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 Honeywell International's (HON) 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 - $5.419 billion + $2.238 billion = $7.657 billion
- 2008 - $5.865 billion + $2.510 billion = $8.375 billion
- 2009 - $6.246 billion + $1.361 billion = $7.607 billion
- 2010 - $5.755 billion + $889 million = $6.654 billion
- 2011 - $6.881 billion + $674 million = $7.555 billion
Honeywell International's total debt has decreased over the past five years. The company reported a five-year low of $6.654 billion in 2010, and a five-year high in 2008 at $8.375 billion. In 2011, the company reported a total debt of $7.555 billion, which was an decrease of 1.35% 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 - $24.583 billion
- 2008 - $28.303 billion
- 2009 - $27.160 billion
- 2010 - $27.168 billion
- 2011 - $29.002 billion
Honeywell's liabilities have increased from $24.583 billion in 2007, to $29.002 billion in 2011, an increase of 17.98%.
In analyzing the company's total debt and liabilities, we can see that the company currently has a moderate amount of debt at $7.555 billion and a large amount of liabilities at $29.002 billion for the size of the company. Over the past five years, the total debt has decreased by 1.35%, while total liabilities have increased by 17.98%. As the company's still has a moderate amount of debt and the liabilities have increased over the past five years, the next step will reveal if the company has the ability to pay for their debt and liabilities.
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 - $7.607 billion / $36.004 billion = 0.21
- 2010 - $6.654 billion / $37.834 billion = 0.18
- 2011 - $7.555 billion / $39.808 billion = 0.19
As Honeywell International's total-debt-to-total-assets ratio is well below 1 and dropping, this indicates that Honeywell 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 - $27.160 billion / $36.004 billion = 0.75
- 2010 - $27.168 billion / $37.834 billion = 0.72
- 2011 - $29.002 billion / $39.808 billion = 0.73
In looking at Honeywell'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 0.75 mark, this indicates that Honeywell has financed most of the company's assets through debt. As Honeywell's debt ratio is 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 - $27.160 billion / $8.844 billion = 3.07
- 2010 - $27.168 billion / $10.666 billion = 2.55
- 2011 - $29.002 billion / $10.806 billion = 2.68
Over the past three years, Honeywell International's debt-to-equity ratio has been moderately high. In 2011, the ratio was calculated at 2.68, as the ratio is well above 1 this indicates that suppliers, lenders, creditors and obligators have more equity invested than shareholders; 2.68 indicates a moderately high amount of risk for the company. As the ratio is well above 1 and considered moderately high, 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 - $6.246 billion / $15.090 billion = 0.41
- 2010 - $5.755 billion / $16.421 billion = 0.35
- 2011 - $6.881 billion / $17.687 billion = 0.39
Over the past three years, Honeywell's capitalization ratio has been between .41 to .35. This implies that the company has had relatively the same amount of equity compared with its long-term debt. As this is the case, the company has had around the same amount of equity to support its operations and add growth through its equity. As the ratio has been relatively the same 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 - $3.437 billion / $459 million = 7.49
- 2010 - $3.229 billion / $386 million = 8.36
- 2011 - $2.658 billion / $376 million = 7.07
Honeywell's interest coverage ratio has ranged between 7.07 and 8.36 over the past 3 years. As the interest ratio has been 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 - $3.946 billion / $7.607 billion = 0.52
- 2010 - $4.203 billion / $6.654 billion = 0.63
- 2011 - $2.833 billion / $7.555 billion = 0.37
Over the past 3 years the cash flow to total debt ranged between .63 to .37. As the ratio is well below 1 this 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 Honeywell International has very stable results in regards to its debt ratios. As the ratios results are very stable, this indicates that Honeywell 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.
- S&P rated Honeywell's bonds "A"
- Current 20-year corporate bond Rate of "A" = 3.83%
- Current cost of Debt as of September 3rd 2012 = 3.83%
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." Honeywell Company has a rating that meets this description.
10. Current tax rate ( Income Tax total / Income before Tax)
- 2007 - $877 million / $3.321 billion = 26.41%
- 2008 - $1.009 billion / $3.801 billion = 26.55%
- 2009 - $789 million / $2.978 billion = 26.49%
- 2010 - $808 million / $2.843 billion = 28.42%
- 2011 - $417 million / $2.282 billion = 18.27%
5-year average = 25.22%
Over the past five years, Honeywell International has averaged a tax rate of 25.22%.
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.
- .0383 x (1 - .2522) = Cost of debt after tax
The cost of debt after tax for Honeywell International 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 = U.S. 10-year bond = 1.58% (Bloomberg)
- average market return 1950 - 2011 = 7%
- Beta = (Google Finance) Honeywell International beta = 1.35
Risk free rate + Beta equity (Average market return - Risk free rate)
- 1.58 + 1.35 (7-1.58)
- 1.58 + 1.35 x 5.42
- 1.58 + 7.32 = 8.90%
Honeywell International has a cost of equity or R Equity of 8.90%. So investors should expect to get a return of 8.90% 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 = 25.22% (Honeywell's five-year average Tax Rate)
Cost of Debt (before tax) or R debt = 3.83%
Cost of Equity or R equity = 8.90%
Debt (Total Liabilities) for 2011 or D = $29.002 billion
Stock Price = $58.45 (September 3rd, 2012)
Outstanding Shares = 780.57 Million
Equity = Stock price x Outstanding Shares or E = $45.624 billion
Debt + Equity or D+E = $74.626 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 - .2522) x .0383 x ($29.002/$74.626) + .0890 ($45.624/$74.626)
.7478 x .0383 x .3886 + .0890 x .6113
.0111 + .0544
Based on the calculations above, we can arrive that Honeywell International pays 6.55% on every dollar that it finances or .0655 on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0655, 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 moderate amount of debt at $7.555 billion and a large amount of liabilities at $29.002 billion for the size of the company. Over the past five years, the total debt has decreased by 1.35%, while total liabilities have increased by 17.98%.
Based on the above six debt ratios, we can see that Honeywell International has very stable results in regards to its debt ratios. Based on the good results from the ratios above, this indicates that Honeywell has the ability to pay for its debt and is not on the verge of bankruptcy.
As Honeywell's bond rating currently stands at "A" this indicates that the company has a "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 8.90% 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 6.55% on every dollar that it finances. As the current WACC of Honeywell International is currently 6.55% and the beta is above average at 1.35, it implies that the company needs 6.55% on future investments and will have above average volatility moving forward.
Based on the calculations above, the company has a moderate amount of debt and a large amount of liabilities 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 Honeywell International's debt and liabilities indicates a strong company with a manageable amount of debt and liabilities. The analysis also reveals the company is strong and stable in regards to the debt ratios. The WACC reveals that Honeywell also and has the ability to add future investments and assets at reasonably low rates. Currently, Honeywell International 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 low risk.
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