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

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Automatic Data Processing, Inc. (NASDAQ:ADP) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. 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 think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Automatic Data Processing

How Much Debt Does Automatic Data Processing Carry?

As you can see below, Automatic Data Processing had US$3.01b of debt, at December 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$1.67b, its net debt is less, at about US$1.35b.

How Healthy Is Automatic Data Processing's Balance Sheet?

The latest balance sheet data shows that Automatic Data Processing had liabilities of US$48.1b due within a year, and liabilities of US$4.65b falling due after that. Offsetting these obligations, it had cash of US$1.67b as well as receivables valued at US$3.37b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$47.7b.

Automatic Data Processing has a very large market capitalization of US$99.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. Carrying virtually no net debt, Automatic Data Processing has a very light debt load indeed.

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). 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 has a low net debt to EBITDA ratio of only 0.25. And its EBIT easily covers its interest expense, being 32.2 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also good is that Automatic Data Processing grew its EBIT at 15% over the last year, further increasing its ability to manage debt. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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 71% 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

The good news is that Automatic Data Processing's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its level of total liabilities does undermine this impression a bit. When we consider the range of factors above, it looks like Automatic Data Processing is pretty sensible with its use of 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.

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.

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.