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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. We can see that Paycom Software, Inc. (NYSE:PAYC) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, 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 examine debt levels, we first consider both cash and debt levels, together.
What Is Paycom Software’s Net Debt?
As you can see below, Paycom Software had US$34.0m of debt, at March 2019, which is about the same the year before. You can click the chart for greater detail. However, its balance sheet shows it holds US$91.3m in cash, so it actually has US$57.4m net cash.
A Look At Paycom Software’s Liabilities
We can see from the most recent balance sheet that Paycom Software had liabilities of US$1.48b falling due within a year, and liabilities of US$180.6m due beyond that. Offsetting these obligations, it had cash of US$91.3m as well as receivables valued at US$3.84m due within 12 months. So it has liabilities totalling US$1.57b more than its cash and near-term receivables, combined.
Given Paycom Software has a humongous market capitalization of US$13.4b, it’s hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Given that Paycom Software has more cash than debt, we’re pretty confident it can manage its debt safely.
On top of that, Paycom Software grew its EBIT by 44% over the last twelve months, and that growth will make it easier to handle its debt. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Paycom Software’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. While Paycom Software has net cash on its balance sheet, it’s still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Paycom Software produced sturdy free cash flow equating to 75% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
While Paycom Software does have more liabilities than liquid assets, it also has net cash of US$57m. And it impressed us with its EBIT growth of 44% over the last year. So is Paycom Software’s debt a risk? It doesn’t seem so to us. Another factor that would give us confidence in Paycom Software would be if insiders have been buying shares: if you’re conscious of that signal too, you can find out instantly by clicking this link.
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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