Is Kosmos Energy (NYSE:KOS) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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, Kosmos Energy Ltd. (NYSE:KOS) does carry debt. But the real question is whether this debt is making the company risky.

We've discovered 4 warning signs about Kosmos Energy. View them for free.

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Kosmos Energy's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2024 Kosmos Energy had US$2.74b of debt, an increase on US$2.39b, over one year. On the flip side, it has US$85.0m in cash leading to net debt of about US$2.66b.

A Look At Kosmos Energy's Liabilities

We can see from the most recent balance sheet that Kosmos Energy had liabilities of US$594.9m falling due within a year, and liabilities of US$3.51b due beyond that. On the other hand, it had cash of US$85.0m and US$165.0m worth of receivables due within a year. So its liabilities total US$3.86b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the US$798.1m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Kosmos Energy would likely require a major re-capitalisation if it had to pay its creditors today.

See our latest analysis for Kosmos Energy

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).

Kosmos Energy's net debt is 3.0 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 14.5 is very high, suggesting that the interest expense on the debt is currently quite low. Unfortunately, Kosmos Energy saw its EBIT slide 8.1% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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 Kosmos Energy'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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Kosmos Energy recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

To be frank both Kosmos Energy's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We're quite clear that we consider Kosmos Energy to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 4 warning signs for Kosmos Energy (1 is concerning) you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.