American Electric Power Company (NASDAQ:AEP) Seems To Be Using A Lot Of Debt

By
Simply Wall St
Published
February 08, 2021
NasdaqGS:AEP

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We note that American Electric Power Company, Inc. (NASDAQ:AEP) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for American Electric Power Company

What Is American Electric Power Company's Debt?

As you can see below, at the end of September 2020, American Electric Power Company had US$32.5b of debt, up from US$28.4b a year ago. Click the image for more detail. Net debt is about the same, since the it doesn't have much cash.

debt-equity-history-analysis
NasdaqGS:AEP Debt to Equity History February 7th 2021

A Look At American Electric Power Company's Liabilities

The latest balance sheet data shows that American Electric Power Company had liabilities of US$9.05b due within a year, and liabilities of US$49.0b falling due after that. Offsetting these obligations, it had cash of US$618.7m as well as receivables valued at US$1.85b due within 12 months. So its liabilities total US$55.6b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's huge US$40.8b 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). 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).

With a net debt to EBITDA ratio of 5.9, it's fair to say American Electric Power Company does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 2.6 times, suggesting it can responsibly service its obligations. Given the debt load, it's hardly ideal that American Electric Power Company's EBIT was pretty flat over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine American Electric Power Company'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 the logical step is to look at the proportion of that EBIT that is matched by actual 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

On the face of it, American Electric Power Company's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn't such a worry. We should also note that Electric Utilities industry companies like American Electric Power Company commonly do use debt without problems. After considering the datapoints discussed, we think American Electric Power Company has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for American Electric Power Company (of which 1 is a bit concerning!) you should know about.

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. 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.
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