Net Debt: Definition, Formula & Calculation

KEY TAKEAWAYS

• Net debt is a liquidity measure that is used to help companies figure out how well they can meet their debt obligations. 
• It shows how much cash would remain once all debts have been paid off. 
• Net debt can be calculated by taking a company’s total cash and cash equivalents and subtracting it from its total short and long-term debt.

What Is Net Debt?

Net debt is a liquidity measure. It works by helping to figure out how well a company could feasibly pay all of its debts if they were immediately due. Net debt shows how much debt a company has on its balance sheet. This is in comparison to its liquid assets. 

The measure shows how much cash would be left over if all of the company’s debt were to be paid off as well as shows whether a company has enough liquidity to meet its debt obligations. 

Why Net Debt Is Important

Net debt is used as an indication of a company’s ability to pay off all of its debts if they suddenly become due on the day of calculation. This is done using only its highly liquid assets, or cash equivalents, and its available cash. 

This method helps to figure out whether a company is overleveraged. As well as figure out whether the company has too much debt when compared to its liquid assets. A company with a negative net debt would be assumed to have more cash and cash equivalents than its financial obligations. This would be an indication that it is a financially stable company as it has more cash than it does debt. 

A positive net debt would indicate that a company has more debt on its balance sheet than it has liquid assets. Although it is important to note that it is common for companies to have less cash than debt. This means investors have to compare the net debt of a company with other companies in the same industry. 

Net Debt Formula

In order to figure out the financial stability of a company, analysts and investors will look at the net debt. They can do this by using the following calculation and formula.

The net debt formula is as follows:

Where:

ND = Net Debt

STD = Short-Term Debt. This is debt that is due to be paid in 12 months or less. This can include short-term bank loans, lease payments, and accounts payable. 

LTD = Long-Term Debt. This is any long-term liabilities that have a maturity date that is longer than one year. This can include lease payments, term loans, bonds, small and notes payable. 

CCE = Cash and Cash Equivalents. These are assets that can easily be converted into cash at short notice. Cash equivalents are liquid investments that have a maturity of 90 days or less. They include Treasury bills, certificates of deposit, and any marketable security.

Net Debt Calculation

There are five steps to calculating net debt. They are as follows:

1. Add up and find the total of all short-term debt amounts. These are the amounts listed on a company’s balance sheet.

2. Add up and find the total of all long-term debt amounts. These are also listed on a company’s balance sheet. 

3. Add the figure from short-term debt to the figure from long-term debt.

4. Add up and find the total of all cash and cash equivalents. 

5. Subtract this result from the total short-term and long-term debt. 

Limitations of Using Net Debt

The calculations of net debt mean that it is difficult to compare cross-industry companies. It is often believed that a negative net debt means a company is able to better withstand economic downtrends. However, a lack of debt can also be read as a warning sign. If a company isn’t taking out debt to invest in its long-term growth it can struggle in the market against its competitors. 

As a result, net debt is not always a good indicator when comparing companies of different industries. This is because the separate companies may have completely different borrowing needs and capital structures.

Example of Net Debt

Let’s say that Company X is looking to figure out its liquidity in relation to its debt. They look at their balance sheet and see the following information:

• Accounts Payable: $200,000
• Credit Line: $100,000
• Term Loan: $400,000
• Cash: $60,000
• Cash Equivalents: $40,000

In order for Company X to calculate its net debt, they first need to find its totals. This would be the total of all debt, and total all cash and cash equivalents. 

The next step is to subtract the total cash or liquid assets from the amount of total debt. This would be as follows:

• Total Debt: $200,000 + $100,000 + $400,000 = $700,000
• Cash and Cash Equivalents: $60,000 + $40,000 = $100,000
• Net Debt: $700,000 – $100,000 = $600,000 in net debt

So in this case, Company X’s net debt would total $600,000.

Summary

Net debt is a good financial measure of a company’s debt management and liquidity. However, it can fall down when used to compare companies in separate industries. As with any debt metric, net debt should be used alongside other liquidity and leverage ratios. This mix of financial ratios allows for a more accurate representation of the financial health of a company.