Is Cosmo Energy Holdings (TSE:5021) Using Too Much Debt?

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Cosmo Energy Holdings Co., Ltd. (TSE:5021) does carry debt. But is this debt a concern to shareholders?

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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Cosmo Energy Holdings

What Is Cosmo Energy Holdings's Net Debt?

As you can see below, Cosmo Energy Holdings had JP¥618.3b of debt at March 2024, down from JP¥686.2b a year prior. On the flip side, it has JP¥117.3b in cash leading to net debt of about JP¥501.0b.

How Strong Is Cosmo Energy Holdings' Balance Sheet?

We can see from the most recent balance sheet that Cosmo Energy Holdings had liabilities of JP¥1.01t falling due within a year, and liabilities of JP¥477.5b due beyond that. Offsetting this, it had JP¥117.3b in cash and JP¥496.4b in receivables that were due within 12 months. So it has liabilities totalling JP¥871.5b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of JP¥714.5b, we think shareholders really should watch Cosmo Energy Holdings's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Cosmo Energy Holdings's net debt to EBITDA ratio of about 2.5 suggests only moderate use of debt. And its strong interest cover of 1k times, makes us even more comfortable. Sadly, Cosmo Energy Holdings's EBIT actually dropped 8.9% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Cosmo Energy Holdings's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Cosmo Energy Holdings recorded free cash flow of 30% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Mulling over Cosmo Energy Holdings's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Cosmo Energy Holdings's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Cosmo Energy Holdings (at least 1 which is significant) , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.