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 Chevron Corporation's (CVX) 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
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 - $6.070 billion + $1.162 billion = $7.232 billion
- 2008 - $6.083 billion + $2.818 billion = $8.901 billion
- 2009 - $10.130 billion + $384 million = $10.514 billion
- 2010 - $11.289 billion + $187 million = $11.476 billion
- 2011 - $9.812 billion + $340 million = $10.152 billion
Chevron's total debt has increased over the past five years. The company reported a five-year low of $7.232 billion in 2007, and a five-year high in 2010 at $11.476 billion. In 2011, the company reported a total debt of $10.152 billion, which was an increase of 40.38% 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 - $71.698 billion
- 2008 - $74.517 billion
- 2009 - $72.707 billion
- 2010 - $79.688 billion
- 2011 - $88.092 billion
Chevron's liabilities have increased from $71.698 billion in 2007, to $88.092 billion in 2011, an increase of 22.87%.
In analyzing the company's total debt and liabilities, we can see that the company currently has a moderate amount of debt at $10.152 billion and a large amount of liabilities at $88.092 billion. Over the past five years, the total debt has increased by 40.38%, while total liabilities have increased by 22.87%. As the company's has a moderate amount of debt and a large amount of liabilities, 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 - $10.514 billion / $164.621 billion = 0.06
- 2010 - $11.476 billion / $184.769 billion = 0.06
- 2011 - $10.152 billion / $209.474 billion = 0.05
As Chevron's total-debt-to-total-assets ratio is very low and well below 1, this indicates that Chevron 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 - $72.707 billion / $164.621 billion = 0.44
- 2010 - $79.688 billion / $184.769 billion = 0.43
- 2011 - $88.092 billion / $209.474 billion = 0.42
In looking at Chevron's total liabilities to total assets ratio, we can see that the ratio has declined very slightly over the past three years. As these numbers are below the 0.50 mark, this indicates that Chevron has financed some of the company's assets through debt. As Chevron'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 - $72.707 billion / $91.914 billion = 0.79
- 2010 - $79.688 billion / $105.081 billion = 0.76
- 2011 - $88.092 billion / $121.382 billion = 0.73
Over the past three years, Chevron's debt-to-equity ratio has been decreasing. The company's debt-to-equity ratio has dropped from 0.79 to 0.73. In 2011, the ratio was calculated at 0.73, as the ratio was below 1 this indicates that suppliers, lenders, creditors and obligators have less equity invested than shareholders; 0.73 indicates a moderately low amount of risk for the company. As the ratio is below 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 - $10.130 billion / $102.044 billion = 0.10
- 2010 - $11.289 billion / $116.370 billion = 0.10
- 2011 - $9.812 billion / $131.194 billion = 0.07
Over the past three years, Chevron's capitalization ratio has dropped from 0.10 to .07. This implies that the company has had more equity compared with 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. As the ratio has been dropping and is very low so has the company's risk.
7. 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 - $19.373 billion / $10.514 billion = 1.84
- 2010 - $31.359 billion / $11.476 billion = 2.73
- 2011 - $41.098 billion / $10.152 billion = 4.04
Over the past three years, the cash flow to total debt ratio has increased from 1.84 to 4.04. As the ratio is well above 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 five debt ratios, we can see that Chevron has extremely strong results in regards to its debt ratios. As the ratios results are very strong, this indicates that Chevron has the ability to pay for its debt, has the ability to cover its total debt from operating cash flow 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 Chevron bonds "AA"
- Current 20-year corporate bond Rate of "AA" = 3.64%
- Current cost of Debt as of September 15th 2012 = 3.64%
According to the S&P rating guide, the "AA" rating is - "Very strong capacity to meet financial commitments." Chevron has a rating that meets this description.
10. Current tax rate ( Income Tax total / Income before Tax)
- 2007 - $13.479 billion / $32.274 billion = 41.76%
- 2008 - $19.026 billion / $43.057 billion = 44.19%
- 2009 - $7.965 billion / $18.528 billion = 42.99%
- 2010 - $12.919 billion / $32.055 billion = 40.30%
- 2011 - $20.626 billion / $47.634 billion = 43.30%
5-year average = 42.50%
Over the past five years, Chevron has averaged a tax rate of 42.50%.
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.
- .0364 x (1 - .4250) = Cost of debt after tax
The cost of debt after tax for Chevron is 2.09%
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 = 1.87% (Bloomberg)
- average market return 1950 - 2011 = 7%
- Beta = (Google Finance) Chevron's beta = 0.79
Risk free rate + Beta equity (Average market return - Risk free rate)
- 1.87 + 0.79 (7-1.87)
- 1.87 + 0.79 x 5.22
- 1.87 + 4.12 = 5.99%
Chevron has a cost of equity or R Equity of 5.99%. So investors should expect to get a return of 5.99% per year average 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 = 42.50% (Chevron's five-year average Tax Rate)
Cost of Debt (before tax) or R debt = 3.64%
Cost of Equity or R equity = 5.99%
Debt (Total Liabilities) for 2011 or D = $88.092 billion
Stock Price = $117.25 (September 15th, 2012)
Outstanding Shares = 1.96 billion
Equity = Stock price x Outstanding Shares or E = $229.81 billion
Debt + Equity or D+E = $317.902 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 - .425) x .0364 x ($88.092/$317.902) + .0599 ($229.81/$317.902)
.575 x .0364 x .2796 + .0599 x .7229
.0058 + .0433
Based on the calculations above, we can arrive that Chevron's pays 4.91% on every dollar that it finances or .0491 on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0491, 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 $10.152 billion and a large amount of liabilities at $88.092 billion. Over the past five years, the total debt has increased by 40.38%, while total liabilities have increased by 22.87%.
Based on the above five debt ratios, we can see that Chevron has had strong results regarding its debt ratios. Based on the strong results from the ratios above, this indicates that Chevron has the ability to pay for its debts.
As Chevron'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 5.99% average per year 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 4.91% on every dollar that it finances. As the current WACC of Chevron is currently 4.91% and the beta is below average at 0.79, this implies that the company needs at least 4.91% on future investments and will have below average volatility moving forward.
Based on the calculations above, the company has a moderate amount of debt and a large amount of liabilities, but currently the company has the capacity to make its debts payments, meet its tax obligations and is not in danger of bankruptcy.
The analysis of Chevron's debt and liabilities indicates a very strong company, with a very manageable amount of debt and liabilities for the company. The analysis also reveals the company is strong and stable regarding the debt ratios. The WACC reveals that Chevron also and has the ability to add future investments and assets at low rates. Currently, Chevron 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 another article on Chevron please read: Chevron: Inside The Numbers.