Net debt compares the total debt and liquid assets of a company. It is the ability of a company to pay off its total debt using liquid assets only. However, a company can repay its debt using current and fixed assets.

Net debt compares the short-term solvency of a company. It is an important financial performance metric that provides useful information to investors and creditors. A particularly important solvency ratio for every company.

## What is net debt?

Net debt is the debt that remains after repaying all debts through liquid assets. That is, it is the “net” of debts and liquid assets. The resulting figure can be negative or positive. It measures the ability of a company to pay off its debt using only its most liquid assets.

The liquid assets of a company include cash and cash equivalents. It means the figure tells us what a company will be left with if all of its debts are settled today in terms of its liquid assets.

Thus, important to note that the net debt is different from the net worth or net assets of a company. It compares only the liquid assets of a company (generated through cash inflows of the company) with its total debt.

## Net debt formula and calculation

The formula to calculate the net debt of a company is given here.

Net Debt = (Short term debt + Long-term Debt) - Cash and Cash Equivalents

Short term debt = debt that is due within one year

Long-term debt = debt that is due after one year

Cash and cash equivalents = liquid assets of a company that can be converted to cash within 90 days.

Common examples of short-term debt include bank overdrafts, credit card bills, accounts payable, and other short-term obligations of a company.

Long-term debt includes mortgages, bank loans, bonds, lease payments, and other types of debts that have a longer maturity period.

Cash and cash equivalent include cash balances, bank term certificates, commercial papers, and treasury bills. It also includes other investments that can be converted to cash within 90 days.

## Interpretation of net debt

Putting the input pieces together we can now interpret net debt as a company’s ability to pay off its total debt using only its liquid assets. It means what the company will be left off if it pays all of its debts in case of liquidation.

Investors and creditors would like to see a negative net debt figure that is achieved when a company has more liquid assets than its total debt. Contrarily, a positive debt figure means a company has more debt than its liquid assets.

Net debt is an important financial health indicator. It provides useful information about the total debt and total cash held by a company. It is a quick and easy method to analyze the financial health of a company in the short term.

## Special considerations

Analysts must carefully interpret the net debt results. As with any other financial performance metric, benchmarking is important. Benchmarking can be against the internal performance indicators or external standards within the same industry.

It is also important to compare companies of similar sizes. Most companies will have more debt than their liquid assets and will be profitable yet. Companies can build fixed assets through their long-term debt. It means comparing only liquid assets with the total debt does not provide the full information.

Although a positive net debt figure is desired, it also means a company does not invest in its long-term growth. It also means a company’s cost of capital will be higher if it has a larger proportion of equity capital.

### Capital allocation

Although a negative net debt is considered a strong liquidity sign, it can also mean that the company may not be allocating capital in the best way. Companies that are able to deploy and allocate capital efficiently may choose to have a positive net debt. This is because the return on their invested capital is higher than the interest expenses.

In turn, a company with such features will tend to have a much higher return on equity. Making it a more desirable investment than comparable companies. It is important to note that debt, as well as capital allocation, varies extensively depending on the industry and sectors. Therefore it is unfair to compare companies that are not operating in the same sectors in that way.

## Solvency

A negative net debt figure does not always mean a company is facing solvency issues. The solvency of a company should be determined using the value of a company.

Some industries such as construction or oil and gas are debt-intensive. It is because companies in these industries require long-term debts to finance their fixed asset purchases. Thus, it is inevitable to find companies with negative net debt figures in these industries.

Other companies are extremely dependent on debt to finance their growth, and therefore they might also have a positive net debt. Another important consideration is to dig deeper into the utilization of available debt by a company. If a company has invested in its growth, it means it will grow financially strong over time.

Thus, it will be able to repay through its capital investments in the long term as well and not just through liquid assets. In short, even though net debt is an important metric, it should be used in conjunction with other performance metrics. The financial stability of a company should be measured using several financial performance indicators including debt.

Image source: HBS