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Net debt is a means of gauging the ability of a business to repay all its outstanding debt, if that debt were suddenly called. The purpose behind the calculation is to assess the current financial strength of the business, in terms of its ability to manage debt even if the company encounters some sort of temporary financial reversal. Investors often look closely at the debt-service coverage ratio, or DSCR, as a means of determining if investing in a given business is likely to generate equitable returns over the long-term.
A basic approach to calculating this type of debt involves identifying the current amounts owed all short-term and long-term debts, and adding those debts into one sum. Next, all cash on hand as well as all cash equivalents are totaled, representing the total amount of cash that a company can generate quickly if necessary. By subtracting the cash and cash equivalents from the total debt identified, the remainder constitutes net debt.
While identifying the current amount of net debt is very helpful in assessing the financial stability of a company, there is no magic number that automatically means a company is in excellent condition. For this reason, it is often helpful to compare the amount of the debt to that of another company that is similar in size and associated with the same industry. Doing so helps to place the figure in perspective, and set expectations for what is a working standard for a given industry. From there, it is easier to evaluate the figure and decide if the company is carrying an above average amount of debt, or has a relatively low debt load.
Looking more closely at the factors that determine net debt is also helpful. For example, knowing whether the majority of the debt is short-term or long-term, or if some of the debt was created due to refinancing older debt, may be important for an investor. An analysis of this type will often yield clues as to how well the company would manage its operations if demand for their products suddenly dropped, or a natural disaster crippled a portion of the operating facilities.
Just about every business will have some amount of net debt. Ideally, the data will indicate that the total amount of that debt is comparable to the debt load of its competitors, and that the business does have resources in hand to handle emergency situations. Should an investor feel somewhat uncomfortable with the amount of net debt carried by a given company, he or she may do well to move on and find a different investment opportunity.
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