Net Debt

What is net debt?

Net debt (German: Nettofinanzverschuldung or Nettoverschuldung) is the sum of a company's financial liabilities less its freely available liquid funds. Financial liabilities are debts from borrowed money, such as bank loans or shareholder loans. Liquid funds are cash on hand and bank balances. If the result is negative, liquid funds exceed financial debt, and the company has net cash (Nettofinanzvermögen).

Formula: net debt = financial liabilities - freely available liquid funds; adjusted net debt = net debt + debt-like items

Someone who is repaying a EUR 15,000 student loan and has EUR 5,000 in an instant-access savings account could immediately repay part of it with the savings. Net, EUR 10,000 of debt remains. Net debt makes the same offsetting for a company.

The figure appears in three contexts. In loan agreements, it is the basis of financial covenants that the bank monitors on an ongoing basis. In valuation, it links the enterprise value, the value of the ongoing business, with the equity value, the value of the shares. In a company purchase, its contractual definition therefore directly determines the purchase price for the shares. The term is not defined by law; each document determines its scope itself.

Narrow and broad definitions of net debt

Under the narrow definition, net debt covers only financing in the proper sense. This includes bank loans, credit lines drawn, Schuldschein loans (large loans from institutional investors) and bonds, shareholder loans and prefinancing from recourse factoring, in each case including accrued interest. Deducted are cash on hand, bank balances and short-term marketable securities, to the extent the company can dispose of them freely.

The broad definition adds debt-like items. These are obligations that are not reported as financing but lead to payments outside ongoing business, such as pension provisions for future company pensions. In a company purchase, this adjusted net debt is usually used. The negotiation of the individual items is part of the bridge calculation from enterprise value to purchase price (equity bridge). Loan agreements and financial analysis, by contrast, mostly prefer the narrow definition, because it can be read from the financial statements without additional valuation.

Which items belong in net debt

Credit lines, guarantees and factoring

A drawn overdraft facility, that is, the credit limit used on the business account, belongs in net debt. This also applies if its balance fluctuates daily and it mainly finances working capital, the capital tied up in day-to-day business. Undrawn credit lines do not count, nor do bank guarantees (Avale), that is, guarantees from the bank for the benefit of third parties, as long as no payment has been made under them.

With factoring, a company sells open customer invoices to a financial services provider and receives the money immediately. With recourse factoring (unechtes Factoring), where the company continues to bear the risk that customers do not pay, the receivable stays on the balance sheet, and the prefinancing is a financial liability. With non-recourse factoring (echtes Factoring), the sold receivables leave the balance sheet. Buyers nevertheless often demand an adjustment, because without factoring more capital would be tied up.

Shareholder loans with a subordination agreement

Shareholder loans remain liabilities in the commercial balance sheet even if a qualified subordination agreement (qualifizierter Rangrücktritt) has been agreed. With a subordination agreement, the shareholder declares that it ranks its claim behind all other creditors. It has the effect that the loan is not recognised in the over-indebtedness test (Section 19 (2) sentence 2 of the German Insolvency Code, Insolvenzordnung, InsO). Banks therefore often treat such loans in their ratios as economic equity.

A different view applies in a company purchase. The loan is repaid on completion, the day of transfer, or assigned to the buyer. The seller thus receives the amount separately in any case. So that the buyer does not pay for it twice, once in the price for the shares and once for the loan claim, the loan is deducted there as a financial liability. The same item can therefore stand outside net debt in the loan agreement and inside it in the purchase agreement. The statutory subordination of shareholder loans in insolvency proceedings (Section 39 (1) no. 5 InsO) does not change this.

Convertible loans and mezzanine capital

A convertible loan, that is, a loan that can later be converted into shares, is a liability until conversion. If it is repaid on completion, it belongs in net debt. If it is converted into shares beforehand, the lender participates in the purchase price for the shares, and an additional deduction would count the same amount twice. For mezzanine capital, hybrid forms between equity and debt capital such as profit participation rights or silent partnerships, repayment obligation, term and participation in losses decide the classification.

Trade payables and obligations from acquisitions

Trade payables in principle belong in working capital. It is different if a company has deferred payments to suppliers before the reporting date beyond the usual terms. Suppliers are then in economic terms granting a loan, and buyers often deduct the overdue portion as a debt-like item. Outstanding purchase price instalments, earn-out obligations (success-dependent parts of the purchase price) and vendor loans from earlier acquisitions by the company are also covered under the broad definition.

Reporting date and seasonal fluctuations

Net debt is a point-in-time figure, that is, a value on a specific day. Within a year it can fluctuate widely, for example with seasonal business, large project payments or subscriptions invoiced annually in advance. A financial year end at which customers have just paid their annual invoices paints a more favourable picture than the annual average.

Buyers and lenders therefore look at the trend over 12 to 24 months. In a company purchase, the question is resolved through the interplay with working capital. If customers have just paid, the bank balance is high but working capital is low, because hardly any receivables are open. If it is below the agreed target value, the purchase price falls accordingly, and the effect balances out. Without this coordination, the choice of reporting date alone shifts the purchase price by amounts that have nothing to do with the value of the company.

Net debt in the purchase agreement and as a ratio

In a company purchase agreement, net debt usually arises from two definitions, financial liabilities and cash. A list of specific balance sheet items is widespread. In addition comes a catch-all clause that also covers economically comparable obligations arising up to the reporting date. A trial calculation based on the last financial statements shows whether the definitions lead to the expected result.

In loan agreements, net debt serves as the numerator of the dynamic leverage ratio (leverage, net debt to EBITDA): net debt divided by EBITDA, earnings before interest, taxes, depreciation and amortisation. The ratio indicates in how many years the company could arithmetically repay its net debt from its operating result. Loan agreements often set a ceiling for it (covenants). The relationship between debt capital and equity, by contrast, is described by the static debt ratio. If net debt is set in relation to equity, the result is net gearing.

Net cash at technology companies

After a funding round, technology companies often have substantial net cash. In a company purchase, it in principle increases the purchase price for the shares. As long as the company is making losses, however, part of the liquidity is earmarked for ongoing operations up to break-even. Buyers who would have to finance this loss path themselves therefore often try to treat part of the balance as necessary for operations. The yardstick for the argument is the burn rate, the monthly outflow of liquid funds, in relation to the funds available.

Worked example: calculating net debt on a narrow and a broad basis

A company with EBITDA of EUR 2.5 million reports the following items at the reporting date:

• Bank loan EUR 4.00 million, drawn overdraft facility EUR 0.80 million, accrued interest EUR 0.05 million
• Shareholder loan with a qualified subordination agreement EUR 1.50 million
• Bank balances EUR 2.60 million, of which EUR 0.30 million in a pledged security account, so freely available EUR 2.30 million
• Narrow net debt: 4.00 + 0.80 + 0.05 + 1.50 minus 2.30 = EUR 4.05 million
• Debt-like items: pension provisions EUR 0.90 million, overdue trade payables EUR 0.40 million, open earn-out obligation from an acquisition EUR 0.60 million, together EUR 1.90 million
• Broad net debt: 4.05 + 1.90 = EUR 5.95 million
• Dynamic leverage under a loan agreement that treats the shareholder loan as economic equity: (4.05 minus 1.50) / 2.5 = 1.02
• Dynamic leverage on the narrow definition: 4.05 / 2.5 = 1.62; on the broad definition: 5.95 / 2.5 = 2.38

Depending on the definition, the same company appears with debt of between 1.0 times and 2.4 times its EBITDA. If the purchase agreement is based on the broad definition, it reduces the equity value by EUR 1.90 million compared with the narrow one. Which figure applies is determined by the contract in question.

Distinction: net debt, debt capital and working capital

• Debt capital: all debts and provisions on the balance sheet including trade payables, without offsetting against liquid funds. Net debt is narrower and net.
• Working capital: the capital tied up in operating business. The boundary between the two figures must be drawn unambiguously in the purchase agreement so that no item counts twice.

Common mistakes

• Taking over the definition from the loan agreement. Anyone who argues with the bank definition in the purchase price negotiation leaves out shareholder loans with a subordination agreement, which the buyer will deduct.
• Single reporting date without the trend. A favourable year-end value is presented as a lasting level, although the monthly trend shows a different picture.
• Overlooking factoring. Even non-recourse factoring works economically like financing and is regularly picked up in due diligence.
• Convertible loan counted twice. A loan that is converted before completion must not additionally be deducted as debt.
• Stretched supplier payments. Payments delayed before the reporting date lower net debt only in appearance; buyers deduct them again.

Frequently asked questions

Is a negative net debt always a good sign?

Not necessarily. It shows that liquid funds exceed financial debt. For a company with high losses, however, it says little about how long the funds will last.

How is net debt calculated?

The financial liabilities including accrued interest are added up and the freely available liquid funds are deducted. In the worked example, this gives 6.35 minus 2.30 = EUR 4.05 million, and with the debt-like items EUR 5.95 million.

Do pension provisions belong in net debt?

Not under the narrow definition; under the broad definition, as a rule yes. In a company purchase, they are usually deducted as a debt-like item.

What ratio of net debt to EBITDA is considered sustainable?

There is no general limit. Banks set ceilings depending on the sector, the predictability of earnings and collateral; for growth-oriented companies with fluctuating results, the ratio is in any case only of limited informative value.

How does a funding round affect net debt?

An equity round lowers it by the amount paid in, as long as the funds have not been used up. With a convertible loan, by contrast, bank balances and financial liabilities rise by the same amount. Net debt therefore initially remains unchanged and falls only on conversion into shares.

The Roemer Capital view

In its work as fractional CFO, that is, as finance lead for a period, Roemer Capital agrees with the client a definition of net debt that applies unchanged in monthly reporting. In addition, it carries out the calculation according to the bank's covenants. This keeps it visible why the two figures differ.

For a later sale, this monthly series is valuable. It shows buyers the trend over 12 to 24 months, makes seasonal patterns comprehensible and provides the basis for the discussion on reporting date, minimum liquidity and target value of working capital.