Here's Why Automatic Data Processing (NASDAQ:ADP) Can Manage Its Debt Responsibly

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.' 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. We note that Automatic Data Processing, Inc. (NASDAQ:ADP) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.

Check out our latest analysis for Automatic Data Processing

What Is Automatic Data Processing's Net Debt?

The chart below, which you can click on for greater detail, shows that Automatic Data Processing had US$2.00b in debt in March 2021; about the same as the year before. However, it also had US$1.90b in cash, and so its net debt is US$93.5m.

How Strong Is Automatic Data Processing's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Automatic Data Processing had liabilities of US$44.6b due within 12 months and liabilities of US$4.12b due beyond that. Offsetting these obligations, it had cash of US$1.90b as well as receivables valued at US$2.77b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$44.1b.

This deficit isn't so bad because Automatic Data Processing is worth a massive US$87.5b, and thus could probably raise enough capital to shore up 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. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With debt at a measly 0.025 times EBITDA and EBIT covering interest a whopping 225 times, it's clear that Automatic Data Processing is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. Automatic Data Processing's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Automatic Data Processing produced sturdy free cash flow equating to 74% of its EBIT, about what we'd expect. 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. All these things considered, it appears that Automatic Data Processing can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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, 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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