Net debt shows a business's overall financial situation by subtracting the total value of a company's liabilities and debts from the total value of its cash, cash equivalents and other liquid assets, a process called netting. All the information necessary to determine a company's net debt can be found on its balance sheet.
Net Debt = (Short-Term Debt + Long-Term Debt) - Cash and Cash Equivalents
The net debt figure is used as an indication of a business's ability to pay off all its debts if they became due simultaneously on the day of calculation, using only its available cash and highly liquid assets.
When calculating net debt, the first figure that is needed is the company's total debt. This includes long-term liabilities, such as mortgages and other loans that do not mature for several years, as well as short-term obligations, including rent, utilities, loan payments and interest due within the next year, credit card and accounts payable balances, and taxes.
The second component of the net debt calculation is total cash. Unlike the debt figure, the total cash includes only the company's current assets, or those that can be liquidated for cash very quickly. This includes highly liquid assets like cash, checking and savings account balances, accounts receivable, stocks, bonds and other marketable securities, and money market accounts. Depending on the operating cycle of the business in question, this may also include the value of any inventory on hand.
The concept of net debt is particularly important in investing and is one of the most commonly used metrics in fundamental analysis. Stocks that perform well over time tend to be issued by companies that are financially healthy and able to afford to meet their obligations with ease. While the net debt figure is a great place to start, a prudent investor must also investigate the company's debt level in more detail. Important factors to consider are the actual debt figures – both short-term and long-term – and what percentage of the total debt needs to be paid off within the coming year.
The reason behind the debt is also important. A business can take on new debt financing to fund an expansion project, or it can use those funds to repay or refinance an older loan that it has not yet paid off, which may be a signal of deeper troubles. If the majority of the company's debts are short-term – meaning they must be repaid within 12 months – consider whether the business could afford to cover those obligations if its sales took a dive. If the company's current revenue stream is the only thing keeping it afloat, its long-term prospects may be in peril.
Because different types of businesses use debt differently, it is also important to compare a company's net debt to that of other companies within the same industry that have a similar business model and are of a comparable size.