Net Debt is a liquidity measure that determines how much debt a company has on its balance sheet relative to its cash on hand.
Conceptually, net debt is the amount of debt remaining once a company hypothetically paid down as much debt as possible using its highly-liquid assets, namely cash.
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.
Frequently used to determine the liquidity of a company, the 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.
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 cash helps offset the debt burden, the value of a company's cash and cash equivalents are deducted from the gross debt.
Calculating a company's net debt balance consists of three steps:
The formula for calculating net debt subtracts gross debt by cash and cash equivalents.
Where:
If the net debt of a company is negative, that implies the company has a significant amount of cash and cash equivalents on its balance sheet.
The negative net debt balance is likely an indication the company is not financed with an excessive amount of debt (i.e. capital structure is composed predominately of equity, rather than debt).
In contrast, the negative balance could also simply indicate that the company is holding onto more cash in comparison to debt.
For instance, Microsoft (MSFT) and Apple (AAPL) are two real-life examples of publicly-traded companies with significant cash sitting on their balance sheet.
Given a negative net balance, 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.
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Suppose we're tasked with calculating the net debt of a hypothetical company given the following financials in Year 0.
Year 0 Financials
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 and cash equivalents, while the debt amount remains constant, it would be reasonable to expect the company's net debt to decrease each year.
For Year 1, the steps to compute net debt are as follows:
Therefore, the net debt balance in Year 1 is $50 million.
A common leverage ratio is the net debt-to-EBITDA ratio, which divides a company's total debt minus cash balance by a cash-flow metric, which is EBITDA in this case.
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 rather than gross debt, as one could argue that net (not gross) debt is a more accurate representation of the company's actual leverage.
From the completed output below, we can see how the net debt-to-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 and cash equivalents.
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Would you include non current marketable securities in net debt calculations?
Hi, Alex,
Yes, it should definitely be included.
BB
If EBITDA is a negative value how we can calculate Net Debt to EBITDA Ratio?
Hi, Rudin,
If a company has negative EBITDA, then net debt/EBITDA will be a meaningless ratio, and chances are that sort of company will not be able to raise debt financing at all. If it already has debt, then it is likely to go into distress and some sort of restructuring scenario.
BB