Is Automatic Data Processing (NASDAQ:ADP) Using Too Much Debt?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Automatic Data Processing, Inc. (NASDAQ:ADP) does carry debt. But the more important question is: how much risk is that debt creating?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 image below, which you can click on for greater detail, shows that at September 2023 Automatic Data Processing had debt of US$3.33b, up from US$3.16b in one year. However, it does have US$1.46b in cash offsetting this, leading to net debt of about US$1.88b.

How Healthy Is Automatic Data Processing's Balance Sheet?

According to the last reported balance sheet, Automatic Data Processing had liabilities of US$41.2b due within 12 months, and liabilities of US$4.62b due beyond 12 months. Offsetting these obligations, it had cash of US$1.46b as well as receivables valued at US$3.10b due within 12 months. So it has liabilities totalling US$41.3b 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$94.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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's net debt is only 0.36 times its EBITDA. And its EBIT covers its interest expense a whopping 36.5 times over. 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 17% 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'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 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 71% 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 truth be told we feel its level of total liabilities does undermine this impression a bit. 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. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Automatic Data Processing is showing 1 warning sign in our investment analysis , you should know about...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.