Understanding net debt

The heart of any financial due diligence is the analysis of net financial debt and debt-like items. If the company is cash-rich, it would rather be net financial cash and cash-like items.

Many discussions and negotiations cover this topic.

Net financial debt contains cash, bank loans, shareholder loans, and any other loans. Debt-like items relate to items that are not directly used to run a company’s operations.

In the following article, I share insights into the net financial debt analysis. Also, I prepared an overview of typical net financial debt and debt-like items.

The net debt analysis focuses on two key questions:

Which financing agreements there are in place?
Which debt-like items or other items to consider? This includes lawsuits, tax, and legal risks.

As most deals are on a cash- and debt-free basis, these items are deducted from the purchase price.

Net financial debt

Net financial debt consists of loans and cash. Trapped cash needs to be deducted from cash and cash equivalents. Depending on the business model, minimum cash balances need to be determined. These are required to operate the business.

Debt-like items

For this, you need to understand the balance sheet and the individual accounts in more detail. This is done by asking detailed questions about the nature and usage of individual accounts. Which portion of a liability is more debt-like? Is there any deferred portion or supplier financing in trade payables?

Double counting should be avoided: items are either considered in working capital

net debt. Depending on the presentation, items are reflected or not reflected in the adjusted EBITDA. If the purchase price contains any exemptions, these should not be considered in the financial due diligence anymore. Also, accounting topics should be taken into account. For example, the translation from IFRS to US GAAP.

Off-balance sheet items to consider

Besides debt-like and cash-like items reflected on the balance sheet, there are also off-balance sheet items. This includes litigations, transaction bonus payments, or deferred capex as well as risks from other areas (e.g. tax and legal due diligence). Also, earn-out components can be considered here.

Negotiation position

Bear in mind that a sell-side advisor tends to only classify cash and loans. Everything else will be defined as other working capital.

A buy-side advisor works differently. This advisor classifies fewer items as other working capital. The buy-side advisor’s incentive is to minimize the purchase price of the equity as much as possible. The sell-side advisor, in turn, will try to maximize the purchase price of the equity.

Overview (non-exhaustive)

Typical items

Cash at bank
Bank loans
Shareholder loans
Pensions

Less obvious

Outstanding bonuses
Outstanding tax payments
Deferred income
Prepayments received
Deferred capex

Off-balance sheet

Options
Net debt of non-consolidated entities
Lawsuits
Legal and tax topics

Key takeaways

Net financial debt consists of cash and loans.
Debt-like items require a more detailed analysis and cover deferred items as well as tax- or pension-related positions
Always bear in mind who provided a certain view given the incentives of the different parties.

Final thoughts

This article intends to give a brief overview of the net debt topic and show typical items that come up during a financial due diligence. Every company and every due diligence is different and so is the classification of different items. It is paramount to understand the business model and the company to draw meaningful conclusions about the character of each item.

Get the latest content directly into your inbox and download your free finance & valuation guide (>50 pages)