Gaining knowledge about a 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 gaining knowledge about the debt of a company, but for this article, I will look at **Continental Resources** (NYSE:CLR) total debt, total liabilities, debt ratios and WACC.

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

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

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.

- 2008 - $376 million + $0 million = $376 million
- 2009 - $524 million + $0 million = $524 million
- 2010 - $926 million + $0 million = $926 million
- 2011 - $1.254 million + $0 million = $1.254 million
- 2012 TTM - $2.944 billion + $0 million = $2.944 billion

Continental Resources total debt has increased since 2008. In 2008, the company reported a total debt of $376 million. In 2012 TTM, the company's total debt increased to $2.944 billion. Over the past 5 years, Continental Resources total debt has increased by 682.98%.

*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.

- 2008 - $1.267 billion
- 2009 - $1.285 billion
- 2010 - $2.384 billion
- 2011 - $3.338 billion
- 2012 TTM - $5.301 billion

Continental Resources liabilities have also increased over the past 5 years. In 2008, the company reported liabilities at $1.267 billion; in 2012 TTM, the company reported liabilities at $5.301 billion. Over the past 5 years, Continental Resources' liabilities have increased by 318.89%.

In analyzing Continental Resources total debt and liabilities, we can see that the company currently has a total debt of $2.944 billion and liabilities at $5.301 billion. Over the past five years, the total debt has increased by 682.98% while total liabilities have increased by 318.89%. As the company's amount of debt and amount of liabilities have increased over the past 5 years, the next step will reveal if the company has the ability to pay them.

## Debt Ratios

*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.

- 2010 - $926 million / $3.592 billion = 0.26
- 2011 - $1.254 million / $5.646 billion = 0.22
- 2012 TTM - $2.944 billion / $8.226 billion = 0.36

Over the past three years, Continental Resources' total debt to total assets ratio has increased. Over the past 3 years, the total debt to total assets ratio has increased from 0.26 in 2010 to 0.36 in 2012. This indicates that since 2010 the company has been adding asset value at a slower rate than its total debt. As the number is currently well below 1, this indicates that the company has more assets than total debt. As the number has been increasing, this states that the risk to the company regarding its debt-to-assets has increased since 2010.

*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.

- 2010 - $2.384 billion / $3.592 billion = 0.66
- 2011 - $3.338 billion / $5.646 billion = 0.59
- 2012 TTM - $5.301 billion / $8.226 billion = 0.64

In looking at Continental Resources total liabilities to total assets ratio over the past three years, we can see that this ratio has declined. As the 2012 TTM numbers are above the 0.50 mark, this indicates that Continental Resources' has financed most of the company's assets through debt. As the number has declined, so is the risk to 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.

- 2010 - $2.384 billion / $1.208 billion = 1.97
- 2011 - $3.338 billion / $2.308 billion = 1.45
- 2012 TTM - $5.301 billion / $2.925 billion = 1.81

Compared to 2010, Continental Resources debt-to-equity ratio has decreased. The ratio has dropped from 1.97 to 1.81. As the ratio is currently above 1, this indicates that suppliers, lenders, creditors and obligators have invested more than shareholders. 1.81 indicates a higher amount of risk for the company. As the ratio is above 1 and considered moderately high, 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.

- 2010 - $926 million / $2.134 billion = 0.43
- 2011 - $1.254 million / $3.562 billion = 0.35
- 2012 TTM - $2.944 billion / $5.869 billion = 0.50

Over the past three years, Continental Resources capitalization ratio has increased from 0.43 to 0.50. This implies that the company has less equity compared with 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. As the ratio is increasing, financially this implies a slight increase 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.

- 2010 - $653 million / $926 million = 0.71
- 2011 - $1.068 billion / $1.254 million = 0.85
- 2012 TTM - $1.546 billion / $2.944 billion = 0.53

Over the past three years, the cash flow to total debt ratio has decreased. The ratio has decreased from 0.71 in 2010 to 0.53 in 2012 TTM. As the ratio is below 1, this implies that the company does not have 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 mixed results regarding the company's debt and liabilities compared to its assets. We can see that the company's debt and liabilities have increased significantly over the past 3 years but we can that the assets and equity have also increased over the past three years. 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 Continental Resources bonds "BB+"
- Continental Res 5% Rate of "BB+" = 5.0%
- Current cost of Debt as of January 15th 2013 = 5.0%

According to the S&P rating guide, the "BB+" rating is - "Considered highest speculative grade by market participants." S&P also has a positive outlook associated with this rating which states "Positive means that a rating may be raised." Continental Resources' has a rating that meets this description.

*9. Current tax rate (Income Tax total / Income before Tax)*

- 2008 - $198 million / $519 million = 38.15%
- 2009 - $39 million / $110 million = 35.45%
- 2010 - $90 million / $258 million = 34.88%
- 2011 - $258 million / $687 million = 37.55%
- 2012 TTM - $241 million / $647 million = 37.25%

2008 - 2012 TTM 5-year average = 36.65%

From 2008 - 2012 TTM, Continental Resources has averaged a tax rate of 36.65%.

*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.

- .05 x (1 - .3665) = Cost of debt after tax

The cost of debt after tax for Continental Resources is *3.17%*

**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 = 1.81% (Bloomberg)
- Average market return 1950 - 2012 = 7%
- Beta = (Google Finance) Continental Resources beta = 1.76

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

- 1.81 + 1.76 (7-1.81)
- 1.81 + 1.76 x 5.19
- 1.81 + 9.13 = 10.94%

Currently, Continental Resources has a cost of equity or R Equity of 10.94%, so investors should expect to get a return of 10.94% 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 = 36.65% (Continental Resources five-year average Tax Rate)

Cost of Debt (before tax) or **R debt** = 5.0%

Cost of Equity or **R equity** = 10.94%

Debt (Total Liabilities) for 2011 or **D** = $5.301 billion

Stock Price = $81.06 (January 15th, 2013)

Outstanding Shares = 185.02 million

Equity = Stock price x Outstanding Shares or **E** = $14.997 billion

Debt + Equity or **D+E** = $20.298 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 - .3665) x .05 x ($5.301/$20.298) + .1094 ($14.997/$20.298)

.6335 x .05 x .2612 + .1094 x .7388

.0083 + .0808

= 8.91%

Based on the calculations above, we can conclude that Continental Resources pays 8.91% on every dollar that it finances, or 8.91 cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0891 plus the cost of the investment for the investment to be feasible for the company.

## Summary

In analyzing Continental Resources total debt and liabilities, we can see that the company currently has a total debt of $2.944 billion and liabilities at $5.301 billion. Over the past five years, the total debt has increased by 682.98% while total liabilities have increased by 318.89%.

Based on the five debt ratios listed above, we can see mixed results regarding the company's debt and liabilities compared to its assets. We can see that the company's debt and liabilities have increased significantly over the past 3 years but we can that the assets and equity have also increased over the past three years.

As Continental Resources' bond rating currently stands at "BB+," this states that the company bonds are "Considered highest speculative grade by market participants."

The CAPM approach for cost of equity states that shareholders need 10.94% 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 8.91% on every dollar that it finances. As the current WACC of Continental Resources is currently 8.91% and the beta is slightly above average at 1.76, this implies that the company needs at least 8.91% on future investments and will have above average volatility moving forward.

The analysis of Continental Resources debt and liabilities indicates a company that has increased its liabilities over the past 3 years. The analysis also reveals that the company's assets growth rate has also increased over the past 3 years. When compared to each other the ratio's calculate mixed results. The Bond rating of "BB+" by Standard & Poor's indicates that the company bonds are "Considered highest speculative grade by market participants." The WACC reveals that Continental Resources has the ability to add future investments and assets at around 8.91%. Currently, Continental Resources has the ability to pay for its debts, meet its obligations, while adding growth.

All indications above reveal a company with some questions regarding its debt and growth. The above ratio's show signs of strength but the Bond rating of "BB+" is "speculative". The analysis indicates a significant amount of risk for the shareholder but if above ratio's begin to show strength in more areas, Continental Resources could be good value for the money. The CAPM reveals that the investor needs 10.94% return so, if you believe that you can get 10.94% year over year over the long term on this investment then you will get good value on your investment.

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