What Does Net Debt Mean?
Net debt is the total debt of an organization minus cash and cash equivalents. It is the excess of cash and cash equivalents over the total debts of the entity which account for the repayment ability of the firm’s debt. Net debt is regarded as one of the financial metrics most used by investors to analyze companies by looking into their financial abilities to meet their obligations.
Divestopedia Explains Net Debt
The debt of a firm is comprised of short and long term debt. Short term debts are used mainly for working capital requirements, financing short term projects and so on. Conversely, long term debts are needed by the organization to expand in ways such as acquiring new facilities or increasing production capabilities.
The debt capacity of a firm is examined by investors to determine whether a company is well off or not with its debt repaying ability and timeliness. The debt capacity can also determine an organization's leveraging capacity compared to its liquid assets.
Net Debt = Short Term Debt + Long Term Debt - Cash and Cash Equivalents
Example: ABC Ltd. reported on December 31 of last year a short term debt of $450,000, a long term debt of $800,000, and cash and cash equivalents amounting to $650,000. Therefore, the
Net Debt = $450,000 + $800,000 - $650,000 = $600,000
Rational investors look for information about the net debt of a company because it helps to evaluate the company’s debt repaying ability; Lenders require the net debt amount as it is the most important criteria for lending money; and creditors seek this information in order to determine the line of credit they can extend.
Net debt is an important metric in valuation as it is used to calculate equity value as follows:
Enterprise Value - Net Debt = Equity Value