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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ 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. Importantly, American Electric Power Company, Inc. (NYSE:AEP) does carry debt. But the real question is whether this debt is making the company risky.
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is American Electric Power Company’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 American Electric Power Company had US$26.6b of debt, an increase on US$24.1b, over 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
We can see from the most recent balance sheet that American Electric Power Company had liabilities of US$7.99b falling due within a year, and liabilities of US$43.4b due beyond that. Offsetting these obligations, it had cash of US$396.6m as well as receivables valued at US$1.88b due within 12 months. So it has liabilities totalling US$49.1b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company’s huge US$43.5b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner’s social media. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price. Either way, since American Electric Power Company does have more debt than cash, it’s worth keeping an eye on its balance sheet.
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).
With a net debt to EBITDA ratio of 5.13, 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 2.97 times, suggesting it can responsibly service its obligations. Another concern for investors might be that American Electric Power Company’s EBIT fell 10% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. 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.
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 investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
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. And furthermore, its interest cover also fails to instill confidence. 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. That sort of riskiness is ok for some, but it certainly doesn’t float our boat. Given the risks around American Electric Power Company’s use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
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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If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.