What is Net Debt?
Net Debt is a liquidity measure that determines how much debt a company has on its balance sheet relative to its cash on hand.
Frequently used to determine the liquidity of a company, the net debt metric shows the remaining debt balance if all of a company’s cash and cash equivalents were hypothetically used to pay down its outstanding debt obligations.
- What does the net debt of a company represent?
- How can the net debt be calculated?
- When calculating enterprise value, why do we add net debt?
- Which types of companies carry negative net debt balances?
Net Debt Formula
The net debt of a company represents the remaining debt balance once the company’s cash is used to help pay down as much debt as possible.
The underlying idea behind net debt is that the cash sitting on a company’s balance sheet could hypothetically be used to pay down outstanding debt if necessary.
Since the assumption is that the cash helps offset the debt burden, the value of a company’s cash and cash equivalents are deducted from the gross debt.
The formula consists of two steps:
- Calculate the Sum of All Debt and Interest-Bearing Obligations
- Subtract Cash and Cash-Equivalents
The debt component includes all short-term and long-term debt obligations, such as short-term and long-term loans and bonds — as well as financial claims such as preferred stock and non-controlling interests, while the cash component contains all cash and highly liquid investments — which refer to short-term holdings such as marketable securities, money market funds, and commercial paper.
Negative Net Debt
If the net debt of a company is negative, this suggests the company has a significant amount of cash and cash equivalents on its balance sheet.
Additionally, the negative balance could be an indication the company is not financed with an excessive amount of debt.
In contrast, it could also just mean the company is holding onto more cash in comparison to debt (e.g. Microsoft, Apple).
In instances of negative net debt, the enterprise value of these companies will be lower than their equity value. Recall that the enterprise value represents the value of a company’s operations – which excludes any non-operating assets. Therefore, companies that have accumulated large cash reserves will have a higher equity value than enterprise value.
Excel File Download
Now, we’ll move onto an example calculation of net debt in Excel. Just fill out the form below to access the file and follow along.
Net Debt Example Calculation Steps
Here, our hypothetical company has the following financials in Year 0:
- Short-Term Borrowings: $40m
- Long-Term Debt: $60m
- Cash & Cash Equivalents: $25m
- Marketable Securities: $15m
For each period in the forecast, all debt and debt-equivalents are assumed to remain constant. Cash and marketable securities, on the other hand, are going to grow by $5m per year.
Given the growth in cash & cash equivalents, while debt remains constant, it would be reasonable to expect the company’s net debt to decrease each year.
For Year 1, the net debt calculation is as follows:
- Total Debt = $40m Short-Term Borrowings + $60m Long-Term Debt = $100m
- Less: Cash & Cash Equivalents = $30m Cash + $20m Marketable Securities
- Net Debt = $100m in Total Debt – $50m Cash & Cash Equivalents = $50m
A common leverage ratio is the net debt-to-EBITDA ratio, which divides the net debt by a cash-flow metric such as EBITDA.
For our EBITDA assumption, we’ll be using $30m for each period in the forecast.
Since cash can be used to pay down debt, many leverage ratios use net debt rather than the gross amount, as one could argue that net debt is a more accurate representation of the company’s “true” leverage.
From the completed output below, we can see how the net debt / EBITDA ratio declines from 2.0x in Year 0 to 0.3x by the end of Year 5, which is driven by the accumulation of highly liquid, cash-like assets.
But in the same time span, our total debt / EBITDA ratio remains constant at 3.3x as it does not take into account the growth in cash & cash equivalents.