Understanding debt carried by a company is key to gaining insight into its financial health. One of the various ways an observer can 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 is simply the sum 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.
Why Looking at Net Debt is Important
Looking at net debt reveals additional details and insight into the financial health of a company. Burdensome debt loads can be problematic for stakeholders in a company. Net debt helps provide comparative metrics when looking at industry peers. Just because a company has more debt does not necessarily mean 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.
Net debt can offer insight and prompt discovery regarding the company's operational strategy. If the difference between net debt and gross debt is large, this indicates the company carries a large cash balance as well as significant debt. Why might a company do that? There are many reasons, such as liquidity concerns, capital investment opportunities and planned acquisitions. Looking at a company's net debt, particularly relative to its peers, prompts further examination into its strategy.
From an enterprise value standpoint, net debt is a key factor during a buyout situation. When a buyer is looking to acquire a company, net debt is more relevant 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 rightly assess the acquisition.