All About Net Debt


What is net debt?

Net debt is a liquidity measure used to determine a company’s ability to repay all its debts with its liquid assets. In other words, net debt is the debt outstanding after the company has paid its maximum debt with its available cash and cash equivalents. The metric helps the investors to know about a company’s financial health by comparing its liabilities and liquid assets.

KEY TAKEAWAYS

  • Net debt is a company’s outstanding debt after it hypothetically clears its debt obligations with its liquid assets.
  • It is a crucial tool to know the financial health of a company.
  • Net debt is calculated by subtracting cash and cash equivalents from the organisation’s total debt or gross debt.
  • Gross debt is the total value of a company’s short and long-term debt obligations.
  • A negative net debt means the company has enough liquid assets to clear its debt obligations.
  • A positive net debt indicates a higher debt compared to the company’s cash and cash equivalents.

How is net debt calculated?

Net debt is an essential tool to know about a business’s financial stability and health. Hence, the following formula is used to measure the net debt:

Net Debt= (Short-term debt + Long-term debt)– Cash and cash equivalents

  • Short-term debt is the debt that is due within 12 months. It may include short-term bank loans, accounts payables, wages, taxes, etc.
  • Long-term debt is the debt that is due after 12 months or above. It may include notes payable, bonds, lease obligations, term loans, etc.
  • Cash and cash equivalents are the company’s liquid assets that can be easily converted into cash. These may include commercial papers, treasury bills, securities, bank deposits, etc.

What does net debt calculation tell us about the company's financial health?

Net debt tells if a company can pay off all its debts if they become due today with the available cash and cash equivalents. It helps the investors and analysts to know whether the company is underleveraged or overleveraged. A negative net debt means the organisation has enough liquid assets to pay off its debts which indicates that the company is financially healthy. Usually, companies that have a negative net debt are better able to endure adverse economic changes, such as recessions or interest rate fluctuations.

On the other hand, the company’s positive net debt means that its debts are more than its cash and cash equivalents. It indicates that the company’s liabilities exceed its liquid assets, which makes it difficult to fulfil its payment obligations.

Gross debt vs Net debt

Gross debt is the total value of all short and long-term debt obligations a company has on its balance sheet at a particular time, while net debt is the debt outstanding once the company pays off its maximum debt obligations with its available cash and cash equivalents.

Net Debt = Gross debt - Cash and cash equivalent

Example

Let’s take an example to understand the concept of net debt and gross debt.

Suppose company XYZ has the following debt information on its balance sheet:

Bonds: ₹5 Lakh

Long-term loan: ₹10 Lakh

Accounts payable: ₹1 Lakh

Short-term loan: ₹ 5 Lakh

Cash: ₹3 Lakh

Treasury bills: ₹5 Lakh

Marketable securities: ₹5 Lakh

Short-term debt will include accounts payable and the short-term loan= ₹ (1 Lakh+5 Lakh) = ₹6 Lakh

Long-term debt will have bonds and the long-term loan = ₹ (5 Lakh+10 Lakh) = ₹15 Lakh

Total debt will include the total value of all debt obligations= ₹ (5 Lakh+10 Lakh+1 Lakh+5 Lakh) = ₹21 Lakh

Cash and cash equivalents include cash, treasury bills, and marketable securities = ₹ (3 Lakh+5 Lakh+5 Lakh) = ₹13 Lakh

Net debt= Total debt- Cash and cash equivalents = ₹ (21 Lakh-13 Lakh) = ₹8 Lakh

Thus, the company XYZ has a positive net debt of ₹8 Lakh. This indicates that the company has a remaining debt of ₹8 Lakh after paying maximum debt obligations with its liquid assets.

What does net debt reveal, and what does it hide?

Net debt reveals the company’s ability to pay off all of its debts using only its cash and equivalents. The metric indicates how leveraged an organisation is and how much cash is available with it to fulfil its payment obligations. A positive net debt reveals that the company has more debt than its liquid assets, while negative net debt indicates higher cash and equivalents than its debt obligations.

However, a positive net debt doesn’t necessarily mean the company is over-leveraged. It might be possible that the company doesn’t keep its cash in liquid form and prefers to invest more in inventory or capital assets. Also, the metric of net debt doesn’t reveal the actual financial condition of an organisation.

Final words

Net debt is an essential metric to gauge an organisation’s financial health, but it must not be the only instrument to determine its financial stability. Thus, other metrics, such as current ratio, debt-equity ratio, etc., should be used in conjunction with net debt to assess the true financial status of a company.

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