Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Paycom Software, Inc. (NYSE:PAYC) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Paycom Software's Debt?
You can click the graphic below for the historical numbers, but it shows that Paycom Software had US$33.5m of debt in June 2019, down from US$35.3m, one year before. However, it does have US$94.8m in cash offsetting this, leading to net cash of US$61.3m.
How Healthy Is Paycom Software's Balance Sheet?
According to the last reported balance sheet, Paycom Software had liabilities of US$1.20b due within 12 months, and liabilities of US$190.2m due beyond 12 months. Offsetting these obligations, it had cash of US$94.8m as well as receivables valued at US$13.5m due within 12 months. So its liabilities total US$1.28b more than the combination of its cash and short-term receivables.
Given Paycom Software has a humongous market capitalization of US$12.1b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Paycom Software also has more cash than debt, so we're pretty confident it can manage its debt safely.
Also positive, Paycom Software grew its EBIT by 28% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Paycom Software can strengthen its balance sheet over time. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Paycom Software 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, Paycom Software recorded free cash flow worth 71% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Although Paycom Software's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$61.3m. And it impressed us with its EBIT growth of 28% over the last year. So we don't think Paycom Software's use of debt is risky. Over time, share prices tend to follow earnings per share, so if you're interested in Paycom Software, you may well want to click here to check an interactive graph of its earnings per share history.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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