How Net Debt Is Calculated and Why It Matters to a Company

What Is Net Debt?

Net debt is a liquidity metric used to determine how well a company can pay all of its debts if they were due immediately. Net debt shows how much debt a company has on its balance sheet compared to its liquid assets.

Net debt shows how much cash would remain if all debts were paid off and if a company has enough liquidity to meet its debt obligations.

Net Debt Formula and Calculation

To determine the financial stability of a business, analyst and investors will look at the net debt using the following formula and calculation.

 $\begin{aligned} &\text{Net Debt} = \text{STD} + \text{LTD} - \text{CCE}\\ &\textbf{where:}\\ &\begin{aligned} \text{STD} = &\text{ Debt that is due in 12 months or less}\\ &\text{ and can include short-term bank}\\ &\text{ loans, accounts payable, and lease}\\ &\text{ payments}\end{aligned}\\ &\begin{aligned} \text{LTD} = &\text{ Long-term debt is debt that with a}\\ &\text{ maturity date longer than one year}\\ &\text{ and include bonds, lease payments,}\\ &\text{ term loans, small and notes payable}\end{aligned}\\ &\begin{aligned} \text{CCE} = &\text{ Cash and liquid instruments that can be}\\ &\text{ easily converted to cash.}\end{aligned}\\ &\text{Cash equivalents are liquid investments with a}\\ &\text{maturity of 90 days or less and include}\\ &\text{certificates of deposit, Treasury bills, and}\\ &\text{commercial paper} \end{aligned}$​Net Debt=STD+LTD−CCEwhere:STD=​ Debt that is due in 12 months or less and can include short-term bank loans, accounts payable, and lease​LTD=​ Long-term debt is debt that with a maturity date longer than one year and include bonds, lease payments,​CCE=​ Cash and liquid instruments that can be​Cash equivalents are liquid investments with amaturity of 90 days or less and includecertificates of deposit, Treasury bills, and​

1. Total up all short-debt amounts listed on the balance sheet.
2. Total all long-term debt listed and add the figure to the total short-term debt.
3. Total all cash and cash equivalents and subtract the result from the total of short-term and long-term debt.

What Net Debt Indicates

The net debt figure is used as an indication of a business's ability to pay off all of its debts if they became due simultaneously on the date of calculation, using only its available cash and highly liquid assets called cash equivalents.

Net debt helps to determine whether a company is overleveraged or has too much debt given its liquid assets. A negative net debt implies that the company possesses more cash and cash equivalents than its financial obligations and is hence more financially stable.

A negative net debt means a company has little debt and more cash, while a company with a positive net debt means it has more debt on its balance sheet than liquid assets. However, since it's common for companies to have more debt than cash, investors must compare the net debt of a company with other companies in the same industry.

Net Debt and Total Debt

Net debt is in part, calculated by determining the company's total debt. Total debt includes long-term liabilities, such as mortgages and other loans that do not mature for several years, as well as short-term obligations, including loan payments, credit cards, and accounts payable balances.

Net Debt and Total Cash

The net debt calculation also requires figuring out a company's total cash. Unlike the debt figure, the total cash includes cash and highly liquid assets. Cash and cash equivalents would include items such as checking and savings account balances, stocks, and some marketable securities. However, it's important to note that many companies may not include marketable securities as cash equivalents since it depends on the investment vehicle and whether it's liquid enough to be converted within 90 days.

Comprehensive Debt Analysis

While the net debt figure is a great place to start, a prudent investor must also investigate the company's debt level in more detail. Important factors to consider are the actual debt figures—both short-term and long-term—and what percentage of the total debt needs to be paid off within the coming year.

Debt management is important for companies because if managed properly they should have access to additional funding if needed. For many companies, taking on new debt financing is vital to their long-growth strategy since the proceeds might be used to fund an expansion project, or to repay or refinance older or more expensive debt.

A company might be in financial distress if it has too much debt, but also the maturity of the debt is important to monitor. If the majority of the company's debts are short term, meaning the obligations must be repaid within 12 months, the company must generate enough revenue and have enough liquid assets to cover the upcoming debt maturities. Investors should consider whether the business could afford to cover its short-term debts if the company's sales decreased significantly.

On the other hand, if the company's current revenue stream is only keeping up with paying its short-term debts and isn't able to adequately pay down long-term debt, it's only a matter of time before the company will face hardship or will need an injection of cash or financing. Since companies use debt differently and in many forms, it's best to compare a company's net debt to other companies within the same industry and of comparable size.

Example of Net Debt

Company A has the following financial information listed on its balance sheet. Companies will typically break down whether the debt is short-term or long-term.

• Accounts payable: $100,000
• Credit Line: $50,000
• Term Loan: $200,000
• Cash: $30,000
• Cash equivalents: $20,000

To calculate net debt, we must first total all debt and total all cash and cash equivalents. Next, we subtract the total cash or liquid assets from the total debt amount.

• Total debt would be calculated by adding the debt amounts or $100,000 + $50,000 + $200,000 = $350,000.
• Cash and cash equivalents are totaled or $30,000 + $20,000 and equal $50,000 for the period.
• Net debt is calculated by $350,000 - $50,000 equaling $300,000 in net debt.

Net Debt vs. Debt-to-Equity

The debt-to-equity (D/E) ratio is a leverage ratio, which shows how much of a company's financing or capital structure is made up of debt versus issuing shares of equity. The debt-to-equity ratio is calculated by dividing a company’s total liabilities by its shareholders' equity and is used to determine if a company is using too much or too little debt or equity to finance its growth.

Net debt takes it to another level by measuring how much total debt is on the balance sheet after factoring in cash and cash equivalents. Net debt is a liquidity metric while debt-to-equity is a leverage ratio.

Limitations of Using Net Debt

Although it's typically perceived that companies with negative net debt are better able to withstand economic downtrends and deteriorating macroeconomic conditions, too little debt might be a warning sign. If a company is not investing in its long-term growth as a result of the lack of debt, it might struggle against competitors that are investing in its long-term growth.

For example, oil and gas companies are capital intensive meaning they must invest in large fixed assets, which include property, plant, and equipment. As a result, companies in the industry typically have significant portions of long-term debt to finance their oil rigs and drilling equipment.

An oil company should have a positive net debt figure, but investors must compare the company's net debt with other oil companies in the same industry. It doesn't make sense to compare the net debt of an oil and gas company with the net debt of a consulting company with few if any fixed assets. As a result, net debt is not a good financial metric when comparing companies of different industries since the companies might have vastly different borrowing needs and capital structures.