Analyzing Caterpillar's Debt And Risk

| About: Caterpillar Inc. (CAT)

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 helping aid in a 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 Caterpillar Incorporation's (NYSE:CAT) 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.

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

1. Total Debt = Long Term Debt + Short Term Debt

A debt is an amount of money borrowed by one party from another, and must be paid back. Total debt is the addition 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. The combination of the two is total debt.

  • 2007 - $17.829 billion + $10.600 billion = $28.429 billion
  • 2008 - $22.834 billion + $12.701 billion = $35.535 billion
  • 2009 - $21.847 billion + $9.784 billion = $31.631 billion
  • 2010 - $20.437 billion + $7.981 billion = $30.085 billion
  • 2011 - $24.944 billion + $9.648 billion = $34.592 billion

Caterpillar's total debt has fluctuated greatly over the past five years. The company reported a five-year low of $28.429 billion in 2007 and a high a year later of $35.535 billion. In 2011, the company reported a total debt of $34.592 billion, an increase of 21.67% 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 are the addition of long-term liabilities, which are the liabilities that are due in one year or more, and short-term, or current liabilities, are any liabilities due within one year. The combination of the two equals the total liabilities.

  • 2007 - $47.249 billion
  • 2008 - $61.695 billion
  • 2009 - $51.298 billion
  • 2010 - $53.196 billion
  • 2011 - $68.563 billion

Caterpillar's liabilities have increased from $47.249 billion in 2007 to $68.563 billion in 2011, an increase of 45.11%.

In analyzing the company's total debt and liabilities, we can see that the company's total debt is quite high in relation to the size of the company. Over the past five years, the total debt has increased by 21.67%, while the total liabilities have increased by 45.11%. As most of the debt and liabilities were acquired in the acquisition of assets, the next step will reveal if the company has the ability to pay for these assets.


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 - $31.631 billion / $60.038 billion = 0.53
  • 2010 - $30.085 billion / $64.020 billion = 0.50
  • 2011 - $34.592 billion / $81.446 billion = 0.42

As Caterpillar's total debt to total assets ratio is well below 1, this indicates that Caterpillar Inc. 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 which 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 - $51.298 billion / $60.038 billion = 0.85
  • 2010 - $53.196 billion / $64.020 billion = 0.83
  • 2011 - $68.563 billion / $81.446 billion = 0.84

In looking at Caterpillar's total liabilities to total assets ratio, we can see that the ratio has been very consistent over the past three years. As these numbers are above .50, this indicates that Caterpillar has financed most of the company's assets through debt, but as the ratio is below 1, currently the company is not in danger becoming insolvent and/or going bankrupt.

5. Debt to Equity Ratio = Total Liabilities / Shareholder's Equity

The debt to equity ratio is another leverage ratio that compares a company's total liabilities to its total shareholder's 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 - $51.298 billion / $12.883 billion = 3.98
  • 2010 - $53.196 billion / $10.824 billion = 4.91
  • 2011 - $68.563 billion / $8.740 billion = 7.84

Caterpillar's 2011 debt to equity ratio has increased significantly compared to 2009. Overall, as the ratio is high, this indicates that suppliers, lenders, creditors and obligators have more equity invested than shareholders. This indicates a high amount of risk for the company. As the ratio has been increasing over the past three years so has 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. The 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 - $21.847 billion / $34.370 billion = 0.64
  • 2010 - $20.437 billion / $31.261 billion = 0.65
  • 2011 - $24.944 billion / $33.684 billion = 0.74

Over the past three years, Caterpillar Inc.'s capitalization ratio has been increasing. This implies that the company has had less equity compared to its long-term debt. As this is the case, the company has had less equity to support its operations and add growth through its equity, thus increasing the company's risk.

7. Interest Coverage Ratio = EBIT (Earnings before interest and taxes) / Interest Expenses

The interest coverage ratio is used to determine how easily a company can pay interest expenses on outstanding debt. The ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by the company's interest expenses for the same period. The lower the ratio, the more the company is burdened by debt expense, the higher the ratio the better. When a company's interest coverage ratio is 1.5 or lower, its ability to meet interest expenses may be questionable.

  • 2010 - $2.003 billion / $1.434 billion = 1.40
  • 2010 - $5.007 billion / $1.257 billion = 3.98
  • 2011 - $7.947 billion / $1.222 billion = 6.50

In 2009, Caterpillar's Interest Coverage Ratio was in the "questionable" range as it received a ratio of 1.40. Since then, the ratio has been recovering but is still quite low. A low interest coverage ratio indicates that the company could be burdened by debt expenses. Something to watch moving forward is if the ratio falls below 1.5 again.

8. Cash Flow to Total Debt Ratio = Operating Cash Flow / Total Debt

This coverage ratio compares a company's operating cash flow to 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 - $6.343 billion / $31.631 billion = 0.20
  • 2010 - $5.009 billion / $30.085 billion = 0.17
  • 2011 - $7.010 billion / $34.592 billion = 0.20

As the cash flow to debt ratio in the previous three years is below 100% or 1, this implies that the company has not had the ability to cover its total debt with its yearly cash flow from operations.

Based on the above six debt ratios, we can see that Caterpillar Inc. has had mixed results in regards to its debt ratios. Based on the results indicated above, the interest coverage ratio is the ratio to "keep an eye on". As the interest coverage ratio was very low in 2009, this indicated that the company may have not been able to meet its interest expenses. The other ratios have indicated an increase in risk over the past three years, but also indicate that Caterpillar Inc. has the ability to pay for its debt, 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 to 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.

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." Caterpillar Inc. has a rating that meets this description."

10. Current tax rate ( Income Tax total / Income before Tax)

  • 2007 - $1.485 million / $4.990 billion = 29.75%
  • 2008 - $953 million / $4.501 billion = 21.17%
  • 2009 - $(270) million / $569 million = -47.45%
  • 2010 - $968 million / $3.750 million = 25.81%
  • 2011 - $1.720 million / $6.725 million = 25.57%

4 year average discounting 2009 = 25.57%

Over the past five years discounting 2009, Caterpillar Inc. has averaged a tax rate of 25.57%.

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.

  • .0395 x (1 - .2557) = Cost of debt after tax

The cost of debt after tax for Caterpillar Inc. is 2.94%

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 = US 10 year bond = 1.80% (Bloomberg)
  • average market return 1950 - 2011 = 7%
  • Beta = (Google finance) Caterpillar Inc. beta = 1.86

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

  • 1.80 + 1.86 (7-1.80)
  • 1.80 + 1.86 x 5.20
  • 1.80 + 9.67 = 11.47%

Caterpillar Inc. has a cost of equity or R Equity of 11.47%. So investors should expect to get a return of 11.47% 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 US 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 = 25.57% (Caterpillar Inc. five-year average Tax Rate)

Cost of Debt (before tax) or R debt = 3.95%

Cost of Equity or R equity = 11.47%

Debt (Total Liabilities) for 2011 or D = $68.563 billion

Stock Price = $90.01 (August 20, 2012)

Outstanding Shares = 653.27 Million

Equity = Stock price x Outstanding Shares or E = $ 58.800 billion

Debt + Equity or D+E = $127.36 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 - .2557) x .0395 x ($68.563/$127.36) + .1147 ($58.800/$127.36)

.7443 x .0395 x .5383 + .1147 x .4617

.0158 + .0529

= 6.87%

Based on the calculations above, we can arrive that Caterpillar Inc pays 6.87% on every dollar that it finances or .0687 on every dollar. From this calculation we understand that on every dollar the company spends on an investment, the company must make $.0687, 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's total debt and liabilities are high at $34.592 billion and $68.563 billion respectively. Over the past five years, Caterpillar has increased their total debt by 21.67% and their liabilities by 45.11%. Even though the debt and liabilities have increased by 21.67% and 45.11%, much of this debt was incurred by the purchase of assets in the anticipation of growing and improving the company.

As illustrated above, we can see that Caterpillar Inc. has purchased many of its assets through debt. The listed ratios above indicate that the company has been increasing the amount of debt incurred relative to the company's equity and assets. This is one area of the company to "keep an eye on" moving forward. Currently, indications above reveal that the company has the ability to manage its debt and is not in danger of bankruptcy.

As Caterpillar Inc.'s bond rating received a "A" rating through S&P, this indicates that the company has a "Strong capacity to meet financial commitments but somewhat susceptible to adverse economic conditions and changes in circumstances."

As Caterpillar Inc. is quite a volatile stock, the CAPM approach for cost of equity states that shareholders need 11.47% 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 to 2011 at 7%.

The WACC calculation reveals that the company pays 6.87% on every dollar that it finances. As the current WACC of Caterpillar Inc is currently 6.87% and the beta is high at 1.86, it implies that the company needs 6.87% on future investments and will have high volatility moving forward.

Based on the calculations above, the company has high debt in comparison to the size of the company but currently, has the capacity to make its debts payments, meet its tax obligations and is not in danger of bankruptcy.

The analysis of Caterpillar's debt and liabilities indicates a strong company with a high amount of debt but currently has the ability to pay for it. The analysis also reveals the company has had some weaknesses in its debt ratios, mainly the interest coverage ratio. The WACC reveals that Caterpillar also and has the ability to add future investments and assets at very manageable rates. Currently, Caterpillar Inc. 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 moderate risk.

For other articles on Cat please read my articles:

Caterpillar: Profitability Analysis and

Caterpillar: Inside The Numbers

For an excellent article by another author please read:

Caterpillar: A Cheap Way To Bet On The World Not Ending (Plus A Dividend)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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