The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Automatic Data Processing, Inc. (NASDAQ:ADP) does use debt in its business. But should shareholders be worried about its use of debt?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.
View our latest analysis for Automatic Data Processing
What Is Automatic Data Processing's Debt?
The chart below, which you can click on for greater detail, shows that Automatic Data Processing had US$3.10b in debt in June 2023; about the same as the year before. However, it also had US$2.10b in cash, and so its net debt is US$997.4m.
How Healthy Is Automatic Data Processing's Balance Sheet?
According to the last reported balance sheet, Automatic Data Processing had liabilities of US$42.8b due within 12 months, and liabilities of US$4.69b due beyond 12 months. Offsetting these obligations, it had cash of US$2.10b as well as receivables valued at US$3.01b due within 12 months. So its liabilities total US$42.4b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Automatic Data Processing is worth a massive US$99.4b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. But either way, Automatic Data Processing has virtually no net debt, so it's fair to say it does not have a heavy debt load!
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.
Automatic Data Processing has a low net debt to EBITDA ratio of only 0.20. And its EBIT covers its interest expense a whopping 43.9 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. And we also note warmly that Automatic Data Processing grew its EBIT by 19% last year, making its debt load easier to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Automatic Data Processing can strengthen its balance sheet over time. 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 always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Automatic Data Processing recorded free cash flow worth 74% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Our View
Automatic Data Processing's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. Looking at the bigger picture, we think Automatic Data Processing's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. Over time, share prices tend to follow earnings per share, so if you're interested in Automatic Data Processing, you may well want to click here to check an interactive graph of its earnings per share history.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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.
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