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 General Electric's (NYSE:GE) 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 - $319.015 billion + $195.101 billion = $514.116 billion
- 2008 - $330.067 billion + $193.695 million = $523.762 billion
- 2009 - $338.215 billion + $133.054 billion = $471.269 billion
- 2010 - $323.383 billion + $107.750 million = $431.133 billion
- 2011 - $272.717 billion + $137.611 billion = $410.328 billion
GE's total debt has been decreasing over the past five years. In 2007, GE reported a total debt of $514.116 billion. In 2011, the company reported a total debt of $410.328 billion. Even though this is a still a very high number, the total debt has decreased by 20% since 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 - $671.774 billion
- 2008 - $684.157 billion
- 2009 - $656.682 billion
- 2010 - $623.595 billion
- 2011 - $599.108 billion
GE's liabilities have decreased from $671.774 billion in 2007 to $599.108 billion in 2011, a decrease of 10.82%.
In analyzing GE's total debt and liabilities, we can see that the company currently has a very large amount of debt at $410.328 billion and a very large amount of liabilities at $599.108 billion. Over the past five years, the total debt has decreased by 20%, while total liabilities have decreased by 10.82%. As the company has a very large amount of debt and a very large amount of liabilities, the next step will reveal if the company has the ability to pay for their them.
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 - $471.269 billion / $781.818 billion = 0.60
- 2010 - $431.133 billion / $747.793 billion = 0.58
- 2011 - $410.328 billion / $717.242 billion = 0.57
As GE's total-debt-to-total-assets ratio has been declining and is below 1, this states that GE's total debt has been decreasing faster than its total assets. As the number is currently below 1 and decreasing this states that the risk to the company regarding its debt to assets has been decreasing over the past three years.
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 is 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 - $656.682 billion / $781.818 billion = 0.84
- 2010 - $623.595 billion / $747.793 billion = 0.83
- 2011 - $599.108 billion / $717.242 billion = 0.84
In looking at GE's total liabilities to total assets ratio, we can see that the ratio has remained relatively the same over the past three years. As these numbers are above the 0.50 mark, this indicates that GE has financed most of the company's assets through debt. As GE's debt ratio is currently below 1 but still high, this implies that the company currently is not in danger of becoming insolvent and/or going bankrupt but is close to being considered "highly leveraged" and still has a significant amount of risk.
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 - $656.682 billion / $117.291 billion = 5.60
- 2010 - $623.595 billion / $118.936 billion = 5.24
- 2011 - $599.108 billion / $116.438 billion = 5.15
Over the past three years, GE's debt-to-equity ratio has been decreasing. The debt-to-equity ratio has dropped from 5.60 in 2007 to 5.15 in 2011. As the ratio was well above 1, this indicates that suppliers, lenders, creditors and obligators have more equity invested than shareholders. 5.15 indicates a higher amount of risk for the company. As the ratio is above 1 and considered quite 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 - $338.215 billion / $455.506 billion = 0.74
- 2010 - $323.383 billion / $442.319 billion = 0.73
- 2011 - $272.717 billion / $389.155 billion = 0.70
Over the past three years, GE's capitalization ratio has decreased from 0.74 to 0.70. 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 decreasing 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 - $24.417 billion / $471.269 billion = 0.05
- 2010 - $36.124 billion / $431.133 billion = 0.08
- 2011 - $33.359 billion / $410.328 billion = 0.08
Over the past three years, the cash flow to total debt ratio has increased from 0.05 to 0.08. The increase is positive, but as the ratio is still well below 1, this implies that the company does not have the ability to cover its total debt with its yearly cash flow from operations.
Based on the above five debt ratios listed above, we can see that GE still carries a large amount of risk. Even though most of the ratios have been improving over the past three years, the ratios still indicate a higher amount of risk. Having stated that, the company is improving its debt ratios thus indicating that GE is paying for its debt and is reducing its overall debt. 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.
8. Cost of debt (before tax) = Corporate Bond rate of company's bond rating.
- S&P rated GE bonds "AA+"
- Current 20-year corporate bond Rate of "AA" = 3.48%
- Current cost of Debt as of October 4th 2012 = 3.48%
According to the S&P rating guide, the "AA" rating is - "Very strong capacity to meet financial commitments." GE has a rating that meets this description.
9. Current tax rate ( Income Tax total / Income before Tax)
- 2007 - $4.130 billion / $26.598 billion = 15.52%
- 2008 - $1.052 billion / $19.141 billion = 5.50%
- 2009 - $(1.090) billion / $10.344 billion = -10.53%
- 2010 - $1.050 billion / $14.208 billion = 7.39%
- 2011 - $5.732 billion / $20.098 billion = 28.52%
5-year average subtracting 2009 = 14.32%
Over the past five years subtracting 2009, GE has averaged a tax rate of 14.32%.
10. 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.
- .0348 x (1 - .1432) = Cost of debt after tax
The cost of debt after tax for GE's is 2.98%
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 = 1.64% (Bloomberg)
- Average market return 1950 - 2011 = 7%
- Beta = (Google Finance) GE's beta = 1.59
Risk free rate + Beta equity (Average market return - Risk free rate)
- 1.64 + 1.59 (7-1.64)
- 1.64 + 1.59 x 5.36
- 1.64 + 6.95 = 8.59%
GE has a cost of equity or R Equity of 8.59%, so investors should expect to get a return of 8.59% 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 = 14.32% (GE's five-year average Tax Rate)
Cost of Debt (before tax) or R debt = 3.48%
Cost of Equity or R equity = 8.59%
Debt (Total Liabilities) for 2011 or D = $410.328 billion
Stock Price = $22.96 (October 4th, 2012)
Outstanding Shares = 10.56 billion
Equity = Stock price x Outstanding Shares or E = $242.457 billion
Debt + Equity or D+E = $652.785 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 - .1432) x .0348 x ($410.328/$652.785) + .0859 ($242.457/$652.785)
.8568 x .0348 x .6286 + .0859 x .3714
.0187 + .0319
Based on the calculations above, we can conclude that GE pays 5.06% on every dollar that it finances, or 5.06 cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0506 plus the cost of the investment for the investment to be feasible for the company.
In analyzing GE's total debt and liabilities, we can see that the company currently has a very large amount of debt at $410.328 billion and a very large amount of liabilities at $599.108 billion. Over the past five years, the total debt has decreased by 20%, while total liabilities have decreased by 10.82%.
Based on the above five debt ratios, we can see that GE is improving regarding its debt ratios. Even though the ratios are still quite high and in some cases reveal a significant amount of risk, the ratios are getting better. Based on the improving results from the ratios above, this indicates that currently GE currently has the ability to pay for its debts.
As GE'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 8.59% 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 5.06% on every dollar that it finances. As the current WACC of GE is currently 5.06% and the beta is above average at 1.59, this implies that the company needs at least 5.06% on future investments and will have above average volatility moving forward.
Based on the calculations above, the company has a large amount of debt and a large amount liabilities, but currently has the capacity to make its debt payments and meet its tax obligations.
The analysis of GE's debt and liabilities indicates a company with a very large amount of debt and a very large amount of liabilities. The analysis also reveals the company is showing improving results regarding the debt ratios. The Bond rating of "AA+" by S&P indicates that a company has a "Very strong capacity to meet financial commitments." The WACC reveals that GE has the ability to add future investments and assets at low rates. Currently, GE has the ability to pay for its debts and improve its debt ratios thus lowering its risk to shareholders.