American Electric Power Company (NASDAQ:AEP) Takes On Some Risk With Its Use Of Debt

By
Simply Wall St
Published
May 24, 2022
NasdaqGS:AEP
Source: Shutterstock

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that American Electric Power Company, Inc. (NASDAQ:AEP) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for American Electric Power Company

What Is American Electric Power Company's Debt?

The image below, which you can click on for greater detail, shows that at March 2022 American Electric Power Company had debt of US$37.2b, up from US$35.4b in one year. However, because it has a cash reserve of US$884.1m, its net debt is less, at about US$36.4b.

debt-equity-history-analysis
NasdaqGS:AEP Debt to Equity History May 24th 2022

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

According to the last reported balance sheet, American Electric Power Company had liabilities of US$13.6b due within 12 months, and liabilities of US$52.2b due beyond 12 months. On the other hand, it had cash of US$884.1m and US$2.00b worth of receivables due within a year. So it has liabilities totalling US$62.9b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's massive market capitalization of US$51.5b, we think shareholders really should watch American Electric Power Company'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.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a net debt to EBITDA ratio of 5.5, it's fair to say American Electric Power Company does have a significant amount of debt. However, its interest coverage of 3.1 is reasonably strong, which is a good sign. However, one redeeming factor is that American Electric Power Company grew its EBIT at 18% over the last 12 months, boosting its ability to handle its debt. 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 American Electric Power Company's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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 that may be a result of expenditure for growth, it does make the debt far 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 it's pretty decent at growing its EBIT; that's encouraging. We should also note that Electric Utilities industry companies like American Electric Power Company commonly do use debt without problems. Overall, it seems to us that American Electric Power Company's balance sheet is really quite a risk to the business. 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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 4 warning signs for American Electric Power Company (1 is concerning) you should be aware of.

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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