Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Continental Resources, Inc. (NYSE:CLR) does carry debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Continental Resources Carry?
The image below, which you can click on for greater detail, shows that at December 2021 Continental Resources had debt of US$6.83b, up from US$5.53b in one year. And it doesn’t have much cash, so its net debt is about the same.
A Look At Continental Resources’ Liabilities
The latest balance sheet data shows that Continental Resources had liabilities of US$1.50b due within a year, and liabilities of US$9.23b falling due after that. On the other hand, it had cash of US$20.9m and US$1.40b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$9.32b.
While this might seem like a lot, it is not so bad since Continental Resources has a huge market capitalization of US$23.4b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With a debt to EBITDA ratio of 1.5, Continental Resources uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 9.8 times its interest expenses harmonizes with that theme. Although Continental Resources made a loss at the EBIT level, last year, it was also good to see that it generated US$2.5b in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Continental Resources’s ability to maintain a healthy balance sheet going forward.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Continental Resources saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Our View
Continental Resources’s conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its interest cover was re-invigorating. Taking the abovementioned factors together we do think Continental Resources’s debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. There’s no doubt that we learn most about debt from the balance sheet.
