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 **Duke Energy's** (NYSE:DUK) 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 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 - $9.498 billion + 2.268 billion = $11.766 billion
- 2008 - $13.250 billion + $1.189 billion = $14.439 billion
- 2009 - $16.113 billion + $902 million = $17.015 billion
- 2010 - $17.935 billion + $491 million = $18.426 billion
- 2011 - $18.679 billion + $2.321 billion = $21.00 billion

Duke Energy's total debt has increased greatly over the past five years. The company reported a five-year low of $11.766 billion in 2007 and a five-year high in 2011 at $21.00 billion. The company's 2011 reported total debt of $21.00 billion is an increase of 78.48% 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 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 - $28.505 billion
- 2008 - $32.089 billion
- 2009 - $35.290 billion
- 2010 - $36.568 billion
- 2011 - $39.754 billion

Duke Energy's liabilities have increased from $28.505 billion in 2007 to $39.754 billion in 2011, an increase of 39.46%.

In analyzing the company's total debt and liabilities, we can see that the company currently has a large amount of debt at $21.00 billion and a sizeable amount of liabilities at $39.754 billion. Over the past five years, the total debt has increased by 78.48%, while total liabilities have increased by 39.46%. 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.

**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.

- 2009 - $17.015 billion / $57.040 billion = 0.30
- 2010 - $18.426 billion / $59.090 billion = 0.31
- 2011 - $21.000 billion / $62.526 billion = 0.34

As Duke Energy's total debt to total assets ratio is well below 1, this indicates that Duke Energy 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 - $35.290 billion / $57.040 billion = 0.62
- 2010 - $36.568 billion / $59.090 billion = 0.62
- 2011 - $39.754 billion / $62.526 billion = 0.64

In looking at Duke Energy's total liabilities to total assets ratio, we can see that the ratio has increased very slightly over the past three years. As these numbers are above are around 0.50, this indicates that Duke Energy has financed some of the company's assets through debt. Duke Energy has quite a low debt ratio implying that the company is not in danger of becoming insolvent and/or going bankrupt.

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 to 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 - $35.290 billion / $21.750 billion = 1.62
- 2010 - $36.568 billion / $22.522 billion = 1.62
- 2011 - $39.754 billion / $22.772 billion = 1.75

Duke Energy's 2011 debt to equity ratio has increased compared to 2009, but overall, the ratio is very low. As the ratio is below 1 this indicates that suppliers, lenders, creditors and obligators have less equity invested than shareholders. This also indicates a low amount of risk for the company. As the ratio is below 1 and considered 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. 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 - $16.113 billion / $37.863 billion = 0.43
- 2010 - $17.935 billion / $40.457 billion = 0.44
- 2011 - $18.679 billion / $41.451 billion = 0.45

Over the past three years, Duke Energy's capitalization ratio has been increasing very slightly. This implies that the company has had slightly less equity compared to its long-term debt. As this is the case, the company has had slightly less equity to support its operations and add growth through its equity. As the ratio has only slightly increased so has 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 - $2.582 billion / $751 million = 3.43
- 2010 - $3.050 billion / $840 million = 3.63
- 2011 - $3.324 billion / $859 million = 3.87

Like the other ratios listed above, Duke Energy's interest coverage ratio has been increasing very slightly. As the interest ratio is quite moderate at 3.87, this implies that the company is not burdened by debt expenses.

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 - $3.463 billion / $17.015 billion = 0.20
- 2010 - $4.511 billion / $18.426 billion = 0.24
- 2011 - $3.672 billion / $21.000 billion = 0.17

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 Duke Energy has strong results in regards to its debt ratios. Based on the results indicated above, all of the ratios except the cash flow to debt ratio have been increasing, but as they have only slightly increased no red flags are raised. Based on the strong results from the ratios above, this indicates that Duke Energy 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.

- S&P rated Duke Energy bonds "BBB+"
- Current 20 year corporate bond Rate of "BBB" = 6.69%
- Current cost of Debt as of August 22nd 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." Duke Energy has a rating that meets this description. (Please note: As BBB+ was not listed, I used the BBB rating for this section.)

An excellent article in regards to the recent downgrade of Duke Energy. S&P Cuts Duke Energy Corp Rating.

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

- 2007 - $712 million / $2.234 billion = 31.87%
- 2008 - $616 million / $1.895 billion = 32.51%
- 2009 - $758 million / $1.831 billion = 41.39%
- 2010 - $890 million / $2.210 billion = 40.27%
- 2011 - $752 million / $2.465 billion = 30.50%

5-year average discounting 2009 = 35.30%

Over the past five years, Duke Energy has averaged a tax rate of 35.30%.

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.

- .0669 x (1 - .3530) = Cost of debt after tax

The cost of debt after tax for Duke Energy is *4.33%*

**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 = US 10 year bond = 1.75% (Bloomberg)
- average market return 1950 - 2011 = 7%
- Beta = (Google Finance) Duke Energy beta = 0.33

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

- 1.75 + 0.33 (7-1.75)
- 1.75 + 0.33 x 5.25
- 1.75 + 1.73 = 3.48%

Duke Energy has a cost of equity or R Equity of 3.48%. So investors should expect to get a return of 3.48% 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 = 35.30% (Duke Energy's five-year average Tax Rate)

Cost of Debt (before tax) or **R debt** = 6.69%

Cost of Equity or **R equity** = 3.48%

Debt (Total Liabilities) for 2011 or **D** = $39.754 billion

Stock Price = $65.85 (August 22, 2012)

Outstanding Shares = 704.13 Million

Equity = Stock price x Outstanding Shares or **E** = $ 46.366 billion

Debt + Equity or **D+E** = $86.120 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 - .3530) x .0669 x ($39.754/$86.120) + .0348 ($46.366/$86.120)

.647 x .0669 x .4616 + .0348 x .5383

.0199 + .0187

= 3.86%

Based on the calculations above, we can arrive that Duke Energy pays 3.86% on every dollar that it finances or .0386 on every dollar. From this calculation we understand that on every dollar the company spends on an investment, the company must make $.0386, plus the cost of the investment for the investment to be feasible for the company.

**Summary**

In analyzing the company's total debt and liabilities, we can see that the company currently has a large amount of debt at $21.00 billion and a sizeable amount of liabilities at $39.754 billion. Over the past five years, the total debt has increased by 78.48%, while the total liabilities have increased by 39.46%. Even though the debt and liabilities have increased by 78.48% and 39.46% , much of this debt was incurred by the purchase of assets in the anticipation of growing and improving the company.

Based on the above six debt ratios, we can see that Duke Energy has strong results in regards to its debt ratios. Based on the results indicated above, all of the ratios except the cash flow to debt ratio have been increasing, but as they have only slightly increased, no red flags are raised. Based on the strong results from the ratios above, this indicates that Duke Energy has the ability to pay for its debt and is not on the verge of bankruptcy.

As Duke Energy's bond rating currently was downgraded the company received a "BBB+" rating through S&P, 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 3.48% 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 2011 at 7%.

The WACC calculation reveals that the company pays 3.86% on every dollar that it finances. As the current WACC of Duke Energy is currently 3.86% and the beta is low at 0.33, it implies that the company needs 3.86% on future investments and will have very low volatility moving forward.

Based on the calculations above, the company has a sizeable amount of 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 Duke Energy's debt and liabilities indicates a strong company with a sizeable amount of debt but currently has the ability to pay for it. The analysis also reveals the company has had some increases in its debt ratios over the past three years but also reveals that the company is very strong in regards to their debt ratios. The WACC reveals that Duke Energy also and has the ability to add future investments and assets at very low rates. Currently, Duke Energy 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 low risk.

**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.