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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 aiding 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 Chesapeake Energy's (CHK) 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 the company webpage.

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

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 - $10.950 billion + $0 billion = $10.950 billion
  • 2008 - $14.184 billion + $0 billion = $14.184 billion
  • 2009 - $12.295 billion + $0 billion = $12.295 billion
  • 2010 - $12.640 billion + $0 billion = $12.640 billion
  • 2011 - $10.626 billion + $0 billion = $10.626 billion

Chesapeake's total debt has slightly declined over the past five years. In 2007 Chesapeake reported a total debt of $10.950 billion. In 2011, the company reported a total debt of $10.626 billion, which was an decrease of 2.96% 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 - $18.604 billion
  • 2008 - $22.147 billion
  • 2009 - $18.470 billion
  • 2010 - $21.915 billion
  • 2011 - $25.211 billion

Chesapeake's liabilities have increased from $18.604 billion in 2007, to $25.211 billion in 2011, an increase of 35.53%.

In analyzing Chesapeake's total debt and liabilities, we can see that the company currently has a moderate amount of debt at $10.626 billion and a moderate amount of liabilities at $25.211 billion compared to the size of the company. Over the past five years, the total debt has decreased by 2.96%, while total liabilities have increased by 35.53%. As the company has a moderate amount of debt and liabilities, the next step will reveal if the company has the ability to pay for their 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.

  • 2009 - $12.295 billion / $29.914 billion = 0.41
  • 2010 - $12.640 billion / $37.179 billion = 0.34
  • 2011 - $10.626 billion / $41.835 billion = 0.25

As Chesapeake's total-debt-to-total-assets ratio has been declining and is well below 1, this indicates that Chesapeake's assets have been increasing while the company's total debt has been decreasing, 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 that 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 - $18.470 billion / $29.914 billion = 0.62
  • 2010 - $21.915 billion / $37.179 billion = 0.59
  • 2011 - $25.211 billion / $41.835 billion = 0.60

In looking at Chesapeake's total liabilities to total assets ratio, we can see that the ratio has remained relatively the same over the past three years. As these numbers are above the 0.50 mark, this indicates that Chesapeake has financed most of the company's assets through debt. As Chesapeake's debt ratio is below 1, this implies 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 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 - $18.470 billion / $11.444 billion = 1.61
  • 2010 - $21.915 billion / $15.264 billion = 1.44
  • 2011 - $25.211 billion / $16.624 billion = 1.52

Over the past three years, Chesapeake's debt-to-equity ratio has bounced around, ranging from 1.61 to 1.44. In 2011, the ratio was calculated at 1.52; as the ratio was above 1, this indicates that suppliers, lenders, creditors and obligators have more equity invested than shareholders. 1.52 indicates a moderately 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 - $12.295 billion / $23.739 billion = 0.52
  • 2010 - $12.640 billion / $27.904 billion = 0.45
  • 2011 - $10.626 billion / $27.250 billion = 0.39

Over the past three years, Chesapeake Energy's capitalization ratio has decreased from 0.52 to .39. This implies that the company has had more equity compared with its long-term debt. As this is the case, the company has had more equity to support its operations and add growth through its equity. As the ratio has decreased and considered low so is the company's risk.

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 - $4.356 billion / $12.295 billion = 0.35
  • 2010 - $5.117 billion / $12.640 billion = 0.40
  • 2011 - $5.903 billion / $10.626 billion = 0.56

Over the past three years, the cash flow to total debt ratio has been increasing. The cash flow to total debt ratio has increased from 0.35 to 0.56 over the past 3 years. The increase is positive, but as the ratio is below 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 five debt ratios, we can see that Chesapeake has good results regarding its debt ratios. As the ratios look to be in good standing, this indicates that Chesapeake 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 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 Chesapeake Energy bonds "BB-"
  • Current 20-year corporate bond Rate of "BBB" = 6.69% (Please note as the rate for "BB-" was not listed I used the rate for "BBB".)
  • Current cost of Debt as of September 24th 2012 = 6.69%

According to the S&P rating guide, the "BB-" rating is - "Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions." Chesapeake has a rating that meets this description.

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

  • 2007 - $890 million / $2.341 billion = 38.01%
  • 2008 - $463 million / $1.186 billion = 39.04%
  • 2009 - $(3.483) billion / $(9.288) billion = 37.50%
  • 2010 - $1.110 billion / $2.884 billion = 38.49%
  • 2011 - $1.123 billion / $2.880 billion = 38.99%

5-year average = 38.41%

Over the past five years, Chesapeake has averaged a tax rate of 38.41%.

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 - .3841) = Cost of debt after tax

The cost of debt after tax for Chesapeake is 4.12%

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 = 1.70% (Bloomberg)
  • average market return 1950 - 2011 = 7%
  • Beta = (Google Finance) Chesapeake's beta = 1.28

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

  • 1.70 + 1.28 (7-1.70)
  • 1.70 + 1.28 x 5.30
  • 1.70 + 6.58 = 8.28%

Chesapeake has a cost of equity or R Equity of 8.28%, so investors should expect to get a return of 8.28% 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 - 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 = 38.41% (Chesapeake's five-year average Tax Rate)

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

Cost of Equity or R equity = 8.28%

Debt (Total Liabilities) for 2011 or D = $25.211 billion

Stock Price = $19.38 (September 25th, 2012)

Outstanding Shares = 665.41 million

Equity = Stock price x Outstanding Shares or E = $12.895 billion

Debt + Equity or D+E = $38.106 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 - .3841) x .0669 x ($25.211/$38.106) + .0828 ($12.895/$38.106)

.6159 x .0669 x .6616 + .0828 x .3384

.0272 + .0280

= 5.52%

Based on the calculations above, we can conclude that Chesapeake Energy pays 5.52% on every dollar that it finances, or 5.52 cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0552 plus the cost of the investment for the investment to be feasible for the company.

Summary

In analyzing Chesapeake's total debt and liabilities, we can see that the company currently has a moderate amount of debt at $10.626 billion and a moderate amount of liabilities at $25.211 billion compared to the size of the company. Over the past five years, the total debt has decreased by 2.96%, while total liabilities have increased by 35.53%.

Based on the above five debt ratios, we can see that Chesapeake has had good results regarding its debt ratios. Based on the good results from the ratios above, this indicates that currently Chesapeake has the ability to pay for its debts.

As Chesapeake's bond rating currently stands at "BB-," this indicates that the company is "less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions."

The CAPM approach for cost of equity states that shareholders need 8.28% 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 2011 at 7%.

The WACC calculation reveals that the company pays 5.52% on every dollar that it finances. As the current WACC of Chesapeake is currently 5.52% and the beta is above average at 1.28, this implies that the company needs at least 5.52% on future investments and will have slightly above average volatility moving forward.

Based on the calculations above, the company has a moderate amount of debt and liabilities, but currently has the capacity to make its debt payments and meet its tax obligations. The company is not in danger of bankruptcy.

The analysis of Chesapeake Energy's debt and liabilities indicates a good company, with a moderate amount of debt and liabilities for the size of the company. The analysis also reveals the company is good and stable regarding the debt ratios. The Bond rating of "BB-" by S&P indicates that the company could face some economic headwinds in the future thus adding to the risk of the investment. The WACC reveals that Chesapeake has the ability to add future investments and assets at low rates. Currently, Chesapeake has the ability to pay for its debts, meet its tax obligations and is currently not in danger of bankruptcy.

Source: Analyzing Chesapeake Energy's Debt And Risk