A company's debt, liabilities and financial risk are very important factors in understanding the company. Having an understanding of a company's debt and liabilities is a key component in analyzing 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 Apache Corporation's (APA) 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 Devon Energy Corp. (DVN) and Encana Corp (ECA), you will be able 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 - $4.012 billion + $215 million = $4.227 billion
- 2008 - $4.809 billion + $113 million = $4.922 billion
- 2009 - $4.950 billion + $117 million = $5.067 billion
- 2010 - $8.095 billion + $46 million = $8.141 billion
- 2011 - $6.785 billion + $431 million = $7.216 billion
Apache's total debt has been increasing over the past five years. In 2007, Apache reported a total debt of $4.227 billion. In 2011, the company reported a total debt of $7.216 billion. Over the past 5 years, Apache's total debt has increased by 70.71%.
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 - $13.257 billion
- 2008 - $12.678 billion
- 2009 - $12.407 billion
- 2010 - $19.048 billion
- 2011 - $23.058 billion
Apache's liabilities have increased from $13.257 billion in 2007 to $23.058 billion in 2011, an increase of 73.93%.
In analyzing Apache's total debt and liabilities, we can see that the company currently has a total debt of $13.257 billion and liabilities at $23.058 billion. Over the past five years, the total debt has increased by 70.71%, while total liabilities have increased by 73.93%. Much of the company's debt and liabilities have been accumulated through acquisition of assets such as some of Marathon Oil's (MRO) properties, Devon Energy's properties, the merger with Mariner Energy and others. 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 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 - $5.067 billion / $28.186 billion = 0.18
- 2010 - $8.141 billion / $43.425 billion = 0.19
- 2011 - $7.216 billion / $52.051 billion = 0.14
As Apache's total-debt-to-total-assets ratio has been declining and is below 1, this states that Apache's assets have been increasing faster than its total debt. 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 - $12.407 billion / $28.186 billion = 0.44
- 2010 - $19.048 billion / $43.425 billion = 0.44
- 2011 - $23.058 billion / $52.051 billion = 0.44
In looking at Apache's total liabilities to total assets ratio, we can see that the ratio has remained the same over the past three years. As these numbers are below the 0.50 mark, this indicates that Apache has not financed most of the company's assets through debt. 0.44 indicates a moderately low 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 - $12.407 billion / $15.779 billion = 0.79
- 2010 - $19.048 billion / $24.377 billion = 0.78
- 2011 - $23.058 billion / $28.993 billion = 0.80
Over the past three years, Apache's debt-to-equity ratio has remained relatively the same. As the ratio has remained consistent and is below 1, this indicates that shareholders have more equity invested than suppliers, lenders, creditors and obligators. 0.80 indicates a lower 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 - $4.950 billion / $20.729 billion = 0.24
- 2010 - $8.095 billion / $32.472 billion = 0.25
- 2011 - $6.785 billion / $35.778 billion = 0.19
Over the past three years, Apache's capitalization ratio has decreased from 0.24 to 0.19. 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 decreased 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 - $4.224 billion / $5.067 billion = 0.83
- 2010 - $6.726 billion / $8.141 billion = 0.83
- 2011 - $9.953 billion / $7.216 billion = 1.38
Over the past three years, the cash flow to total debt ratio has increased from 0.83 to 1.38. This increase is very positive. As the ratio is now 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 Apache's ratios indicate increasing health regarding its debt and income. The ratios indicate that the company's assets have been increasing slightly faster than the company's total debt. As this is the case, the ratios indicate a lower amount of 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, 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 Apache bonds "A-"
- Current 20-year corporate bond Rate of "A" = 3.70%
- Current cost of Debt as of November 8th 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." Apache Corp. has a rating that meets this description.
9. Current tax rate ( Income Tax total / Income before Tax)
- 2007 - $1.860 billion / $4.673 billion = 39.80%
- 2008 - $220 million / $932 million = 23.61%
- 2009 - $611 million / $326 million = 187.42%
- 2010 - $2.174 billion / $5.206 billion = 41.75%
- 2011 - $3.509 billion / $8.093 billion = 43.36%
5-year average subtracting 2009 = 37.13%
Over the past five years subtracting 2009, Apache Corporation has averaged a tax rate of 37.13%.
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 - .3713) = Cost of debt after tax
The cost of debt after tax for Apache is 2.33%
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 = 1.67% (Bloomberg)
- Average market return 1950 - 2011 = 7%
- Beta = (Google Finance) Apache's beta = 1.32
Risk free rate + Beta equity (Average market return - Risk free rate)
- 1.67 + 1.32 (7-1.67)
- 1.67 + 1.32 x 5.33
- 1.67 + 7.04 = 8.71%
Apache Corporation has a cost of equity or R Equity of 8.71%, so investors should expect to get a return of 8.71% 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 = 37.13% (Apache's five-year average Tax Rate)
Cost of Debt (before tax) or R debt = 3.70%
Cost of Equity or R equity = 8.71%
Debt (Total Liabilities) for 2011 or D = $23.058 billion
Stock Price = $79.89 (November 8th, 2012)
Outstanding Shares = 391.00 million
Equity = Stock price x Outstanding Shares or E = $31.236 billion
Debt + Equity or D+E = $54.294 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 - .3713) x .037 x ($23.058/$54.294) + .0871 ($31.236/$54.294)
.6287 x .037 x .4247 + .0871 x .5753
.0099 + .0501
Based on the calculations above, we can conclude that Apache Corp. pays 6.00% on every dollar that it finances, or 6.00 cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.06 plus the cost of the investment for the investment to be feasible for the company.
In analyzing Apache's total debt and liabilities, we can see that the company currently has a total debt of $13.257 billion and liabilities at $23.058 billion. Over the past five years, the total debt has increased by 70.71%, while total liabilities have increased by 73.93%. Much of the company's debt and liabilities have been accumulated through acquisition of assets such as some of Marathon Oil's properties, Devon Energy's properties, the merger with Mariner Energy and others.
Based on the five debt ratios listed above, we can see that Apache's ratios indicate increasing health regarding its debt and income. The ratios indicate that the company's assets have been increasing slightly faster than the company's total debt. As this is the case, the ratios indicate a lower amount of financial risk to the company.
As Apache'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 8.71% 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 6.00% on every dollar that it finances. As the current WACC of Apache Corp. is currently 6.00% and the beta is above average at 1.32, this implies that the company needs at least 6.00% on future investments and will have above average volatility moving forward.
Based on the calculations above, we can see that the company has increased its total debt and liabilities over the past 5 years but the company has also increased its assets. All indications above reveal that Apache currently has the capacity to make its debt payments and meet its tax obligations.
The analysis of Apache's debt and liabilities indicates a company with an increase in its debt and liabilities but an increase in assets to back it up. The analysis also reveals the company is showing strong results regarding the debt ratios. The Bond rating of "A-" by S&P indicates that the company has a "Strong capacity to meet financial commitments but somewhat susceptible to adverse economic conditions and changes in circumstances." The WACC reveals that Apache has the ability to add future investments and assets at relatively low rates. Currently, Apache has the ability to pay for its debts and improve its debt ratios thus lowering its risk to shareholders.
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.
To read more on Apache Corporation please read my article: Apache Corporation: Inside The Numbers