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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 a key component in understanding the risk of a company, thus aiding in the 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 3M Company's (MMM) 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 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 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 - $4.088 billion + $901 million = $4.989 billion
  • 2008 - $5.224 billion + $1.552 billion = $6.776 billion
  • 2009 - $5.204 billion + $613 million = $5.817 billion
  • 2010 - $4.277 billion + $1.269 billion = $5.546 billion
  • 2011 - $4.563 billion + $682 million = $5.245 billion

3M Company's total debt has increased over the past five years. The company reported a five-year low of $4.989 billion in 2007, and a five-year high in 2008 at $6.776 billion. In 2011, the company reported a total debt of $5.245 billion, which was an increase of 5.13% 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 - $12.947 billion
  • 2008 - $15.668 billion
  • 2009 - $14.486 billion
  • 2010 - $14.493 billion
  • 2011 - $16.196 billion

3M's liabilities have increased from $12.947 billion in 2007, to $16.196 billion in 2011, an increase of 25.09%.

In analyzing the company's total debt and liabilities, we can see that the company currently has a moderate amount of debt at $5.245 billion and a moderate amount of liabilities at $16.196 billion for the size of the company. Over the past five years, the total debt has increased by 5.13%, while total liabilities have increased by 25.09%. As the company's debt and liabilities have increased over the past five years, the next step will reveal if the company has the ability to pay for these debts.

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 - $5.817 billion / $27.250 billion = 0.21
  • 2010 - $5.546 billion / $30.156 billion = 0.18
  • 2011 - $5.245 billion / $31.616 billion = 0.17

As 3M Company's total-debt-to-total-assets ratio is well below 1 and dropping, this indicates that 3M 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 - $14.486 billion / $27.250 billion = 0.53
  • 2010 - $14.493 billion / $30.156 billion = 0.48
  • 2011 - $16.196 billion / $31.616 billion = 0.51

In looking at 3M'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 around 0.50 mark, this indicates that 3M has financed some of the company's assets through debt. As 3M'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 - $14.486 billion / $12.764 billion = 1.13
  • 2010 - $14.493 billion / $15.663 billion = 0.93
  • 2011 - $16.196 billion / $15.420 billion = 1.05

Over the past three years, 3M company's debt-to-equity ratio has been around 1. In 2011, the ratio was calculated at 1.05, as the ratio is slightly above 1 this indicates that suppliers, lenders, creditors and obligators have slightly more equity invested than shareholders; 1.05 indicates a moderately low amount of risk for the company. As the ratio has been around 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.

  • 2009 - $5.204 billion / $17.968 billion = 0.28
  • 2010 - $4.277 billion / $19.940 billion = 0.21
  • 2011 - $4.563 billion / $19.983 billion = 0.23

Over the past three years, 3M's capitalization ratio has decreased slightly. 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 - $4.851 billion / $219 million = 22.15
  • 2010 - $5.956 billion / $201 million = 29.63
  • 2011 - $6.217 billion / $186 million = 33.42

3M'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 - $4.941 billion / $5.817 billion = 0.85
  • 2010 - $5.174 billion / $5.546 billion = 0.93
  • 2011 - $5.284 billion / $5.245 billion = 1.01

In 2011, 3M's cash flow to debt ratio was just above 100% or 1, this implies that in 2011 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 3M Company has very strong results in regards to its debt ratios. As the ratios results are very strong, this indicates that 3M has the ability to pay for its debt, is not burdened by tax expenses, 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.

According to the S&P rating guide, the "AA-" rating is - "Very strong capacity to meet financial commitments." 3M Company has a rating that meets this description. (Please note: As AA- was not listed, I used the AA rating for this section.)

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

  • 2007 - $1.964 billion / $6.115 billion = 32.11%
  • 2008 - $1.588 billion / $5.108 billion = 31.08%
  • 2009 - $1.388 billion / $4.632 billion = 29.97%
  • 2010 - $1.592 billion / $5.755 billion = 27.66%
  • 2011 - $1.674 billion / $6.031 billion = 27.76%

5-year average = 29.71%

Over the past five years, 3M has averaged a tax rate of 29.71%.

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.

  • .0354 x (1 - .2971) = Cost of debt after tax

The cost of debt after tax for 3M is 2.49%

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 = 1.62% (Bloomberg)
  • average market return 1950 - 2011 = 7%
  • Beta = (Google Finance) 3M Company beta = 0.86

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

  • 1.62 + 0.86 (7-1.62)
  • 1.62 + 0.86 x 5.38
  • 1.62 + 4.63 = 6.25%

3M Company has a cost of equity or R Equity of 6.25%. So investors should expect to get a return of 6.25% 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 = 29.71% (3M Company's five-year average Tax Rate)

Cost of Debt (before tax) or R debt = 3.54%

Cost of Equity or R equity = 6.25%

Debt (Total Liabilities) for 2011 or D = $16.196 billion

Stock Price = $92.02 (August 30, 2012)

Outstanding Shares = 691.32 Million

Equity = Stock price x Outstanding Shares or E = $63.615 billion

Debt + Equity or D+E = $79.811 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 - .2971) x .0354 x ($16.196/$79.811) + .0625 ($63.615/$79.811)

.7029 x .0354 x .2029 + .0625 x .7970

.0050 + .0498

= 5.48%

Based on the calculations above, we can arrive that 3M Company pays 5.48% on every dollar that it finances or .0548 on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0548, 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 currently has a moderate amount of debt at $5.245 billion and a moderate amount of liabilities at $16.196 billion for the size of the company. Over the past five years, the total debt has increased by 5.13%, while total liabilities have increased by 25.09%. Even though the debt and liabilities have increased by 5.13% and 25.09% , much of this debt was incurred in the anticipation of growing and improving the company.

Based on the above six debt ratios, we can see that 3M Company has very strong results in regards to its debt ratios. Based on the strong results from the ratios above, this indicates that 3M Company has the ability to pay for its debt and is not on the verge of bankruptcy.

As 3M Company's bond rating currently stands at "AA-" this indicates that the company has a "Very strong capacity to meet financial commitments."

The CAPM approach for cost of equity states that shareholders need 6.25% 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 5.48% on every dollar that it finances. As the current WACC of 3M Company is currently 5.48% and the beta is moderate at 0.86, it implies that the company needs 5.48% on future investments and will have moderate volatility moving forward.

Based on the calculations above, the company has a moderate amount of 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 3M Company's debt and liabilities indicates a strong company with a manageable amount of debt. The analysis also reveals the company is very strong in regards to the debt ratios. The WACC reveals that 3M also and has the ability to add future investments and assets at low rates. Currently, 3M 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 low risk.

For other articles on 3M please read: 3M: Profitability Analysis and 3M Company: Inside The Numbers. For excellent articles by other authors please read: 3M Can Lead The Way From Here and 3M Company Dividend Stock Analysis.

Source: Analyzing 3M Company's Debt And Risk