Definition: A net debt is a financial metric used to analyze the liquidity of company by comparing a company’s current assets and total liabilities. It shows a company’s ability to pay off its obligations if they all become due today.
What Does Net Debt Mean?
What is the definition of net debt? It’s a indication of a company’s ability to pay off its debts only using cash and equivalents in the event that the company has to shutdown.
Although this shut down concept is rarely a reality, it demonstrates an important point about the company’s liquidity. It shows how leveraged the company is and also shows how much cash the company keeps on hand. Both of these concepts are important.
If a company has a regular amount of liabilities and a low amount of cash reserves, its metric would be high. This doesn’t necessarily mean the company is over leveraged. It simply means the company doesn’t keep much cash in its bank account. For example, the company might simply use a high percentage of its cash to reinvest in inventory or capital assets.
The net debt formula is calculated as follows:
ND = Total Liabilities – Current Assets (Cash and cash equivalents)
Let’s take a look at an example.
Example
ABC Company, Ltd published its audited financial statement for 2016 last week. John has shares in the company and wanted to gauge the liquidity of the company. The balance sheet reported the following:
Cash and cash equivalents: $511,428
Total Liabilities: 569,500
Using the net debt equation above, John would perform the following calculation:
$569,500 – $511,428 = $58,072
The $58,072 represents the net liabilities of ABC Company Ltd. This means that the company cannot pay off its financial obligations in the short term. In other words, the company wouldn’t be able to pay off all of its debt tomorrow. It would need to sell some of its inventory or long-term assets in order to pay off its obligations and this process can take some time.
Although, this metric doesn’t necessarily show the company is unhealthy, it does show its level of liquity.
Summary Definition
Define Net Debt: Net debt means a liquidity ratio that demonstrates a company’s ability to pay off its liabilities with its current assets.
