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.’ 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 the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, 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.
What Is Paycom Software’s Debt?
As you can see below, Paycom Software had US$30.9m of debt at December 2020, down from US$32.6m a year prior. But on the other hand it also has US$151.7m in cash, leading to a US$120.8m net cash position.
A Look At Paycom Software’s Liabilities
According to the last reported balance sheet, Paycom Software had liabilities of US$1.72b due within 12 months, and liabilities of US$234.2m due beyond 12 months. Offsetting this, it had US$151.7m in cash and US$19.6m in receivables that were due within 12 months. So it has liabilities totalling US$1.78b more than its cash and near-term receivables, combined.
Given Paycom Software has a humongous market capitalization of US$22.2b, 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.
But the bad news is that Paycom Software has seen its EBIT plunge 18% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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. Over the most recent three years, Paycom Software recorded free cash flow worth 66% 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.
We could understand if investors are concerned about Paycom Software’s liabilities, but we can be reassured by the fact it has has net cash of US$120.8m. And it impressed us with free cash flow of US$133m, being 66% of its EBIT. So we don’t have any problem with Paycom Software’s use of debt. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it.