Net Debt – What It Is, How To Calculate It And What It Tells?

Net debt is a very useful financial metric to assess the liquidity position of a company. It shows the ability of a company to pay its obligations if all of them become due today. In other words, it compares the total debt with the liquid assets of a company. Liquid assets include cash and cash equivalents.

Net debt is the amount remaining after using the liquid assets to pay as much debt as possible. It helps to determine if a company can pay its obligations and if it can take on more debt.

Net Debt

Calculation of Net Debt

All the data that one needs to calculate the net debt is available in the balance sheet. The formula to calculate is:

Net Debt = (Short-Term Debt + Long-Term Debt) – Cash and Cash Equivalents

Long-term debt includes obligations that are due beyond a 12-month period. Like mortgages, lease obligations, notes payable, bonds and other long-term loans.

The short-term debt includes financial obligations that are due within the twelve months. Like, accounts payable, taxes, loan payments and interest due for next year, rent and credit card.

Cash and cash equivalents will include stock, marketable securities, commercial paper, treasury bills, and bank account balances.

Let’s understand the calculation with the help of an example. Assume Company A has a long-term debt of $10,000, short-term debt of $5,000, and Cash and Cash Equivalents of $4,000. In this case the net debt = $10,000 + $5,000 – $4,000 = $11,000

It shows that if all debt falls due tomorrow, the company won’t be able to pay it. The company will have to sell its inventory or fixed assets to pay the debt.

How Is It Different from Gross debt?

Gross debt is the total debt that a company owns. It is the sum total of the book value of a company’s debt obligations. If the difference between the net and gross debt is big, it means that a company keeps big cash balance.

Importance of Net Debt

Management uses this metric to determine if it can take on more debt for expanding the operations. Analysts and investors also regularly use the net debt to analyze the financial health of a company. It helps analysts and investors to understand if the company is over or under-leveraged. Usually, it is seen that companies with big debt and big cash positions perform better when it comes to adverse economic changes, like recessions, interest rate fluctuations, and more.

However, if a company’s net debt is high due to low cash reserves, it does not necessarily mean that it over-leveraged. It may also mean that it does not keep all its cash in the bank, rather reinvests it in the business. Similarly, having more cash and cash Equivalents is not always good. It could also suggest that the company is not managing its cash efficiently.

How to Use It Efficiently?

To get a better understanding, it is important to compare the net debt of a company with other same size companies in the same industry. Like companies in mining, drilling, and construction carry a huge amount of debt. On the other hand, software or accounting firms have little debt.

Using this metric in combination with other metric gives a better understanding of the company’s health. Like using Net Financial Debt to Total Asset tells how much the company’s assets are leveraged after accounting for the cash and cash equivalents. Other things remaining constant, a company with low or negative ratio would mean that it is less risky than a company with a higher ratio.

One more ratio that is often used by analysts is the net debt to EBITDA (earnings before interest depreciation and amortization) ratio. It helps in measuring the leverage. Further, it also tells how many years a company would take to pay its debt if EBITDA and net debt are held constant.

Though net debt is a good indicator of a company’s financial health, a wise investor must dive further into the debt details to come up with a conclusion. For instance, the investor must separately study the short-term and long-term debt, along with the debt amount that the company needs to pay within the next year.

Also, to get the whole picture, analysts and investor must use this metric with other liquidity and leverage ratios. Other ratios like debt to equity ratio, cash conversion cycle, and net liquidity ratio will help to get a better picture of the company’s financial position.

Last updated on : December 22nd, 2018

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