Automatic Data Processing (NASDAQ:ADP) Seems To Use Debt Quite Sensibly

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 note that Automatic Data Processing, Inc. (NASDAQ:ADP) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Automatic Data Processing

What Is Automatic Data Processing's Net Debt?

As you can see below, Automatic Data Processing had US$2.99b of debt, at March 2023, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$1.85b, its net debt is less, at about US$1.14b.

How Healthy Is Automatic Data Processing's Balance Sheet?

We can see from the most recent balance sheet that Automatic Data Processing had liabilities of US$51.5b falling due within a year, and liabilities of US$4.65b due beyond that. On the other hand, it had cash of US$1.85b and US$3.07b worth of receivables due within a year. So it has liabilities totalling US$51.3b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Automatic Data Processing has a huge market capitalization of US$91.4b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Carrying virtually no net debt, Automatic Data Processing has a very light debt load indeed.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Automatic Data Processing's net debt is only 0.23 times its EBITDA. And its EBIT easily covers its interest expense, being 59.4 times the size. 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 17% 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 it is future earnings, more than anything, that will determine Automatic Data Processing'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, 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. Over the most recent three years, Automatic Data Processing recorded free cash flow worth 73% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, Automatic Data Processing's impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its level of total liabilities. Taking all this data into account, it seems to us that Automatic Data Processing takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Automatic Data Processing's earnings per share history for free.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.