Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. We can see that Advance Auto Parts, Inc. (NYSE:AAP) uses debt in its operations. But should shareholders worry about its use of debt?
When is debt a problem?
Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. In the worst case, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. When we think about a company’s use of debt, we first look at cash and debt together.
What is Advance Auto Parts’ net debt?
As you can see below, at the end of April 2022, Advance Auto Parts had $1.19 billion in debt, up from $1.03 billion a year ago. Click on the image for more details. However, he has $138.7 million in cash to offset this, resulting in a net debt of around $1.05 billion.
A Look at Advance Auto Parts’ Responsibilities
We can see from the most recent balance sheet that Advance Auto Parts had liabilities of $5.05 billion due in one year, and liabilities of $4.04 billion beyond that. On the other hand, it had a cash position of 138.7 million dollars and 957.8 million dollars of receivables at less than one year. Thus, its liabilities total $8.00 billion more than the combination of its cash and short-term receivables.
This shortfall is sizable relative to its very large market capitalization of US$11.5 billion, so it suggests shareholders watch Advance Auto Parts’ use of debt. If its lenders asked it to shore up its balance sheet, shareholders would likely face significant dilution.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
Advance Auto Parts has a low net debt to EBITDA ratio of just 0.96. And its EBIT covers its interest charges 21.0 times. One could therefore say that he is no more threatened by his debt than an elephant is by a mouse. On the other hand, Advance Auto Parts’ EBIT fell by 16% compared to last year. If this rate of decline in profits continues, the company could find itself in a difficult situation. There is no doubt that we learn the most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Advance Auto Parts’ ability to maintain a healthy balance sheet in the future. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, while the taxman may love accounting profits, lenders only accept cash. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past three years, Advance Auto Parts has recorded free cash flow of 65% of its EBIT, which is about normal, given that free cash flow excludes interest and taxes. This cold hard cash allows him to reduce his debt whenever he wants.
Our point of view
Advance Auto Parts’ EBIT growth rate and the level of its total liabilities are certainly weighing on it, in our view. But his coverage of interest tells a very different story and suggests a certain resilience. Looking at all the angles discussed above, it does seem to us that Advance Auto Parts is a somewhat risky investment due to its leverage. Not all risk is bad, as it can increase stock price returns if it pays off, but this leverage risk is worth keeping in mind. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks reside on the balance sheet, far from it. For example – Advance Auto Parts has 1 warning sign we think you should know.
In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.
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