Is Kodiak Gas Services (NYSE:KGS) 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.' 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. We note that Kodiak Gas Services, Inc. (NYSE:KGS) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Kodiak Gas Services

What Is Kodiak Gas Services's Debt?

The image below, which you can click on for greater detail, shows that Kodiak Gas Services had debt of US$2.49b at the end of June 2024, a reduction from US$2.77b over a year. Net debt is about the same, since the it doesn't have much cash.

How Strong Is Kodiak Gas Services' Balance Sheet?

We can see from the most recent balance sheet that Kodiak Gas Services had liabilities of US$334.4m falling due within a year, and liabilities of US$2.64b due beyond that. Offsetting these obligations, it had cash of US$11.0m as well as receivables valued at US$208.9m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.76b.

Given this deficit is actually higher than the company's market capitalization of US$2.25b, we think shareholders really should watch Kodiak Gas Services'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.

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). 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).

Kodiak Gas Services shareholders face the double whammy of a high net debt to EBITDA ratio (5.5), and fairly weak interest coverage, since EBIT is just 1.6 times the interest expense. The debt burden here is substantial. Notably, Kodiak Gas Services's EBIT was pretty flat over the last year, which isn't ideal given the debt load. 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 Kodiak Gas Services'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Kodiak Gas Services created free cash flow amounting to 3.7% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

To be frank both Kodiak Gas Services's net debt to EBITDA and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. We're quite clear that we consider Kodiak Gas Services to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we've spotted with Kodiak Gas Services (including 2 which can't be ignored) .

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.