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

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 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?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View 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 2023 American Electric Power Company had debt of US$42.8b, up from US$37.2b in one year. And it doesn't have much cash, so its net debt is about the same.

A Look At American Electric Power Company's Liabilities

The latest balance sheet data shows that American Electric Power Company had liabilities of US$12.6b due within a year, and liabilities of US$57.9b falling due after that. On the other hand, it had cash of US$538.1m and US$2.45b worth of receivables due within a year. So it has liabilities totalling US$67.6b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the US$43.1b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, American Electric Power Company would probably need a major re-capitalization if its creditors were to demand repayment.

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 6.1, 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 2.5 times, suggesting it can responsibly service its obligations. 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, 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

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. Taking into account all the aforementioned factors, it looks like American Electric Power Company has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 3 warning signs for American Electric Power Company (1 shouldn't be ignored!) that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.