Kodiak Gas Services (NYSE:KGS) Takes On Some Risk With Its Use Of 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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Kodiak Gas Services, Inc. (NYSE:KGS) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Kodiak Gas Services

What Is Kodiak Gas Services's Debt?

You can click the graphic below for the historical numbers, but it shows that Kodiak Gas Services had US$1.75b of debt in September 2023, down from US$2.72b, one year before. Net debt is about the same, since the it doesn't have much cash.

A Look At Kodiak Gas Services' Liabilities

Zooming in on the latest balance sheet data, we can see that Kodiak Gas Services had liabilities of US$223.2m due within 12 months and liabilities of US$1.85b due beyond that. Offsetting this, it had US$7.69m in cash and US$126.5m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.94b.

When you consider that this deficiency exceeds the company's US$1.92b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While we wouldn't worry about Kodiak Gas Services's net debt to EBITDA ratio of 4.1, we think its super-low interest cover of 1.2 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. However, one redeeming factor is that Kodiak Gas Services grew its EBIT at 12% over the last 12 months, boosting its ability to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Kodiak Gas Services can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Kodiak Gas Services reported free cash flow worth 5.6% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

We'd go so far as to say Kodiak Gas Services's interest cover was disappointing. But at least it's pretty decent at growing its EBIT; that's encouraging. 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. 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. To that end, you should learn about the 3 warning signs we've spotted with Kodiak Gas Services (including 2 which make us uncomfortable) .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.