveals that the company pays 10.05% on every dollar that it finances. As the current WACC of Cummins Inc is currently 10.05% and the beta is high at 2.01, it implies that the company needs 10.05% on future investments for the company and high volatility moving forward.

Based on the calculations above, the company has very manageable debt in comparison to the size of the company and currently has the capacity to make its debts payments, meet its tax obligations and is not in danger of bankruptcy.

The analysis of Cummins debt and liabilities indicates a very strong company with a manageable amount of debt and 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 a very manageable rate. Currently Cummins Inc. 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 Cummins Inc. please read my articles:

Cummins: Profitability Analysis

and

Cummins: Inside The Numbers

For other excellent articles on Cummins Inc. by other authors please read:

Does The Market Love Cummins Too Much?

Cummins Is A Bargain Right Now

and

Cummins Looks Ahead To Bright Future After Earnings Release

Source: Analyzing Cummins' Debt And Risk