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In corporate valuation, as in corporate accounting, numerous metrics are used to assess the worth of a business and its ability to generate profit while meeting its financial obligations. One of the simplest ways to evaluate the financial fitness of a company is to calculate its net debt.
Net debt is calculated by adding up all of a company’s short- and long-term liabilities and subtracting its current assets. This figure reflects a company’s ability to meet all of its obligations simultaneously using only those assets that are easily liquidated.
Key Takeaways
- Net debt reveals how much a company owes after taking into account its readily available assets, highlighting its financial health.
- It is calculated by subtracting current assets from total liabilities (short-term liabilities plus long-term liabilities).
- Net debt is important to investors and analysts because it allows them to gauge a company’s financial strategy, liquidity, and potential risks or opportunities.
Liabilities and Assets
Short-term liabilities are those debts that must be paid within one year. Typically, these consist of items such as accounts payable and bills for supplies and operating costs. Long-term liabilities are repaid over the course of a longer period, such as mortgages, loans, and capital leases.
Current assets refer to the amount of money a company has readily available to pay off debts. Therefore, current assets include only cash or cash equivalents, such as stocks, marketable securities, accounts receivable, and other liquid assets. All the information necessary to calculate net debt is readily available on a company’s balance sheet.
The Formula for Net Debt
Net Debt=STL+LTL−CAwhere:STL=total short-term liabilitiesLTL=total long-term liabilitiesCA=total current assets
To calculate net debt, examine the balance sheet to find the following information: total short-term liabilities, total long-term liabilities, and total current assets. Enter these three items into cells A1 through A3. In cell A4, enter the formula “=A1+A2−A3” to render the net debt.
Where:
A1=Total Short-Term Liabilities
A2=Total Long-Term Liabilities
A3=Total Current Assets
Example of Using Excel to Calculate Net Debt
For example, assume Company ABC has short-term liabilities consisting of $10,000 in operating costs and $30,000 in accounts payable. Its long-term liabilities consist of a $100,000 bank loan and a lease for a $25,000 piece of equipment. Its current assets consist of $75,000 in cash and $150,000 in marketable assets.
The balance sheet lists the subtotals for these three categories as $40,000, $125,000, and $225,000, respectively. Using Excel, the business accountant determines that the net debt is $40,000 + $125,000 – $225,000, or -$60,000, indicating that the business has more than enough funds to pay off all its liabilities if they all become due concurrently.
As with all financial analysis, it is important to consider multiple financial metrics and compare them to similar companies in the same industry to get a full picture of a company’s financial profile.
Why Net Debt Is Important
Net debt offers insight into whether a debt load will be problematic for stakeholders in a company. Net debt provides comparative metrics that can be benchmarked against industry peers.
More debt does not necessarily mean it is financially worse off than a company with less debt. In fact, a large debt load on a company’s balance sheet may actually be smaller than that of a competitor.
Net debt also reveals information on a company’s operational strategy. If the difference between net debt and gross debt is large, it indicates a large cash balance as well as significant debt.
This might indicate there are liquidity concerns, capital investment opportunities, or possibilities of planned acquisitions. Looking at a company’s net debt, particularly relative to its peers, prompts further examination of its strategy.
From an enterprise value standpoint, net debt is a key factor during a buyout situation. Net debt is more relevant for a buyer from a valuation standpoint. A buyer is not interested in spending cash to acquire cash. It’s more relevant for a buyer to look at enterprise value, using the target company’s debt net of its cash balances to rightly assess the acquisition.
Is Positive Net Debt Bad?
Positive net debt is not necessarily bad. Positive net debt means a company has more debt than cash but whether it’s good or bad depends on the specifics. If a company can manage debt in a healthy manner, debt can help with business growth, expansion, and managing operations. On the other hand, if a company is struggling to pay back its debt or borrowing too much, it could signal financial trouble.
What Is the Difference Between Debt and Net Debt?
Debt is the total amount of money a company owes, including loans, bonds, and any other money borrowed. Net debt takes cash and cash equivalents into account because they can be used to pay down debt. So net debt is total debt but minus cash and cash equivalents. Debt shows all of the money a company has borrowed while net debt is the actual amount of money owed after taking into consideration cash.
How Can a Company Reduce Debt?
There are a few ways a company can reduce its debt. A company can improve its cash flow so it can pay down its debt, which can be done in a few ways, such as cutting costs, improving efficiency, and increasing sales. It can also restructure its debt to get better terms, such as lower interest rates.
The Bottom Line
Net debt is an important metric of a company’s financial health that sheds light on its ability to meet its obligations using readily available assets. Subtracting current assets from total liabilities allows investors and analysts to assess a company’s liquidity and financial stability. While a high level of debt isn’t necessarily bad, it’s important to evaluate the metric amongst industry peers to get a full understanding of risks and opportunities.
