Financial Analysis of Chevron From the Perspective

¶ … financial analysis of Chevron from the perspective of a potential creditor. The issue surrounds primarily the creditworthiness of Chevron rather than the type of credit that would be issued. Specifically, the issue is whether "we" would lend Chevron 10% of its net assets. The net assets for Chevron are $209.474 billion, so the amount in question is $20.9 billion in new debt. The report will first analyze the financial statements of Chevron in general terms, focusing on trends and ratios, and drawing conclusions about the overall financial health of the company based on that analysis. The second part of the paper will outline some of the criteria that a lending institution would have for lending to a company, and then that criteria will be applied to Chevron specifically.

Chevron operates in the hydrocarbon industry, where it is one of the world's largest companies with sales of $241.9 billion and net income of $26.18 billion. It is the conclusion of this analysis that a creditor should lend Chevron an additional $20.9 billion. The company has the liquidity, solvency and the cash flow to pay back this amount of debt. The company currently finances its operations largely from operating cash flows, with a small amount of long-term debt. This low debt level has left the company with a balance sheet strong enough to withstand a further $20.9 billion in debt. As a lender, it has been found that Chevron meets all of the lending criteria with respect to liquidity, solvency, investment returns and free cash flow. This paper will outline the analysis that led to this conclusion.

Company Background

Chevron is a multinational company whose primary business involves the exploration for, extraction of and retail of hydrocarbon products. The company trades on the New York Stock Exchange under the ticker symbol CVX. Its market cap of $226 billion makes it one of the largest companies in the world by that measure. Chevron has sales of $241.9 billion, net income of $26.18 billion and with a beta of 0.80 is a fairly low-risk investment (MSN Moneycentral, 2013). Chevron's predecessor companies date to the 19th century in southern California, and it was known as Standard Oil until the 1980s. After a merger with Gulf Oil, the company adopted its Chevron retail brand as its company name.

Chevron operates in the hydrocarbon industry, focused on petroleum exploration, extraction, refining and retailing. The company has operations around the world, but retains its California headquarters. The company also has alternative energy businesses, although these remain niche markets for Chevron.

The company's senior management team consists predominantly of industry veterans. The CEO, John Watson, has been in place since 2010. He had joined in the company in 1980 as a financial analyst and made VP in 1998. George Kirkland, Executive VP of Upstream and Gas, joined the company in 1974 as a facility engineer and has been in his current position since 2010 (Chevron, 2013). Most officers have similar biographies, including multiple international assignments, indicating a preference in the company for a long and progressive internal career path.

The general conditions in the global hydrocarbon business are positive, reflecting a combination of factors. There are more people in this world than ever before, more people have achieved at least a middle class standard of living that allows them to consume hydrocarbons, and there are fewer hydrocarbons available, thus increasing the market price. Chevron is engaged in oil and natural gas projects primarily, and these projects span the globe. Chevron also has a downstream business, focusing on petrochemicals, fertilizers, transportation, trading, lubricants, and energy technology (2011 Annual Report).

From a qualitative standpoint, Chevron is in a great business that generates an incredible amount of cash flow. The product has inelastic price elasticity of demand (Moffat, 2013), which a creditor would also view as positive. Further, Chevron has a global, diversified portfolio of businesses within this industry, better enabling it to weather any downturns or recessions that might hit the business. With a positive qualitative situation, the main concern for the potential creditor now rests with an analysis of the company's quantitative situation -- are they performing to expectations and can they be relied upon for repayment?

Financial Analysis

A creditor needs to undertake a thorough financial analysis prior to lending money. The creditor benefits from financial analysis because of the insights the technique gleans with respect to the company's financial condition, specifically its liquidity, solvency, profitability and its efficiency. Understanding the ability to pay back the loan or bonds requires understanding more than just liquidity and solvency, but a deeper understanding of the client's business and the underlying conditions of that business. In addition, the strategy that the company employs is also a factor in the credit decision and to an extent financial analysis can reveal if the company is successfully employing its chosen strategy.

A financial analysis should integrate a number of techniques. Ratio analysis is one of the most common and valuable techniques, but should be used in concert with an analysis of the underlying trends in the business. Common size and horizontal analysis can thus contribute to the understanding of the firm's financial condition, and these techniques should be built into the analysis. In this analysis, the past five years of financial data has been taken into consideration, with emphasis on the past two. Five years are valuable because that timeframe goes back to the depths of recession and creditors like to know how their customers respond to financial upheaval. Chevron reports in U.S. dollars, so all financial data are reported in USD unless otherwise stated.

The ratio analysis findings are summarized in the following table:

Ratio

2010

2011

Current ratio

1.68 ($48,541 / $29,012)

1.58 ($53,234 / $33,600)

Quick ratio

1.49 ($43,348 / $29,012)

1.42 ($47,691 / $33,600)

Cash ratio

0.59 ($14,060 / $29,012)

0.59 ($15,864 / $33,600)

Debt ratio

43.1 ($78.98b / $184.76 b)

42.5 ($87.293b / $209.47b)

Long-Term Debt/Equity

10.7 ($11.0b / $105.08b)

8.1 ($9.68b / $122.18b)

Accounts Receivable Turnover

10.6x ($204.9b / $19.23b)

13.8x ($293.7b / $21.27b)

Total Asset Turnover

1.17x ($204.9b / $54.69b)

1.5x ($293.7b / $197.1b)

Gross Margin

31% ($63.5b / $204.9b)

31% (78.82b / $253.7b)

Net Margin

9.3% ($19.02b / $204.9b)

10.6% ($26.89b / $252.7b)

Effective Tax Rate

40.3% ($12.9b / $32.05b)

43.3% ($20.62b / $47.63b)

Return on Assets

18.1% ($32.05b / $124.7b)

24.1% ($47.63b / $197.1b)

Return on Equity

36.5% ($32.05b / $98.49b)

42% ($47.63b / $119.23b)

Ratio analysis is the first form of analysis that will be utilized. In this form, the company's financial statements are subjected to a set of ratio calculations, from which more insights into the financial condition of the company can be gained. There are several categories of financial ratio, including the liquidity ratios, the solvency ratios, the managerial efficiency ratios, the profitability ratios and the investment return ratios. There are also market ratios but these primarily concern stock market metrics. In addition to market figures (especially stock price) being skewed by the often irrational views of investors, they also concern the value of equity, not the value of debt. Equity tends to be subordinated to debt, so the creditor gains less from this set of ratios than he or she would from the other ratio categories.

The liquidity ratios are important because they illustrate how liquid the company is, specifically answering the question of how well it can meet its obligations for the coming year. The first liquidity ratio is the current ratio. For Chevron in 2011,the current ratio was 1.58 and in 2010 it was 1.68. The quick ratio removes inventories from the equation. The quick ratio for Chevron in 2011 was 1.42 and in 2010 it was 1.49. The final liquidity ratio is the cash ratio, which for Chevron in 2011 was 0.59 and in 2010 it was 0.59. This analysis shows that the cash ratio held steady for Chevron, but the liquidity elsewhere declined. There are two ways to view such a decline in liquidity. The first is to see it as a sign of financial weakness; the second is to see it as an improvement in efficiency. Given that all three ratios are within the healthy range, it would be unfair to view Chevron's efforts to improve efficiency in a negative light, especially considering that the cash ratio remained unchanged in the last year. If the cash ratio had also declined, that might have pointed to a red flag about declining liquidity based on the company's fundamentals, but in this case the decline in liquidity more likely reflects improvements in collections and inventory management.

The next category of ratios is also critical to the prospective creditor -- the solvency ratios. These measure the long-term ability of the company to carry debt, and are of particular importance for a creditor issuing long-term debt. A creditor issuing short-term debt might not care at all about long-term solvency. Given the amount at stake here, however, it is assumed that the debt issue is going to be long-term in nature and therefore that the solvency ratios matter. The first solvency ratio is the debt ratio, which was 42.5% in 2011 and 43.1% in 2010. The long-term debt to equity was 8.1% in 2011 and 10.7% in 2010, reflecting the reduction in long-term debt that the company experienced during the 2011 fiscal year. The decline in the overall debt ratio is also encouraging, though it is more important simply for that ratio to be within a healthy range, which it is.

The ability of the company to pay interest is also important to the long-term creditor. The interest expense is not noted in the 2011 fiscal year in the annual report (p.31), but for 2010 it was $50 million and for 2009 it was $28 million. At a company with revenues of $244 billion, it is clear that the net interest expense is not a significant figure and therefore should not be given much further worry. That said, with a loan amount of $20.9 billion on the table, even at 3% interest, that is $627 million, significantly more than the current expense. The minimal amount of current interest burden merely means that the new income burden does not build on much of a foundation and can be evaluated on its own.

Another category of financial ratio is the managerial efficiency ratio. This reflects the ability of the company to convert its assets into cash, something that clearly would be of interest to a prospective creditor. The first category is the accounts receivable turnover. For 2011, this was 13.8 times and for the previous year was 10.6 times. These figures translate to 26 days and 34 days respectively. The total asset turnover in 2011 was 1.5 times and for 2010 it was 1.17 times. This also reflects improved managerial efficiency. A key point to note here is that the company made significant investments in plant, property and equipment in the 2011 fiscal year, some of which would not yet have come online. To improve this ratio under those circumstances is admirable, and indicates that when Chevron claims it is committed to increased efficiency, as it does in the preamble in its annual report (p.3, 7), it means it. For the creditor, this is a positive.

The profitability ratios are perhaps less important for the creditor, but provide valuable information nonetheless. The first is the gross margin, which was 31% in 2011 and 31% in 2010. Preliminary numbers for 2012 indicate an increase to 32%. For the creditor, it is important that the gross margin is held steady. The reason for this is that it indicates that the company is able to pass along price changes to its customers. In a highly volatile business like hydrocarbons, being able to pass along price increases in particular to customers reduces the risk faced by the producer. Additionally, this ability to pass along prices is expected when there is high price inelasticity of demand. If the company was unable to pass along price increases to customers, that would be a red flag. The operating margin reflects more on the company's ability to control its costs. The operating margin for Chevron in 2011 was 18.8% and in 2010 it was 15.6%. Given what we know about the successful strategy by Chevron to contain its costs, this outcome is not surprising. Preliminary figures for 2012 indicate an operating margin of 19.1%, a further improvement. The net margin for 2011 was 10.6% and for 2010 it was 9.3%. This improvement appears to have largely been the result of the improvement in the operating margin, since the tax as a percentage of revenue was 8.1% in 2011 and 6.3% in 2010.

The effective tax rate for Chevron in 2011 was 43.3% and it was 40.3% in 2010. The improved operational efficiency more than offset the effect of the higher taxation in 2011. Interest payments are made on a pre-tax basis, so the high tax rates are not a particular concern for the creditor. Indeed, the demand for a $20 billion loan probably comes from a desire to lower the company's effective tax rate, so the high taxes are a benefit to our business.

The investment return ratios are likewise based on net income, an after-tax and more importantly after-interest measure. For the creditor, the equivalent measures using EBITDA rather than net income might be more insightful. The ROA was 24.1% for 2011 and 18.1% for 2010, using EBITDA instead of net income. The ROE using EBITDA was 42.0% in 2011 and 36.5% in 2010. Both figures reflect the benefits to the company's value of the improved operational efficiency. Improved investment returns on an EBITDA basis is a positive sign for the company in general, and should reflect an improved cash flow position that would be a positive sign for the prospective creditor as well.

Financial Appraisal

The financial analysis of the company is the first step in the credit decision. The credit decision, however, needs to be weighed against specific criteria as set out by the creditor. In this scenario, it is important to remember that the company is seeking to borrow 10% of total asset value, a figure of $20.9 billion in new debt. Applied to the 2011 balance sheet, the company would have after the issue $30.7 billion in total long-term debt, and $108.99 billion in total liabilities. The latter figure would represent 47.3% of the new total asset figure (which would be bolstered by $20.9 billion in new cash). Thus, the capital structure of the company would increase from its current level of 42.5%. The interest burden would increase more substantially, since net interest is very low at present. The new interest payments are worth over $600 million at current market rates. The encouraging part is that this interest rate accounts for only 1.45% of the current level of cash from operating activities. However, while it looks promising for Chevron to be able to handle this issue, the decision cannot be made without specific financial criteria. The new capital structure is important, as is the ability of the company to meet the new interest payments from its operating cash flow. Further, the company will be evaluated on the basis of its different ratios, and it will be evaluated on the long-term trends in the income statement and balance sheet. In addition, a portion of the evaluation will be dedicated to qualitative factors.

In terms of capital structure, a company in this industry can probably withstand 70-80% debt in order to invest in fixed assets, so the capital structure should be within that parameter. The times interest earned, which is the EBITDA / Interest Expense, should be 10-12 times, meaning that the company turns over enough cash to cover its interest for the year in any month. The current ratio should be over 1.0, the quick ratio over 0.5 and the cash ratio over 0.1 unless there are extenuating circumstances. These are basic guideposts for a company that has a healthy amount of liquidity. With respect to the debt ratio, that is something already discussed above with respect to capital structure. The comfort level for a debt ratio depends on the industry, and since the hydrocarbon industry relies on a high amount of fixed asset investment that generates strong long-term cash flow, the debt ratio for a firm in this industry can be quite high, even over to 0.7 or 0.8. The requirement for long-term debt ratio should be based on the ratio after this loan is made, plus the assumption that it can grow a little bit more. We would be foolish to lend to a company's absolute capacity, so it is assumed that even after our lending, the company can handle more debt.

There should also be minimal figures for accounts receivable turnover, inventory turnover and in this business fixed asset turnover is important as well. The A/R should turn over within 45 days, though sub-30 is optimal. The inventory should turn over 6 times within the year, or 60 days. The fixed assets should turn over once. As noted above, the investment return ratios can serve as valuable guideposts, but they should be calculated based on EBITDA rather than net income, since this is debt we are issuing and therefore as creditor we are much more concerned with cash flow than with accounting net income. The guidelines should be 20% ROE and 10% ROA as a bare minimum.

Qualitatively, it is important as a lender to remember that we are contributing to the deterioration of the company's debt situation. As such, we need to know that the company is facing an upward trend. There are two components to the qualitative evaluation. The first is the general industry and company trends. We want to see that the company is improving its performance, but that the outlook for the industry is generally positive as well. The second component to this evaluation is the ability of the company to perform well within the confines of the industry. We want the company to demonstrate that it has some control over its fate -- that it is not strictly tied to the fate of the industry as a whole. Either this comes from internal factors or it can come from diversification, as long as the bank is not basically buying into overall industry risk. If we wanted to do that, we would buy crude futures -- we are investing in Chevron so it is important that Chevron is not simply a proxy for the hydrocarbon business as a whole. Also, a loan of this amount should not be taken out for no reason -- we want to know for what we are lending, as this will help to determine where the future cash flows will come from that will be used to pay down this debt.

Application of Criteria to Chosen Company

The first criterion is the capital structure. As noted, we believe that the nature of this industry is such that a company in this industry can withstand a debt ratio of upwards of 80%. The current debt ratio for Chevron is 42.5% and with the new debt it will increase to 47.3%, which is well within the "healthy" threshold. The company can handle tens of billions of dollars more in debt than it will have after this deal. The second criterion is with respect to the liquidity ratios. As noted, Chevron has a current ratio of 1.58, a quick ratio of 1.49 and a cash ratio of 0.59. These are all within the guidelines prescribed for lending, and comfortably so. The downward trend in the current and quick ratios is not a concern. The cash ratio has remained unchanged, indicating that the change in the current and quick ratios is more reflective of improved operational efficiency than deteriorating credit quality. Other metrics also support the argument that Chevron has improved its operating efficiency. The times interest earned is approximately 100 times, so there is absolutely no problem for Chevron to meet the TIE threshold, which is around 12 times per year.

The managerial efficiency ratios are generally positive. As of the end of fiscal 2011, the accounts receivable turnover ratio is 11.5 times, and the inventory turnover ratio is 30 times. The latter is well within the threshold of 6 times, but the former is closer to being an area of concern. The accounts receivable turnover at present amounts to 32 days, and while the threshold for safety is 45 days, we would like to see this under 30 days. The ability to collect from customers is critical for the creditor, especially when the company holds 10.4% of its total asset value as accounts receivable. The company has made strides to improve its collection efficiency, but it might be worth focusing on the accounts receivable turnover as one of the restrictive covenants on this debt. The total asset turnover is 1.2 times, better than the 1.0 times that we want to see. This ratio is particularly important in a business like hydrocarbons that requires a substantial amount of fixed investment. We are especially pleased that Chevron has improved this ratio even with a significant amount of new investments, as this illustrates that the company is committed to achieving efficiency and a high level of fixed asset turnover. The company's ROA is 29% and ROE is 49.9% based on EBITDA rather than net income. For both of these ratios, the total is well above the minimum threshold.