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 National Oilwell Varco Incorporation's (NYSE:NOV) 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 FMC Technologies (NYSE:FTI) and Cameron International Corporation (NYSE:CAM) you will be able to see which company has the most debt, thus adding to the company's 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 - $738 million + $153 million = $891 million
- 2008 - $870 million + $4 billion = $874 million
- 2009 - $876 million + $7 million = $883 million
- 2010 - $514 million + $373 million = $887 million
- 2011 - $159 million + $351 million = $510 million
From 2007 to 2010 National Oilwell Varco's total debt has been relatively the same. In 2011, the company's total debt decreased to $510 million. Over the past 5 years National Oilwell's total debt has decreased by 42.76%.
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 - $5.454 billion
- 2008 - $8.851 billion
- 2009 - $7.419 billion
- 2010 - $7.302 billion
- 2011 - $7.896 billion
National Oilwell's liabilities have increased over the past 5 years. In 2007, the company reported liabilities at $5.454 billion; in 2011, the company reported liabilities at $7.896 billion. This is an increase of 44.77%.
In analyzing National Oilwell Varco's total debt and liabilities, we can see that the company currently has a total debt of $510 million and liabilities at $7.896 billion. Over the past five years, the total debt has decreased by 42.76%, while total liabilities have increased by 44.77%. The next step will reveal if the company has the ability to pay for it.
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 - $883 million / $21.532 billion = 0.04
- 2010 - $887 million / $23.050 billion = 0.04
- 2011 - $510 million / $25.515 billion = 0.02
National Oilwell Varco's total-debt-to-total-assets ratio is very low and has been decreasing over the past 3 years. As this ratio has been decreasing over the past 3 years, this states that National Oilwell's total debt has been decreasing while the assets have been increasing. As the number is currently below 1, this states that the company has many more assets than total debt. This states very low risk for the company.
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 - $7.419 billion / $21.532 billion = 0.34
- 2010 - $7.302 billion / $23.050 billion = 0.32
- 2011 - $7.896 billion / $25.515 billion = 0.31
Over the past 3 years the total liabilities to total assets ratio has been decreasing. As these numbers are below the 0.50 mark and decreasing, this indicates that National Oilwell has not financed most of the company's assets through debt. 0.31 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 - $7.419 billion / $14.113 billion = 0.53
- 2010 - $7.302 billion / $15.748 billion = 0.46
- 2011 - $7.896 billion / $17.619 billion = 0.45
Over the past three years, National Oilwell's debt-to-equity ratio has been decreasing. As the ratio has been decreasing and well below 1, this indicates that shareholders have more invested than suppliers, lenders, creditors and obligators. 0.45 indicates a low 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 - $876 million / $14.989 billion = 0.06
- 2010 - $514 million / $16.262 billion = 0.03
- 2011 - $159 million / $17.778 billion = 0.01
Over the past three years, National Oilwell Varco's ratio has been decreasing. This states that the company now has 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. As the ratio is very low this implies a very 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 - $2.095 billion / $883 million = 2.37
- 2010 - $1.542 billion / $887 million = 1.73
- 2011 - $2.143 billion / $510 million = 4.20
Over the past three years, the cash flow to total debt ratio has ranged from 1.73 to 4.20. As the ratio is well above 1, this implies that the company has 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 National Oilwell Varco's ratios indicate a very healthy company regarding its debt and income. The ratios indicate that the company's assets have been increasing while the company's total debt has been decreasing. As this is the case, the ratios indicate a very low amount financial risk to the company. 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 National Oilwell Varco's bonds "A"
- Current 20-year corporate bond Rate of "A" = 3.70%
- Current cost of Debt as of November 6th 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." National Oilwell Varco has a rating that meets this description.
9. Current tax rate ( Income Tax total / Income before Tax)
- 2007 - $676 million / $2.029 billion = 33.31%
- 2008 - $993 million / $2.961 billion = 33.54%
- 2009 - $735 million / $2.208 billion = 33.29%
- 2010 - $738 million / $2.397 billion = 30.79%
- 2011 - $937 million / $2.922 billion = 32.07%
5-year average = 32.60%
Over the past five years, National Oilwell Varco has averaged a tax rate of 32.60%.
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 - .3260) = Cost of debt after tax
The cost of debt after tax for National Oilwell Varco 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 = 1.77% (Bloomberg)
- Average market return 1950 - 2011 = 7%
- Beta = (Google Finance) National Oilwell Varco's beta = 1.72
Risk free rate + Beta equity (Average market return - Risk free rate)
- 1.77 + 1.72 (7-1.77)
- 1.77 + 1.72 x 5.23
- 1.77 + 9.00 = 10.77%
National Oilwell has a cost of equity or R Equity of 10.77%, so investors should expect to get a return of 10.77% 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 = 32.60% (National Oilwell's five-year average Tax Rate)
Cost of Debt (before tax) or R debt = 3.70%
Cost of Equity or R equity = 10.77%
Debt (Total Liabilities) for 2011 or D = $7.896 billion
Stock Price = $71.63 (November 2nd, 2012)
Outstanding Shares = 426.91 million
Equity = Stock price x Outstanding Shares or E = $30.579 billion
Debt + Equity or D+E = $38.475 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 - .3260) x .0370 x ($7.896/$38.475) + .1077 ($30.579/$38.475)
.674 x .0370 x .2052 + .1077 x .7948
.0051 + .0856
Based on the calculations above, we can conclude that National Oilwell pays 9.07% on every dollar that it finances, or 9.07 cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0907 plus the cost of the investment for the investment to be feasible for the company.
In analyzing National Oilwell Varco's total debt and liabilities, we can see that the company currently has a total debt of $510 million and liabilities at $7.896 billion. Over the past five years, the total debt has decreased by 42.76%, while total liabilities have increased by 44.77%.
Based on the five debt ratios listed above, we can see that National Oilwell Varco's ratios indicate a very healthy company regarding its debt and income. The ratios indicate that the company's assets have been increasing while the company's total debt has been decreasing. As this is the case, the ratios indicate a very low amount of financial risk to the company.
As National Oilwell Varco'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 10.77% average per year over a long period of time on their equity to make it worthwhile to invest in the company. This calculation is based on the average market return between 1950 and 2011 at 7%.
The WACC calculation reveals that the company pays 9.07% on every dollar that it finances. As the current WACC of National Oilwell Varco's is currently 9.07% and the beta is above average at 1.72, this implies that the company needs at least 9.07% on future investments and will have above average volatility moving forward.
Based on the calculations above, the company has decreased its total debt over the past 5 years but has increased its liabilities. All indications above reveal that National Oilwell Varco currently has the capacity to make its debt payments and meet its tax obligations.
The analysis of National Oilwell Varco's debt and liabilities indicates a company that has decreased its total debt but increased its liabilities. This reveals a strong signal for financial health moving forward. The analysis also reveals that the company's equity and assets have been increasing over the past 3 years. This indicates that the company's equity has increased much faster than the company's debt. The Bond rating of "A" by S&P indicates that a company has a "Strong capacity to meet financial commitments but somewhat susceptible to adverse economic conditions and changes in circumstances." The WACC reveals that National Oilwell has the ability to add future investments and assets at moderate rates. Currently, National Oilwell has the ability to pay for its debts and meet its obligations.
All indications above reveal a company with very strong investment potential long term for the shareholder, as long as the above ratios maintain or improve on their current standards.
To read more on National Oilwell Varco please read my article: National Oilwell Varco Inc. Profitability Analysis.