Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, American Electric Power Company, Inc. (NASDAQ:AEP) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is American Electric Power Company's Debt?

As you can see below, American Electric Power Company had US$43.7b of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. Net debt is about the same, since the it doesn't have much cash.

How Healthy 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$10.2b falling due within a year, and liabilities of US$63.3b due beyond that. Offsetting these obligations, it had cash of US$428.2m as well as receivables valued at US$2.82b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$70.2b.

When you consider that this deficiency exceeds the company's huge US$52.4b 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 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

American Electric Power Company shareholders face the double whammy of a high net debt to EBITDA ratio (5.9), and fairly weak interest coverage, since EBIT is just 2.3 times the interest expense. This means we'd consider it to have a heavy debt load. However, one redeeming factor is that American Electric Power Company grew its EBIT at 14% over the last 12 months, boosting its ability to handle its debt. 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 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 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. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. It's also worth noting that American Electric Power Company is in the Electric Utilities industry, which is often considered to be quite defensive. 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. 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 3 warning signs for American Electric Power Company (of which 1 is significant!) you should know about.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.