Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Automatic Data Processing, Inc. (NASDAQ:ADP) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Automatic Data Processing Carry?

As you can see below, Automatic Data Processing had US$2.99b of debt, at March 2024, which is about the same as the year before. You can click the chart for greater detail. But on the other hand it also has US$3.29b in cash, leading to a US$300.0m net cash position.

A Look At Automatic Data Processing's Liabilities

We can see from the most recent balance sheet that Automatic Data Processing had liabilities of US$54.9b falling due within a year, and liabilities of US$4.65b due beyond that. On the other hand, it had cash of US$3.29b and US$3.46b worth of receivables due within a year. So its liabilities total US$52.8b more than the combination of its cash and short-term receivables.

Automatic Data Processing has a very large market capitalization of US$101.1b, so it could very likely raise cash to ameliorate 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. Despite its noteworthy liabilities, Automatic Data Processing boasts net cash, so it's fair to say it does not have a heavy debt load!

And we also note warmly that Automatic Data Processing grew its EBIT by 14% last year, making its debt load easier to handle. 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 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. Automatic Data Processing may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. 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.

Summing Up

While Automatic Data Processing does have more liabilities than liquid assets, it also has net cash of US$300.0m. The cherry on top was that in converted 71% of that EBIT to free cash flow, bringing in US$3.5b. So we don't have any problem with Automatic Data Processing's use of debt. 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.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com