What Is the Difference Between Net Debt and Gross Debt?
Understanding the debt carried by a company is key to gaining insight into its financial health. One way to gauge the significance of debt on a company's balance sheet is by calculating net debt. Net debt is the book value of a company's gross debt less any cash and cash-like assets on the balance sheet. Gross debt, on the other hand, is simply the total of the book value of a company's debt obligations. Net debt essentially tells you how much debt is left on the balance sheet if the company pays all its debt obligations with its existing cash balances.
- Net debt is the book value of a company's gross debt less any cash and cash-like assets on the balance sheet.
- Net debt shows how much debt a company has once it has paid all its debt obligations with its existing cash balances.
- Gross debt is the total book value of a company's debt obligations.
- Net debt is significant in buyouts because a buyer will calculate enterprise value using the target company's debt net of its cash balances.
Understanding Net Debt and Gross Debt
A debt is money borrowed from someone else. Debts typically involve paying interest to the lender. Common forms of debt are bank loans, mortgages, and bonds. Gross debt is the total amount of debt a company has at a certain point in time. For example, if a company borrows $40,000 from a bank and $10,000 from a family member and has no other debts, the gross debt is $50,000.
Net debt reveals additional details and insight into the financial health of a company beyond gross debt. For example, burdensome debt loads can be problematic for company stakeholders. Net debt also provides comparative metrics against industry peers. Just because a company has more debt does not necessarily mean that it is financially worse off than a company with less debt. For example, what may appear to be a large debt load on a company's balance sheet may actually be smaller than an industry competitor's debt on a net basis.
What Net Debt Can Tell Investors
Net debt also provides insights into a company's operational strategy. If the difference between net debt and gross debt is substantial, this indicates that the company is carrying a large cash balance as well as significant debt. Why would a company carry both a large cash balance and substantial debt? There are many reasons such as liquidity concerns, capital investment opportunities, and planned acquisitions. Therefore, net debt should be examined in conjunction with industry benchmarks and company strategy.
From an enterprise value standpoint, net debt is a key factor during a buyout. When a buyer is looking to acquire a company, net debt is more relevant than gross debt from a valuation standpoint. A buyer is not interested in spending cash to acquire cash. It is more meaningful for the buyer to look at enterprise value using the target company's debt net of its cash balances to accurately assess the acquisition.