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. As with many other companies Automatic Data Processing, Inc. (NASDAQ:ADP) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.

How Much Debt Does Automatic Data Processing Carry?

The chart below, which you can click on for greater detail, shows that Automatic Data Processing had US$3.01b in debt in December 2023; about the same as the year before. However, it does have US$1.67b in cash offsetting this, leading to net debt of about US$1.35b.

How Healthy 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$48.1b due within 12 months and liabilities of US$4.65b due beyond that. Offsetting these obligations, it had cash of US$1.67b as well as receivables valued at US$3.37b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$47.7b.

While this might seem like a lot, it is not so bad since Automatic Data Processing has a huge market capitalization of US$101.2b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Carrying virtually no net debt, Automatic Data Processing has a very light debt load indeed.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Automatic Data Processing has a low net debt to EBITDA ratio of only 0.25. And its EBIT covers its interest expense a whopping 32.2 times over. So we're pretty relaxed about its super-conservative use of debt. And we also note warmly that Automatic Data Processing grew its EBIT by 15% 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 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into 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 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. Taking all this data into account, it seems to us that Automatic Data Processing takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. 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.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.