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 Baker Hughes (NYSE:BHI) 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 such as Weatherford International (NYSE:WFT), Halliburton (HAL) and Schlumberger (NYSE:SLB) you will be able see which company has the most debt, thus adding to the company's risk.

All material is sourced from Google Finance, Morningstar and the company webpage.

*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 - $1.069 billion + $15 million = $1.084 billion
- 2008 - $1.775 billion + $558 billion = $2.333 billion
- 2009 - $1.785 billion + $15 million = $1.800 billion
- 2010 - $3.554 billion + $331 million = $3.885 billion
- 2011 - $3.845 billion + $224 million = $4.069 billion

Over the past 5 years Baker Hughes' total debt has been steadily increasing. In 2007, the company reported a total debt of $1.084 billion. In 2011, the company reported a total debt of $4.069 billion. Over the past 5 years Baker Hughes' total debt has increased by 375.37%.

*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 - $3.551 billion
- 2008 - $5.054 billion
- 2009 - $4.155 billion
- 2010 - $8.886 billion
- 2011 - $9.101 billion

Baker Hughes' liabilities have increased significantly over the past 5 years. In 2007, the company reported liabilities at $3.551 billion; in 2011, the company reported liabilities at $9.101 billion. This is an increase of 256.29%.

In analyzing Baker Hughes' total debt and liabilities, we can see that the company currently has a total debt of $4.069 billion and liabilities at $9.101 billion. Over the past five years, the total debt has increased by 375.37%, while total liabilities have increased by 256.29%. As the company's amount of debt and amount of liabilities have increased significantly over the past 5 years, the next step will reveal if the company has the ability to pay for their it.

## 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 - $1.800 billion / $11.439 billion = 0.16
- 2010 - $3.885 billion / $22.986 billion = 0.17
- 2011 - $4.069 billion / $24.847 billion = 0.16

Baker Hughes' total-debt-to-total-assets ratio has remained relatively the same over the past 3 years. Even though the company added a significant amount of debt when they acquired BJ Services, the assets that they acquired also kept up with the debt load. As this ratio has remained the same over the past 3 years, this states that Baker Hughes total debt has been increasing at the same rate than its assets. As the number is currently below 1, this states that the company has more assets than total debt.

*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 - $4.155 billion / $11.439 billion = 0.36
- 2010 - $8.886 billion / $22.986 billion = 0.39
- 2011 - $9.101 billion / $24.847 billion = 0.37

Like the total debt to total assets ratio, the total liabilities to total assets ratio has remained relatively the same over the past 3 years. As these numbers are below the 0.50 mark, this indicates that Baker Hughes has not financed most of the company's assets through debt. 0.37 indicates a lower amount of risk for the company.

*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 - $4.155 billion / $7.284 billion = 0.57
- 2010 - $8.886 billion / $14.100 billion = 0.63
- 2011 - $9.101 billion / $15.746 billion = 0.58

Over the past three years, Baker Hughes' debt-to-equity ratio has remained relatively steady. The ratio has bounced between 0.63 and 0.57. As the most current ratio is below 1, this indicates that shareholders have more invested than suppliers, lenders, creditors and obligators. 0.58 indicates a lower amount of 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 - $1.785 billion / $9.069 billion = 0.20
- 2010 - $3.554 billion / $17.654 billion = 0.20
- 2011 - $3.845 billion / $19.591 billion = 0.20

Over the past three years, Baker Hughes ratio has remained the same at 0.20. This states that the company has had the same amount equity compared with its long-term debt. As this is the case, the company has had the same amount of equity to support its operations and add growth. As the ratio is low this implies a low amount of risk to the company.

*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 - $1.239 billion / $1.800 billion = 0.68
- 2010 - $856 million / $3.885 billion = 0.22
- 2011 - $1.507 billion / $4.069 billion = 0.37

Over the past three years, the cash flow to total debt ratio has ranged from 0.68 to 0.22. As the ratio is 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 five debt ratios listed above, we can see that Baker Hughes' ratios have been relatively the same over the past 3 years. Even though the debt and liabilities have increased by 375.37% and 256.29%, the ratios indicate, the company's equity and assets have kept up. This indicates that over the past 3 years, the company's growth has increased about the same as the debt and liabilities. As this is the case, the ratios indicate about the same financial risk to the company as they did 3 years ago. 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 Baker Hughes bonds "A"
- Current 20-year corporate bond Rate of "A" = 3.70%
- Current cost of Debt as of November 2nd 2012 = 3.70%

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." Baker Hughes has a rating that meets this description.

*9. Current tax rate ( Income Tax total / Income before Tax)*

- 2007 - $743 million / $2.257 million = 32.92%
- 2008 - $684 million / $2.319 billion = 29.50%
- 2009 - $190 million / $611 billion = 31.10%
- 2010 - $463 million / $1.282 billion = 36.12%
- 2011 - $596 million / $2.339 billion = 25.48%

5-year average = 31.02%

Over the past five years, Baker Hughes has averaged a tax rate of 31.02%.

*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.

- .0370 x (1 - .3102) = Cost of debt after tax

The cost of debt after tax for Baker Hughes is *2.55%*

**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 = 1.77% (Bloomberg)
- Average market return 1950 - 2011 = 7%
- Beta = (Google Finance) Baker Hughes beta = 1.56

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

- 1.77 + 1.56 (7-1.77)
- 1.77 + 1.56 x 5.23
- 1.77 + 8.16 = 9.93%

Baker Hughes has a cost of equity or R Equity of 9.93%, so investors should expect to get a return of 9.93% 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 = 31.02% (Baker Hughes five-year average Tax Rate)

Cost of Debt (before tax) or **R debt** = 3.70%

Cost of Equity or **R equity** = 9.93%

Debt (Total Liabilities) for 2011 or **D** = $9.101 billion

Stock Price = $42.55 (November 2nd, 2012)

Outstanding Shares = 439.65 million

Equity = Stock price x Outstanding Shares or **E** = $18.707 billion

Debt + Equity or **D+E** = $27.808 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 - .3102) x .0370 x ($9.101/$27.808) + .0993 ($18.707/$27.808)

.6898 x .0370 x .3273 + .0993 x .6727

.0084 + .0668

= 7.52%

Based on the calculations above, we can conclude that Baker Hughes pays 7.52% on every dollar that it finances, or 7.52 cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0752 plus the cost of the investment for the investment to be feasible for the company.

## Summary

In analyzing Baker Hughes' total debt and liabilities, we can see that the company currently has a total debt of $4.069 billion and liabilities at $9.101 billion. Over the past five years, the total debt has increased by 375.37%, while total liabilities have increased by 256.29%.

Based on the five debt ratios listed above, we can see that Baker Hughes' ratios have been relatively the same over the past 3 years. Even though the debt and liabilities have increased by 375.37% and 256.29%, the ratios indicate, the company's equity and assets have kept up. This indicates that over the past 3 years, the company's growth has increased about the same as the debt and liabilities. As this is the case, the ratios indicate about the same financial risk to the company as they did 3 years ago.

As Baker Hughes' bond rating currently stands at "A" this indicates that the company has an "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 9.93% 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 7.52% on every dollar that it finances. As the current WACC of Baker Hughes is currently 7.52% and the beta is above average at 1.56, this implies that the company needs at least 7.52% on future investments and will have above average volatility moving forward.

Based on the calculations above, the company has increased its debt and liabilities but currently has the capacity to make its debt payments and meet its tax obligations.

The analysis of Baker Hughes' debt and liabilities indicates a company with a significant increase in its debt and liabilities. The analysis also reveals that the company's equity and assets have also increased significantly. This indicates that the company's equity and debt have increased at the same pace. The Bond rating of "A" by S&P indicates that a company has an "Strong capacity to meet financial commitments but somewhat susceptible to adverse economic conditions and changes in circumstances." The WACC reveals that Baker Hughes has the ability to add future investments and assets at relatively low rates. Currently, Baker Hughes has the ability to pay for its debts and meet its obligations.

All indications above reveal a company with strong investment potential long term for the shareholder, as long as the above ratios maintain or improve on their current standards.

For more information on Baker Hughes please read: Baker Hughes: Inside The Numbers

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