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. (NYSE:AEP) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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 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.
How Much Debt Does American Electric Power Company Carry?
As you can see below, at the end of June 2019, American Electric Power Company had US$27.7b of debt, up from US$24.6b a year ago. Click the image for more detail. 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$8.36b falling due within a year, and liabilities of US$44.7b due beyond that. On the other hand, it had cash of US$386.2m and US$1.78b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$50.9b.
Given this deficit is actually higher than the company's massive market capitalization of US$45.2b, 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. 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.
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 2.7 is reasonably strong, which is a good sign. Investors should also be troubled by the fact that American Electric Power Company saw its EBIT drop by 17% over the last twelve months. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding 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.
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. And even its level of total liabilities fails to inspire much confidence. We should also note that Electric Utilities industry companies like American Electric Power Company commonly do use debt without problems. After considering the datapoints discussed, we think American Electric Power Company has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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.
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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