Net debt is a financial?liquidity metric?used to measure a company’s ability to pay its obligations by comparing its total debt with its liquid assets. In other words, this calculation shows how much debt a company has relative to its liquid assets. Thus, demonstrating its ability to pay off the debt immediately if it were called.
This?leverage ratio?measures the net amount of liabilities that exceed?cash and cash equivalents. This metric is important for both management and investor analysts because it shows how well a company can handle its current obligations and if it has the ability to take on more debt in the future.
Management uses this leverage ratio when they need to find out the whether they can feasibly borrow more money to expand operations or purchase new assets. Analysts and investors, on the other hand, mostly use this ratio to determine whether the company is highly leveraged or has the ability to pay its obligations easily. Analysts and investors can also use this metric to predict whether the company can withstand adverse economic conditions because it allows them to forecast a company’s ability to take on new debt in times of need.
A ratio higher than one means that the company has more debt than current assets. If all of the company’s creditors called their debts immediately, the company would not be able to pay them without selling long-term assets. If the ratio is less than one, on the other, the company has more than enough liquid assets to pay off its obligations.
Let’s take a look at how to calculate net debt.
The net debt formula is calculated by subtracting all cash and cash equivalents from short-term and long-term liabilities.
Net Debt = Short-Term Debt + Long-Term Debt – Cash and Cash Equivalents.
The First step in calculating the net debt equation is to identify the short term debts, these are those debts which are payable in 12 month period. After this, add all the short term debts of the company.
The second step is to identify the long term debts, obviously these will be those debts which would be payable in more than one year period. After this, add all the long term debts of the company.
Then add all the cash and cash equivalents of the company, cash equivalents means the liquid assets of the company (meaning those assets that are readily or easily converted into cash).
Now the final step is to add up total short-term debt and the total long-term debt and then subtract the total cash and cash equivalents from.
Now let’s take a look at an example.
Company ABC has following items listed in the?balance sheet:
- Bank Overdraft: 100,000
- Trade Payables: 80,000
- Trade Receivables: 150,000
- Bank Loan: 500,000
- Cash on hand: 300,000
- Cash in bank: 450,000
First, let’s identify the short-term debts. In this example, bank overdraft and trade payables are both short-term obligations since these are payable in one year period. Trade payables are the purchases that the company ABC made on credit and are repayable within a 12 month financial year. Bank overdraft is however the limit allowed by bank over the balance in the bank account. It means that if the company’s bank balance reaches zero there is a certain limit allowed by the bank that the company can still make transactions.
Total Short Term Debt = 100,000 + 80,000 = 180,000
Then comes long term debts which in this case is only Bank loan, as this is payable in more than one year period. It is understandable that the bank loan is always repayable after more than one year.
Long Term Debt = 500,000
Now it is time to identify and add up the cash and cash equivalents, which in this case are Cash in hand, trade receivables and cash at bank. Trade Receivables are the sales made on credit over the year.
Cash and Cash Equivalents = 150,000 + 300,000 + 450,000 = 900,000
Finally the last step is to compute the Net Debt of company ABC
Net Debt = 180,000 + 500,000 – 900,000 = -120,000
If the figure of Net Debt is negative then it is a good sign because it means that the company ABC has enough cash to pay off its debts.
As already explained in the example above, the calculation of the net debt ratio is pretty simple. The main issue arises in locating the figures from the?financial statements. It is easy to remember that the short-term debt will always be listed under the current liabilities (liabilities or debts due in a year) and the long-term debt would be listed under the non-current liabilities (liabilities or debts due in more than one year). Finally the cash and equivalents would be listed under current assets excluding the?inventory?figure.
This ratio holds importance mostly to the investor’s point of view because the company stock price fluctuates based on the company’s financial health. A highly leveraged company is not only riskier than a debt free company, it is also less able to expand and grow into new markets.
The Company ABC is financially healthy as the net debt ratio is negative $120 million. This means that the company has $120 million more cash and liquid assets than total debts. This means that the company could pay off its entire liabilities section on the balance sheet without selling off a single long-term or operating asset. Thus, operations could continue even if the debt was called today.
Creditors also use this metric to analyze a company’s ability to take on new loans to finance operations or invest in new equipment. ABC company has a strong ratio, shouldn’t have a problem convincing a bank to extend more debt.
As with all financial ratios, the net debt calculation should not be analyzed in a vacuum. It’s important to use this metric with other liquidity and leverage ratios like the net liquidity ratio,?cash conversion cycle, and the?debt to equity ratio?in order to get a full picture of the company’s financial position and amount of leverage.
It’s also important to compare this metric to other companies in the industry. Since industries are financed differently, it’s important to have a benchmark. For example, it’s not uncommon for industries with heavy equipment requirements like mining, drilling, and construction to have large amounts of debt. Whereas, service based industries like public accounting typically have small amounts of liabilities on their balance sheets.
If the net debt comes higher than the industry average, it means the company may not be able to pay off its debts in the future and the market price of the company’s share might fall. It’s always important to look at industry trends in order to get some relevance in terms of decision making.