Is Automatic Data Processing (NASDAQ:ADP) A Risky Investment?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Automatic Data Processing, Inc. (NASDAQ:ADP) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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 Debt?

As you can see below, Automatic Data Processing had US$2.99b of debt, at December 2022, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$1.36b in cash, and so its net debt is US$1.63b.

How Healthy Is Automatic Data Processing's Balance Sheet?

According to the last reported balance sheet, Automatic Data Processing had liabilities of US$46.8b due within 12 months, and liabilities of US$4.65b due beyond 12 months. Offsetting this, it had US$1.36b in cash and US$3.16b in receivables that were due within 12 months. So its liabilities total US$46.9b more than the combination of its cash and short-term receivables.

Automatic Data Processing has a very large market capitalization of US$88.3b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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's net debt is only 0.35 times its EBITDA. And its EBIT easily covers its interest expense, being 58.0 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 16% 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.

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 72% 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. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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. Be aware that Automatic Data Processing is showing 1 warning sign in our investment analysis , you should know about...

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.

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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.