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.' 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 can see that American Electric Power Company, Inc. (NASDAQ:AEP) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 examine debt levels, we first consider both cash and debt levels, together.

What Is American Electric Power Company's Debt?

The chart below, which you can click on for greater detail, shows that American Electric Power Company had US$43.6b in debt in September 2024; about the same as the year before. Net debt is about the same, since the it doesn't have much cash.

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

The latest balance sheet data shows that American Electric Power Company had liabilities of US$10.6b due within a year, and liabilities of US$62.8b falling due after that. Offsetting this, it had US$474.4m in cash and US$2.72b in receivables that were due within 12 months. So its liabilities total US$70.3b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's massive market capitalization of US$49.4b, 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 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.

Weak interest cover of 2.2 times and a disturbingly high net debt to EBITDA ratio of 5.9 hit our confidence in American Electric Power Company like a one-two punch to the gut. The debt burden here is substantial. The good news is that American Electric Power Company improved its EBIT by 3.6% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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 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 net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn't such a worry. It's also worth noting that American Electric Power Company is in the Electric Utilities industry, which is often considered to be quite defensive. Taking into account all the aforementioned factors, it looks like 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. 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 American Electric Power Company has 2 warning signs (and 1 which can't be ignored) 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.