Net debt is the financial ratio which is used to measure the ability of the company to pay its obligation by comparing the total debt with liquid assets of the company. In other words relative to debt how many assets have by the company.
Definition: What is Net Debt?
Net debt is the leverage ratio which is used to measure the net amount of liabilities that exceed to cash or cash equivalent. Management and investors take this ratio more important because through this ratio they can analyze the ability of the company to pay its obligation and ability to take more debt in the future.
Management uses net debt ratio to find that the company borrow more money for the expansion operations of the business or purchase new assets. Whereas investors and analyst use this leverage ratio to find that the company has the ability to pay off current obligation or not.
If the net debt ratio is high then 1 then the company has more assets as compared to the debt of the company. If all the creditors of the company demand for their debt immediately then the company must sell the long term asset for the payment of debt. If the ratio is less then 1 then current asset of the company is less then debt to pay off its obligation.
Net debt formula can be calculated by the sum of short term and long term debt and then subtract the cash and cash equivalent from the result of the sum.
Net debt = (Short term debt + long term debt) – (cash and cash equivalent)
Calculation of the equation
Short term debt is the debt which payable for the company within 12 months. Long term debt payable for the company for more than 1 year or 12 months so in this way we can ad all the long term and short term debt to put in the above equation.
Cash equivalent means the liquid assets of the company which we need to add with cash for the calculation in the above equation.
Now in the last step, we need to subtract the sum of cash or cash equivalent from the sum of long term and short term debt.
For a better understanding of the calculation of net debt, we take the example here.
Now we consider company A which have the following item in the balance sheet.
- Bank overdraft = 100,000
- Trade payable = 80,000
- Trade receivable = 150,000
- Cash in hand = 300,000
- Cash in bank = 450,000
- Bank loan 500,000
First of all, we need to identify the long term and short term debt. Bank overdraft and trade payable are the short term debt because for the company these are payable within 1 year. Bank overdraft is the limit which is allowed by the bank over the balance in the bank account which means that the balance of the company is zero but bank allows the company to make the transaction.
Total short term debt = 100,000 + 80,000 =180,000
Long term debt is the bank loan because for the company it is payable for more than 1 year which is 500,000 dollars.
Long term debt = 500,000
Cash in hand, cash receivable, and trade receivable are the cash and cash equivalent.
Cash and cash equivalent = 15,000 + 450,000 + 300,000 = 900,000
Now we put all these resulting values in the above equation to find the net debt of the company A as
-$120,000 = $180,000 +$500,000 – $900,000
Net debt is -120,000 dollars which are the negative debt of the company A. It is good for the company because this company has enough cash for the payment of the debt.
Analysis and Interpretation
Net debt equation calculation is so simple that you just need to put a figure from the financial statement of the company and solve the equation for net debt.
For the investor, this ratio is very important because from this they analyze that the company is riskier or not. If this ratio for any company is high then it is difficult for that company to pay off the current obligation. Also, the company cannot expand its operation with a high ratio.
If net debt ratio is negative or less just like the above mention company A then company is the healthy company because for the payment of current obligation it does not need to sell the single asset for company A. Such type of company which has the ratio in negative can expand is operation.
Creditors use this ratio to analyze that the company is able to take a new loan for investment or not. If this ratio is negative then the bank easily approves the loan for that company.
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