What is the net debt?
The ratio of a firm's liquid assets to its total debt is known as its "Net Debt," it may be used as an indicator of the firm's financial health and solvency. Debt minus cash and cash equivalents gives you a rough idea of how much debt a firm has to its liquid assets. It is useful for gauging a firm's debt situation. It is useful for investors to grasp a company's financial obligations better. A corporation should not take on more debt than it can repay with its current cash flow. If not, a business could never settle its bills on time.
The formula for calculating net debt
The formula is as follows:
Net debt = (Short term debt + Long term debt) – Cash & cash equivalents
The above formula for net debt includes three variables:
· The first part is the short-term debts or current debts. Current debts are obligations that must be repaid quickly. They may be expected in a time frame of less than a year. Short-term loans, payments made on long-term loans over a shorter period, etc., all qualify as current debts.
· Long-term debt is the second element of the formula. In the long run, the loan will have to be paid off. But businesses must ensure that their long-term debt is repaid on schedule (either via regular payments or at the end of the term).
· Cash and cash equivalents are the third and final component. Cash & cash equivalents refer to readily available funds such as currency, bank deposits, Treasury Bills, and other short-term investments.
The goal is to determine how much debt would remain after subtracting the cash and cash equivalents (currently part of the firm's ownership) from the equation. It indicates the amount of debt left if all cash and cash equivalents were used to pay down a certain fraction of the total debt.
Interpretation of the net debt
The financial health of a business may be gauged by calculating its net debt. Consider combining it with other financial parameters to portray a firm's financial health effectively. When evaluating a company's financial health using net debt, it is crucial to take into account the following factors:
i. Positive net debt
A corporation with a net debt of more than zero is financially in dire straits. Since net debt comprises and compares short-term obligations to all debts, the firm may sustainably bear net debt if it has strong signs in other evaluations.
ii. Long-term vs short-term debts
When determining net debt, short-term and long-term debt are treated equally, despite their varied impacts on a company. Financial limitations are greater for a business with a lot of short-term debt and relatively little long-term debt because of the time-sensitive nature of the former.
iii. Revenue streams vs current debts
In the short term, a company can stay going if its revenues are sufficient to pay its operational expenses, but this may not be easy in the long run. For instance, a corporation may run into financial difficulties when more long-term debt is converted into short-term debt if it cannot meet its short-term obligations without generating more income for paying down its long-term debt.
iv. High negative debt
Having more assets than liabilities is a sign of financial solidity, but a high negative debt indicates that maybe the firm is not making the most out of its assets. If you have a surplus of funds, you may consider investing in expanding and improving your business.
v. Net debt and total cash
Finding a company's total cash is necessary to determine its net debt. Total cash comprises cash and highly liquid assets, while total debt does not. Stock holdings and certain marketable securities are examples of cash and cash equivalents. Nevertheless, depending on the form of investment and whether or not it may be converted to cash within 90 days, many corporations may not include convertible securities as cash equivalents.
In-depth examination of debt
While the net debt number is a good starting point, a smart investor would dig deeper into the company's financial situation. The actual short-term and long-term debt statistics and the proportion of overall debt that must be paid off within the next year are crucial considerations.
If the debt is well-managed, businesses may tap into more capital whenever required. Obtaining new debt financing is essential to the long-term development plan of many businesses since the revenues may be used for things like funding an expansion project or paying off or restructuring existing, more costly debt.
Too much debt may put a firm in financial peril, but monitoring when that debt is due to mature is crucial. Short-term loans, those with maturities within a year, need that a corporation either earn sufficient income or have sufficient liquid assets to satisfy the upcoming debt maturities. In the event of a sudden drop in sales, investors need to know whether the firm can still meet its short-term obligations.
However, suppose the firm's present income stream covers its short-term obligations and cannot effectively pay its long-term debt. In that case, the company will inevitably encounter difficulties and require an infusion of cash or financing. Corporations' debt may take numerous forms; thus, comparing a firm's net debt to that of other firms in the same sector and of a similar size is useful.
Debt to equity vs net debt
The debt-to-equity (D/E) ratio is a ratio of leverage that indicates the proportion of debt to equity in a business's funding or capital structure. By dividing total liabilities by equity, the debt-to-equity ratio indicates whether or not a firm is relying too heavily on debt or equity financing to fuel its expansion. When total debt is calculated, net debt is the remaining debt after assets and liquid assets are deducted. Debt-to-equity is a measure of leverage, whereas net debt is a measure of liquidity.
The net debt-to-EBITDA ratio
The financial stability of a business may be gauged by looking at its EBITDA or earnings before interest, taxes, depreciation, and amortization. As a measure of leverage, the net debt-to-EBITDA ratio calculates the number of years it would take a firm to repay its debt at its current earnings rate before interest, taxes, depreciation, and amortization (EBITDA).
An elevated net debt-to-EBITDA ratio may suggest that a corporation has a heavy debt load and is hesitant to take on more loans. This ratio often indicates a company's repayment capacity by lending institutions before extending credit. This ratio may be computed using the following formula:
The relevance of net debt
Investors and financial analysts use this indicator to gauge a firm's financial health and show the degree to which it is leveraged. Businesses with a positive net worth are more resilient to economic downturns, interest rate fluctuations, and other economic shocks.
Investors look to it as a possible sign of the company's financial health when deciding whether or not to purchase shares. However, it is important to consider this ratio when assessing a company's financial health.
Uses of net debt
Net debt serves two primary functions, which are:
i. Valuation of enterprise and equity
The equity-to-equity-valuation bridge involves net debt. Enterprise value is the worth of a company's operations apart from its capital structure. The value held by stockholders (sometimes stated on a per-share basis for publicly traded corporations) is known as equity value or market capitalization. When comparing businesses with different capital structures, enterprise value provides more information.
The enterprise value is computed as the sum of net debt and equity value. Net debt should be reflected in the appraisal at its market value rather than its book value or balance sheet amount. The basic idea of this method is that there are surplus funds.
ii. Evaluation of credit
The net debt/EBITDA ratio is one of the most common leverage ratios since it directly compares net debt to the firm's earnings before interest, taxes, depreciation, and amortization. Other common leverage ratios are net debt/equity and net debt/total capital. Credit analysis that considers net debt rather than total debt presupposes that the firm can utilize its cash reserves to repay debt in the event of financial difficulty.
The drawbacks of net debt
Businesses with a negative net debt are often seen to be more resilient during economic downturns and worsening macroeconomic circumstances, but having low debt levels might be a warning indicator. Without debt, a firm may struggle to compete with peers investing in their long-term development.
Capital-intensive businesses, such as those in the oil and gas industry, must invest substantially in infrastructure like buildings and machinery. Since oil rigs and drilling equipment are expensive, most firms rely heavily on long-term debt to fund their operations.
The net debt of an oil firm should be favorable, but investors should still look at how it stacks up against other oil companies. The net debt of the business should not be compared to the net debt of a consulting firm with few fixed assets. Therefore, since businesses in various sectors may have drastically different capital structures and borrowing requirements, net debt is not a useful financial statistic for making cross-sector comparisons.
Is it more crucial to look at net or gross debt?
An organization's debts and other related commitments, expressed as a nominal amount, make up its gross debt. A huge disparity between net and gross debt may cause concern since it suggests a sizable cash reserve and substantial debt. When determining an organization's enterprise value (EV) or looking to make an acquisition, net debt is a helpful metric since it excludes cash and cash equivalents from the total debt. It is because businesses do not want to spend money to make money. Instead, the takeover value may be estimated more accurately by looking at the net debt.
Net debt per capita
Calculating a country's net debt per capita involves dividing the total sovereign debt by the country's population. It compares the relative solvency of different countries by showing how much debt each has to its population.
Do accounts payable contribute toward the net debt?
Accounts payable are often excluded from net debt calculations since short-term debts are included in an organization's current liabilities. Rather, one finds net debt by deducting the cash and cash equivalents from the total debt the firm owes.
Can we consider net debt a GAAP metric?
According to the generally accepted accounting principle, net debt is not a standard metric. Nevertheless, investors and financial analysts often use it as a criterion for judging a firm's leverage and debt service capacity.
Should lease obligations be included in net debt?
Including lease liabilities in net debt may or may not be appropriate depending on the study's objective. Lease obligations, for instance, may not always count against total debt since they are classified as equity. However, lease responsibilities may be considered debt in certain circumstances since they constitute a promise to pay money in the future. Whether lease obligations are included in net debt depends on the nature of the study and the goals of the information consumers.
Conclusion
Net debt is a measure of the ability of an organization to pay all of its obligations, assuming they were to be paid down today. Net debt, in simple terms, compares the total debt of a corporation to its liquid assets. The debt remains after a corporation has used all its liquid assets to pay down as much debt as feasible. It is used to examine whether a firm can fulfill its commitments, say they were all due today, and whether it can take on new debt.