We Think Automatic Data Processing (NASDAQ:ADP) Can Stay On Top Of Its Debt

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. Importantly, Automatic Data Processing, Inc. (NASDAQ:ADP) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. 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

What Is Automatic Data Processing's Debt?

As you can see below, at the end of March 2022, Automatic Data Processing had US$3.00b of debt, up from US$2.00b a year ago. Click the image for more detail. However, it also had US$1.66b in cash, and so its net debt is US$1.33b.

How Healthy Is Automatic Data Processing's Balance Sheet?

The latest balance sheet data shows that Automatic Data Processing had liabilities of US$63.1b due within a year, and liabilities of US$4.77b falling due after that. Offsetting this, it had US$1.66b in cash and US$3.25b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$63.0b.

This is a mountain of leverage even relative to its gargantuan market capitalization of US$92.5b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Carrying virtually no net debt, Automatic Data Processing has a very light debt load indeed.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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 0.32. And its EBIT covers its interest expense a whopping 90.0 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 11% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. 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 company can only pay off debt with cold hard cash, not accounting profits. 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 71% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

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. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.