Warren Buffett famously said, '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. We note that Advance Auto Parts, Inc. (NYSE:AAP) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Advance Auto Parts

You can click the graphic below for the historical numbers, but it shows that as of October 2022 Advance Auto Parts had US$1.37b of debt, an increase on US$1.03b, over one year. However, because it has a cash reserve of US$191.2m, its net debt is less, at about US$1.18b.

We can see from the most recent balance sheet that Advance Auto Parts had liabilities of US$5.44b falling due within a year, and liabilities of US$3.97b due beyond that. Offsetting these obligations, it had cash of US$191.2m as well as receivables valued at US$845.7m due within 12 months. So its liabilities total US$8.38b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of US$9.22b, so it does suggest shareholders should keep an eye on Advance Auto Parts' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Advance Auto Parts's net debt is only 1.2 times its EBITDA. And its EBIT easily covers its interest expense, being 16.3 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Advance Auto Parts's saving grace is its low debt levels, because its EBIT has tanked 23% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Advance Auto Parts can strengthen its balance sheet over time. 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, Advance Auto Parts produced sturdy free cash flow equating to 63% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Neither Advance Auto Parts's ability to grow its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. When we consider all the factors discussed, it seems to us that Advance Auto Parts is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. We've identified 2 warning signs with Advance Auto Parts , and understanding them should be part of your investment process.

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.

Find out whether Advance Auto Parts is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.

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.

Advance Auto Parts, Inc. provides automotive replacement parts, accessories, batteries, and maintenance items for domestic and imported cars, vans, sport utility vehicles, and light and heavy duty trucks.

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