Does American Electric Power Company (NASDAQ:AEP) Have A Healthy Balance Sheet?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We note that American Electric Power Company, Inc. (NASDAQ:AEP) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for American Electric Power Company

How Much Debt Does American Electric Power Company Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2022 American Electric Power Company had US$39.7b of debt, an increase on US$36.1b, over one year. Net debt is about the same, since the it doesn't have much cash.

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

We can see from the most recent balance sheet that American Electric Power Company had liabilities of US$14.6b falling due within a year, and liabilities of US$54.8b due beyond that. Offsetting this, it had US$696.9m in cash and US$2.67b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$66.0b.

Given this deficit is actually higher than the company's massive market capitalization of US$45.9b, 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.

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). 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 2.8 is reasonably strong, which is a good sign. On a slightly more positive note, American Electric Power Company grew its EBIT at 12% over the last year, further increasing its ability to manage 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept 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 level of total liabilities 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. We're quite clear that we consider American Electric Power Company 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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example American Electric Power Company has 2 warning signs (and 1 which is a bit unpleasant) we think 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. 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.