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 a 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 Southern Company's (SO) 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.
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 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.
- 2007 - $14.143 billion + $2.450 billion = $16.593 billion
- 2008 - $16.816 billion + $1.570 billion = $18.386 billion
- 2009 - $18.131 billion + $1.752 billion = $19.883 billion
- 2010 - $18.154 billion + $2.598 billion = $20.572 billion
- 2011 - $18.647 billion + $2.576 billion = $21.223 billion
Southern Company's total debt has increased over the past five years. The company reported a five-year low of $16.593 billion in 2007, and a five-year high in 2011 at $21.223 billion. In 2011 the company reported a total debt of $21.223 billion, which was an increase of 27.90% over 2007.
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.
- 2007 - $33.404 billion
- 2008 - $35.071 billion
- 2009 - $36.461 billion
- 2010 - $38.123 billion
- 2011 - $40.982 billion
Southern Company's liabilities have increased from $33.404 billion in 2007, to $40.982 billion in 2011, an increase of 22.68%.
In analyzing the company's total debt and liabilities, we can see that the company currently has a large amount of debt at $21.223 billion and a very sizable amount of liabilities at $40.982 billion. Over the past five years, the total debt has increased by 27.90%, while total liabilities have increased by 22.68%. As most of the debt and liabilities were acquired in the acquisition 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 - $19.883 billion / $52.046 billion = 0.38
- 2010 - $20.572 billion / $55.032 billion = 0.37
- 2011 - $21.223 billion / $59.267 billion = 0.36
As Southern Company's total-debt-to-total-assets ratio is well below 1, this indicates that Southern Company has many more assets than total debt, ensuring that the company is currently in good financial condition.
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 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 - $36.461 billion / $52.046 billion = 0.70
- 2010 - $38.123 billion / $55.032 billion = 0.69
- 2011 - $40.982 billion / $59.267 billion = 0.69
In looking at Southern Company's total liabilities to total assets ratio, we can see that the ratio has remained almost the same over the past 3 years. As these numbers are above 0.50, this indicates that Southern Company has financed most of the company's assets through debt. As Southern Company's debt ratio is well below 1 this implies that the company is not in danger of becoming insolvent and/or going bankrupt.
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.
- 2009 - $36.461 billion / $15.585 billion = 2.34
- 2010 - $38.123 billion / $16.909 billion = 2.25
- 2011 - $40.982 billion / $18.285 billion = 2.24
Since 2009 the company's debt-to-equity ratio has been dropping but is still moderately high at 2.24. As the ratio is above 1 this indicates that suppliers, lenders, creditors and obligators have more equity invested than shareholders. This also indicates a moderate amount of risk for the company. As the ratio is above 1 and considered moderated, 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. 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 - $18.131 billion / $33.716 billion = 0.54
- 2010 - $18.154 billion / $35.063 billion = 0.52
- 2011 - $18.647 billion / $39.932 billion = 0.47
Over the past three years, Southern Company's capitalization ratio has been decreasing. This implies that the company has had slightly more equity compared with its long-term debt. As this is the case, the company has had slightly more equity to support its operations and add growth through its equity. As the ratio has been decreasing so has 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 - $3.509 billion / $905 million = 3.88
- 2010 - $3.961 billion / $895 million = 4.43
- 2011 - $4.344 billion / $857 million = 5.06
Southern Company's interest coverage ratio has been increasing over the past 3 years. As the interest ratio has been increasing and is well over 1.5, this implies that the company is not burdened by debt expenses.
8. 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.
- 2009 - $3.263 billion / $19.883 billion = 0.16
- 2010 - $3.991 billion / $20.572 billion = 0.19
- 2011 - $5.903 billion / $21.223 billion = 0.28
As the cash flow to debt ratio in the previous three years is below 100% or 1, this implies that the company has not 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 Southern Company has strong results in regards to its debt ratios. As the ratios results are relatively strong, this indicates that Southern Company 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 with 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 Southern Company. bonds "A"
- Current 20-year corporate bond Rate of "A" = 4.00%
- Current cost of Debt as of August 22nd 2012 = 4.00%
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." Southern Company has a rating that meets this description.
10. Current tax rate ( Income Tax total / Income before Tax)
- 2007 - $835 million / $2.617 billion = 31.91%
- 2008 - $915 million / $2.722 billion = 33.61%
- 2009 - $896 million / $2.604 billion = 34.41%
- 2010 - $1.026 billion / $3.066 billion = 33.46%
- 2011 - $1.219 billion / $3.487 billion = 34.96%
5-year average discounting 2009 = 33.67%
Over the past five years, Southern Company has averaged a tax rate of 33.67%.
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.
- .0400 x (1 - .3367) = Cost of debt after tax
The cost of debt after tax for Southern Company is 2.65%
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 = 1.69% (Bloomberg)
- average market return 1950 - 2011 = 7%
- Beta = (Google Finance) Southern Company beta = 0.27
Risk free rate + Beta equity (Average market return - Risk free rate)
- 1.69 + 0.27 (7-1.69)
- 1.69 + 0.27 x 5.31
- 1.69 + 1.43 = 3.12%
Southern Company has a cost of equity or R Equity of 3.12%. So investors should expect to get a return of 3.12% 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 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 = 33.67% (Southern Company's five-year average Tax Rate)
Cost of Debt (before tax) or R debt = 4.00%
Cost of Equity or R equity = 3.12%
Debt (Total Liabilities) for 2011 or D = $40.982 billion
Stock Price = $45.88 (August 25, 2012)
Outstanding Shares = 874.80 Million
Equity = Stock price x Outstanding Shares or E = $ 40.135 billion
Debt + Equity or D+E = $81.117 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 - .3367) x .0400 x ($40.982/$81.117) + .0312 ($40.135/$81.117)
.6633 x .0400 x .5052 + .0312 x .4947
.0134 + .0154
Based on the calculations above, we can arrive that Southern Company pays 2.88% on every dollar that it finances or .0288 on every dollar. From this calculation we understand that on every dollar the company spends on an investment, the company must make $.0288, 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 can see that the company currently has a large amount of debt at $21.223 billion and a sizable amount of liabilities at $40.982 billion. Over the past five years, the total debt has increased by 27.90%, while the total liabilities have increased by 22.68%. Even though the debt and liabilities have increased by 27.90% and 22.68% , much of this debt was incurred by the purchase of assets in the anticipation of growing and improving the company.
Based on the above six debt ratios, we can see that Southern Company has relatively strong results in regards to its debt ratios. The analysis of the ratios also revealed that the company does use debt to finance its assets but based on the results indicated above, the ratios look to be strong. Based on the strong results from the ratios above, this indicates that Southern Company has the ability to pay for its debt and is not on the verge of bankruptcy.
As Southern Company's bond rating currently stands at "A" this indicates that the company has "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 3.12% 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 2011 at 7%.
The WACC calculation reveals that the company pays 2.88% on every dollar that it finances. As the current WACC of Southern Company is currently 2.88% and the beta is very low at 0.27, it implies that the company needs 2.88% on future investments and will have very low volatility moving forward.
Based on the calculations above, the company has a sizable amount of debt in comparison to the size of the company but currently, has the capacity to make its debts payments, meet its tax obligations and is not in danger of bankruptcy.
The analysis of Southern Company's debt and liabilities indicates a strong company with a sizable amount of debt but currently has the ability to pay for it. The analysis also reveals the company is very strong in regards to the debt ratios. The WACC reveals that Southern Company also and has the ability to add future investments and assets at very low rates. Currently, Southern Company 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 very low risk.
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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.