American Electric Power Company (NASDAQ:AEP) Has No Shortage Of Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies American Electric Power Company, Inc. (NASDAQ:AEP) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for American Electric Power Company

What Is American Electric Power Company's Net Debt?

As you can see below, at the end of December 2023, American Electric Power Company had US$43.1b of debt, up from US$41.0b a year ago. Click the image for more detail. And it doesn't have much cash, so its net debt is about the same.

How Strong Is American Electric Power Company's Balance Sheet?

The latest balance sheet data shows that American Electric Power Company had liabilities of US$11.6b due within a year, and liabilities of US$59.8b falling due after that. On the other hand, it had cash of US$544.4m and US$2.60b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$68.3b.

This deficit casts a shadow over the US$44.4b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, American Electric Power Company would likely require a major re-capitalisation if it had to pay its creditors today.

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).

Weak interest cover of 2.2 times and a disturbingly high net debt to EBITDA ratio of 6.1 hit our confidence in American Electric Power Company like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Notably, American Electric Power Company's EBIT was pretty flat over the last year, which isn't ideal given the debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if American Electric Power Company 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, American Electric Power Company burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both American Electric Power Company's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. It's also worth noting that American Electric Power Company is in the Electric Utilities industry, which is often considered to be quite defensive. After considering the datapoints discussed, we think American Electric Power Company has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. We've identified 3 warning signs with American Electric Power Company (at least 1 which doesn't sit too well with us) , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.