Running Numbers: Canadian Oil Sands Analysis Of Debt And Risk $COS.TO
By Contributor: Jeff Williams
Having some knowledge about company’s debt and liabilities is a key component in understanding the risk of a company. An understanding of these factors will aid 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 Canadian Oil Sands (TSE:COS) 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 Suncor Energy Inc TSE:SU, Imperial Oil Ltd (NYSE:IMO), Husky Energy, Inc. (TSE:HSE) or Canadian Natural Resources Ltd (TSE:CNQ) 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 (Current portion of employee future benefits)
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 – $1.218 billion + $16 million = $1.234 billion
- 2008 – $1.258 billion + $17 million = $1.275 billion
- 2009 – $1.163 billion + $17 million = $1.180 billion
- 2010 – $1.251 billion + $51 million = $1.302 billion
- 2011 – $1.132 billion + $47 million = $1.179 billion
Canadian Oil Sands’ total debt has decreased since 2007. In 2007, the company reported a total debt of $1.234 billion. In 2011, the company’s total debt decreased to 1.179 billion. Over the past 5 years, Canadian Oil Sands’ total debt has decreased by 4.45%.
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 – $3.099 billion
- 2008 – $3.023 billion
- 2009 – $2.984 billion
- 2010 – $3.058 billion
- 2011 – $4.410 billion
Canadian Oil Sands’ liabilities have been increasing over the past 5 years. In 2007, the company reported liabilities at $3.099 billion; in 2011, the company reported liabilities at $4.410 billion. Over the past 5 years, Canadian Oil Sands’ liabilities have increased by 42.30%.
In analyzing Canadian Oil Sands’ total debt and liabilities, we can see that the company currently has a total debt of $1.179 billion and liabilities at $4.410 billion. Over the past five years, the total debt has decreased by 4.45%%, while total liabilities have increased by 42.30%. As the company’s amount of amount of liabilities have increased over the past 5 years, the next step will reveal if the company has the ability to pay 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 – $1.180 billion / $6.953 billion = 0.17
- 2010 – $1.302 billion / $7.016 billion = 0.19
- 2011 – $1.179 billion / $8.620 billion = 0.14
Over the past three years Canadian Oil Sands total-debt-to-total-assets ratio has decreased. This indicates that in 2011 the company has been adding more assets than 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 decreased since 2009.
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 – $2.984 billion / $6.953 billion = 0.43
- 2010 – $3.058 billion / $7.016 billion = 0.44
- 2011 – $4.410 billion / $8.620 billion = 0.51
In looking at Canadian Oil Sands’ total liabilities to total assets ratio over the past three years, we can see that the ratio has increased over the past 3 years. As the 2011 number is above the 0.50 mark, this indicates that Canadian Oil Sands has financed most of the company’s assets through debt.
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 – $2.984 billion / $3.969 billion = 0.75
- 2010 – $3.058 billion / $3.958 billion = 0.77
- 2011 – $4.410 billion / $4.210 billion = 1.05
Over the past three years, Canadian Oil Sands’ debt-to-equity ratio has increased from 0.75 to 1.05. As the ratio is above 1, this indicates that suppliers, lenders, creditors and obligators have more invested than shareholders. 1.05 indicates a moderate amount of risk for the company. As the ratio is above 1 and considered moderate, 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 – $1.180 billion / $5.149 billion = 0.23
- 2010 – $1.302 billion / $5.260 billion = 0.25
- 2011 – $1.179 billion / $5.389 billion = 0.22
Over the past three years, Canadian Oil Sands’ capitalization ratio has decreased from 0.23 to 0.22. This implies that the company has had more slightly equity compared with its long-term debt. As this is the case, the company has had slightly more equity to support its operations and add growth through its equity. As the ratio is decreasing, financially this implies a lowering 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 – $547 million / $1.180 billion = 0.46
- 2010 – $1.219 billion / $1.302 billion = 0.94
- 2011 – $1.958 billion / $1.179 billion = 1.66
Over the past three years, the cash flow to total debt ratio has been increasing. This indicates a strengthening of the company. As the ratio is 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 financially the company is getting stronger. Even though the company is gaining strength, there is still some risk associated with Canadian Oil Sands. This statement is supported by the debt to equity ratio being above 1 and the increase in the debt ratio. Having stated that, the increases are minor and show no current red flags. As most of the listed ratios are gaining strength, this indicates the company’s growth has been keeping up with the increase in liabilities. 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 Canadian Oil Sands bonds “BBB Outlook Stable”
- Current 20-year corporate bond Rate of “BBB” = 6.69%
- Current cost of Debt as of December 27th 2012 = 6.69%
According to the S&P rating guide, the “BBB” rating is – “Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.” Canadian Oil Sands Limited has a rating that meets this description.
9. Current tax rate (Income Tax total / Income before Tax)
- 2011 – $387 million / $1.531 billion = 25.27%
- 2012 TTM – $313 million / $1.305 billion = 23.98%
Over the past couple of years, COS has averaged a tax rate of 24.62%.
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.
- .0669 x (1 – .2462) = Cost of debt after tax
The cost of debt after tax for Canadian Oil Sands Limited is 5.04%
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 = 1.75% (Bloomberg)
- Average market return 1950 – 2012 = 7%
- Beta = (MSN Money) Canadian Oil Sands’ beta = 1.30
Risk free rate + Beta equity (Average market return – Risk free rate)
- 1.75 + 1.30 (7-1.75)
- 1.75 + 1.30 x 5.25
- 1.75 + 6.82= 8.57%
Canadian Oil Sands has a cost of equity or R Equity of 8.57%, so investors should expect to get a return of 8.57% 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 – 2012 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 = 24.62% (Canadian Oil Sands’ Two-year average Tax Rate)
Cost of Debt (before tax) or R debt = 6.69%
Cost of Equity or R equity = 8.57%
Debt (Total Liabilities) for 2011 or D = $4.410 billion
Stock Price = $19.74 (December 27th, 2012)
Outstanding Shares = 484.6 million
Equity = Stock price x Outstanding Shares or E = $9.566 billion
Debt + Equity or D+E = $13.976 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 – .2462) x .0857 x ($4.410/$13.976) + .0857 ($9.566/$13.976)
.7538 x .0857 x .3155 + .0857 x .6845
.0204 + .0587
Based on the calculations above, we can conclude that Canadian Oil Sands’ pays 7.91% on every dollar that it finances, or 7.91 cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0791 plus the cost of the investment for the investment to be feasible for the company.
In analyzing Canadian Oil Sands’ total debt and liabilities, we can see that the company currently has a total debt of $1.179 billion and liabilities at $4.410 billion. Over the past five years, the total debt has decreased by 4.45%%, while total liabilities have increased by 42.30%.
Based on the five debt ratios listed above, we can see that financially the company is getting stronger. Even though the company is gaining strength, there is still some risk associated with Canadian Oil Sands. This statement is supported by the debt to equity ratio being above 1 and the increase in the debt ratio. Having stated that, the increases are minor and show no current red flags. As most of the listed ratios are gaining strength, this indicates the company’s growth has been keeping up with the increase in liabilities.
Currently, Canadian Oil Sands’ bond rating stands at “BBB”. According to Standard and Poor’s this indicates that the company has “Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.”
The CAPM approach for cost of equity states that shareholders need 8.57% 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 2012 at 7%.
The WACC calculation reveals that the company pays 7.91% on every dollar that it finances. As the current WACC of Canadian Oil Sands’ is currently 7.91% and the beta is above average at 1.30, this implies that the company needs at least 7.91% on future investments and will have well above 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 Canadian Oil Sands’ debt and liabilities indicates a company with decreasing total debt but increasing liabilities. The analysis also reveals that the company growth rate is increasing at a faster rate than the company’s liabilities. This indicates a lower amount of risk to the company as three years ago. The Bond rating of “BBB Stable Outlook” by S&P indicates that the company has “Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.”. The WACC reveals that Canadian Oil Sands has the ability to add future investments and assets at around 7.91%. Currently, Canadian Oil Sands Limited has the ability to pay for its debts meet its obligations while adding growth.
All indications above reveal a company that is gaining strength but has some risk associated with it. As the CAPM states, from this point on, if you think you can get 8.57% per-year average over the long term on this investment to compensate for the risk you would undertake by investing in this company then you would be getting good value for your money.
Jeff is a published author and educator. He is a value/dividend investor who specializes in long term growth. He is president/CEO of a growing corporation in Music Education publications. He lives in a beautiful seaside town in Canada with his wife and two children.
Seeking Alpha Profile: http://seekingalpha.com/author/jeff-williams
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