Meaning and definition of Net Debt
Net debt can be expressed as a metric that indicates the overall debt situation of a company by netting the value of the liabilities and debts of a company along with its cash and other similar liquid assets. To put it simple, net debt refers to the total debt of a company minus cash on hand. As expressed by Investopedia, one of the most important factors that require consideration while investing in a company is the amount of debt carried by the company.
Why net debt matters?
Net debt is a measure of the ability of a company to repay its debts when due. Therefore, it is helpful to the analysts and investors in getting a better feel for whether a company is over- or under-leveraged, i.e. the capability of a company to afford its debts. Generally, companies with larger debts as well as large cash positions are in better positions to withstand adverse changes in the economic conditions, such as interest rate fluctuations, recessions, etc. thus, net debt is significant for most investors while deciding to buy or sell a company’s stock. A high net debt indicates a poor overall financial health of the company.
The general formula used for computing net debt is:
Net Debt = Short-Term Debt + Long-Term Debt - Cash and Cash Equivalents
Calculating Net Debt
Net debt is, generally, computed by comparing the debts and liabilities of a company. The key steps involved are:
1. Sum up the short term debts of the company and note them.
2. Sum up the long term debts of the company and note them.
3. Determine the amount of cash and cash equivalents on hand possessed by the company.
4. Add the totals of the short term and long term debts together. Deduct the total cash and cash equivalents from the result obtained as the sum of debts thus reaching the net debt.
The net debt concept can be illustrated in the following example:
Let us presume that Company ABC has $10,000,000 as short term debt, $4,000,000 as long term debt, and $1,000,000 in cash and cash equivalents. As per the formula, the net debt for the company is
Net Debt = $10,000,000 + $4,000,000 - $1,000,000 = $13,000,000