Net Debt: The Bridge From Enterprise Value To Equity Value

Net debt is borrowings less the cash held against them. The subtraction measures the distance between what a business is worth and what its owners are paid: take net debt off the enterprise value and what remains is the equity value. Sundarban Polymers Private Limited is valued at Rs 1,320 crore and carries Rs 180 crore of net debt, so its sellers receive Rs 1,140 crore.

Two things sit underneath that, and both are already settled. The statements layer establishes that borrowings and cash are separate lines in a set of accounts, sitting some distance apart and never netted together. The valuation layer establishes what an enterprise value is and how a multiple gets built, so the figure that arrives at the start of a transaction has already been argued out somewhere else. The joinery between the two layers is a subtraction that looks trivial, is argued over for weeks in a real transaction, and decides who walks away with how much money. Everything below runs on one invented purchase, in which Harivansh Packaging Limited buys the whole of Sundarban Polymers Private Limited for a price built on earnings before interest, tax, depreciation and amortisation (EBITDA)A measure of trading profit taken before the cost of funding and before the wearing out of assets is charged. Two businesses with identical operations report the same figure whatever their borrowings look like. of Rs 132 crore at 10.0 times.

What is net debt, and why is it only one line long?

The borrowings, less the cash: what remains is net debt. For Harivansh Packaging Limited the borrowings stand at Rs 740 crore and the cash at Rs 140 crore, and net debt is Rs 600 crore. The formula is the whole of the arithmetic, and if the arithmetic were the whole subject there would be nothing more to say.

The same question about a household settles it quickly. Somebody owes Rs 8,00,000/- on a car loan and keeps Rs 1,50,000/- in a savings account. Asked what they owe, the honest answer is Rs 8,00,000/-. Asked what they owe on balance, after the money they could reach for tomorrow morning, the answer is Rs 6,50,000/-. Neither answer is a lie. The two figures answer two different questions, and net debt is the second one.

The difficulty starts the moment somebody has to pay for it. In a transaction, neither the borrowings figure nor the cash figure is simply read off a statement: both are decided by agreement, and the arguing about what belongs in each is the whole of what follows. A lender might want the disputed tax demand counted. A seller might want the deposit lodged with a landlord counted as cash. A buyer might say that half the cash in the box is needed to pay next week's suppliers and is therefore not cash it will ever see. Every one of those is a real conversation, and none of them is settled by arithmetic.

Why is the enterprise value never the cheque the sellers receive?

An enterprise value is a value put on a business without regard to how that business happens to be funded. An enterprise value answers one question: what is this operation worth, taken whole, before anybody asks who has a claim on it. The framing is deliberate. Two businesses can then be compared on what they do rather than on how their previous owners chose to finance them.

Which is exactly why it cannot be the amount that changes hands. When a buyer acquires the shares of a company, the buyer does not acquire a clean operation floating free of its obligations. The buyer acquires the shares, and the borrowings stay attached to the company underneath them. So the buyer has agreed a value for the whole thing and now hands over only the part the sellers actually own: the whole thing less what is owed on it.

Anyone who has bought a second-hand two-wheeler with instalments still running on it has done this. Buyer and seller agree the machine is worth Rs 60,000/-. There is Rs 22,000/- still owed on it to the finance company. The seller does not receive Rs 60,000/-. The buyer settles the Rs 22,000/- and hands the seller Rs 38,000/-, and the machine is worth exactly what both of them said it was worth throughout. The buyer pays the sellers what is left over once the debt has been accounted for, and the debt is still there afterwards either way. Nothing was made to disappear. The debt was simply paid by a different person.

Put in proportions, the sellers here receive 86.36 per cent of the enterprise value and the remaining 13.64 per cent never reaches them at all. The 86.36 per cent is not a rule about transactions. The proportion is a fact about this particular target, and a business carrying more borrowings would send a larger slice of the same headline figure somewhere other than to its owners.

Which way does the bridge run, and what does a wrong sign cost?

The bridge runs in both directions, and the direction depends on which end the reading starts from. Starting from a value for the business, subtracting net debt gives what the owners get: Rs 180 crore comes off Rs 1,320 crore and leaves Rs 1,140 crore behind. Starting from what the owners get, adding net debt gives back a value for the business: Rs 180 crore goes back onto Rs 1,140 crore and restores the Rs 1,320 crore. The two statements are the same statement, and either one closes back onto the other.

Which makes the sign easy to lose, and expensive to lose. Suppose the arithmetic goes the wrong way and somebody adds Rs 180 crore to Rs 1,320 crore instead of taking it off. The answer comes out at Rs 1,500 crore. The gap between Rs 1,500 crore and the true Rs 1,140 crore is Rs 360 crore. Rs 360 crore is not the net debt and not a rounding, but exactly twice the net debt. The figure does not merely vanish from one side, it crosses over and lands on the other, so reversing the sign on the bridge moves the answer by double the net debt.

Expressed against the answer that was actually correct, Rs 360 crore is an overstatement of 31.58 per cent. A reader who saw a purchase price described as being nearly a third larger than it was would not call that a small slip, and yet it comes from a single wrong operator in a single cell. The reversed sign is the most common arithmetic mistake made about transaction figures, and it survives review precisely because both inputs are right and only the join between them is wrong.

Does the same bridge work on a company nobody is buying?

The bridge does run there, and running it on the buyer is the quickest way to see that the bridge is arithmetic rather than deal machinery. Harivansh Packaging Limited is listed, so the market puts a value on its shares every day without anybody negotiating anything. The company has 18.00 crore shares in issue, and at a reference price of Rs 300/- its market capitalisationThe number of shares in issue multiplied by the price of one share. The measure values what the shareholders hold and says nothing about what the company owes. is Rs 5,400 crore. Market capitalisation values the shares, and only the shares. The 18.00 crore shares carry Rs 225 crore of profit between them, and earnings per share is Rs 12.50/-.

Now run the bridge backwards. Rs 5,400 crore of share value plus Rs 600 crore of net debt gives an enterprise value of Rs 6,000 crore. The Rs 6,000 crore is the value the market is implicitly putting on the operation as a whole, and it is the figure that goes over Rs 477 crore of earnings to give 12.58 times. Notice that the multiple people quote for a listed company is built on the larger figure, not on the share value. A company with heavy borrowings can look cheap on its share price and not at all cheap on its business.

The same subtraction runs on a listed company where nobody is buying anything and on a private company being sold outright. The bridge belongs to arithmetic and not to any particular kind of transaction. On this pair of businesses it happens to run in opposite directions: for the buyer the share value is known and the business value is wanted, and for the target the business value is known and the share value is wanted. One equation, read from either end.

Why do two people compute net debt differently and both stay right?

No set of published accounts carries a line headed net debt. There is a line for borrowings, usually split into the part falling due soon and the part falling due later. There is a line for cash and equivalents. There is no line where somebody has already done the subtraction, and no rule anywhere obliging anybody to draw it.

Which means net debt is something a reader constructs, and in a transaction it is something two sides construct together, under pressure, with money attached to the outcome. Net debt in a deal is a defined term inside an agreement rather than a figure computed from a statement, and two entirely competent people can produce different numbers from identical accounts without either of them having made a mistake. They have not disagreed about arithmetic. The two sides have disagreed about the definition, and the definition is a commercial question wearing an accountant's clothes.

The difference shows in a much smaller setting. Two people split the cost of a shared flat. One says the deposit already paid to the landlord counts as money the household still has. The other says it is gone until the day they move out and should not be counted at all. Both can add up. Neither can settle the question by adding up harder. Somebody has to decide what the word means before the sum has an answer, and once it is decided the sum takes four seconds.

Debt-like items: what behaves like a borrowing without being one?

Here is where the negotiation actually happens. A debt-like item is an obligation that no lender arranged and no loan agreement governs, but which behaves in the buyer's hands exactly the way a borrowing behaves: it is money the buyer will have to find, and finding it will not buy anything new.

Four kinds turn up constantly. There is capital expenditureSpending on long-lived assets such as plant, buildings or machinery, as against spending consumed within the year. Where it has been committed under a signed order but not yet paid, the money is owed even though no asset has arrived. already committed under signed orders but not yet paid, where the machine is coming whether the buyer wants it or not. There is an unfunded retirement obligationA promise of future payments to employees for which no separate pot of money has been set aside. The promise is real and the money to keep it has to come from somewhere., where a promise has been made to employees and nothing has been put aside to keep it. There is a dividend declared but not yet paid. The money is already legally owed to somebody who will not be a shareholder much longer. And there is a tax demand under dispute, where the amount is uncertain but the possibility of having to pay it is not.

Every one of these is money the buyer will have to hand over after completion for something the buyer did not choose, and the question the two sides ask about each is how it behaves rather than what a set of accounts calls it. Classification is an accounting question, and the accounting answer may well be that a committed order is not a liability at all until the goods arrive. The transaction is not asking that question. The transaction is asking whether the buyer will be writing a cheque, and if the answer is yes, the item is a candidate for the bridge.

Work it. Suppose the two sides agree that Rs 30 crore of committed but unpaid capital expenditure and Rs 20 crore of unfunded retirement obligation both behave like debt. Net debt for the bridge is no longer Rs 180 crore. The Rs 180 crore takes on Rs 30 crore, then takes on Rs 20 crore, and lands at Rs 230 crore, so the equity value falls from Rs 1,140 crore to Rs 1,090 crore.

Read the last column on its own. Rs 50 crore has moved from the sellers to the buyer, 4.39 per cent of what the sellers thought they were receiving, and not one rupee of borrowing was involved in moving it. Nobody took out a loan. Nobody repaid a loan. Two items that a bank has never heard of shifted Rs 50 crore across the table, and that is the reason the definition gets argued over for weeks rather than agreed in an afternoon.

Trapped and operating cash: is every rupee on the balance sheet available?

The debt-like argument runs from the buyer's side. The cash argument runs from the seller's, and it is the same argument turned around. The bridge subtracts cash, and subtracting it asserts quietly that every rupee of cash sitting in the accounts is spare money the buyer could take out on the first morning. Sometimes that is true. Frequently it is nowhere near true.

Cash comes in at least three flavours on a closer look. Some of it is genuinely surplus and could be swept out tomorrow without anything breaking. Some of it is operating cash, needed to pay suppliers and wages in the ordinary rhythm of the month, and removing it would stop the business rather than enrich anybody. And some of it is trapped: sitting in a subsidiary that cannot move money out without consent, or pledged against a guarantee, or held in a jurisdiction where taking it home would cost something to do.

A street vendor is the clearest version of this. There is Rs 12,000/- in the cash box at the end of the day, and it looks like Rs 12,000/- of profit until Rs 9,000/- of it turns out to be tomorrow morning's stock. Sweep the box and the stall does not open. The money was in the box, it was real, and it was never available. Deducting the whole cash balance treats every rupee of it as surplus. Treating it that way is a claim somebody is making, not an observation anybody has verified.

Work the smaller version. A business holds Rs 60 crore of cash and needs Rs 40 crore of it to run week to week, so Rs 20 crore is surplus. The Rs 20 crore looks like a reading of a fact and is not. The figure is a position. A lower requirement means more cash to deduct and a larger cheque, so the seller will argue that the working requirement is lower than the buyer claims. The buyer will argue the opposite for the mirror-image reason.

Move it to the ends and the point lands. With nothing to settle, at an agreed net debt of nil the sellers take the whole Rs 1,320 crore. At Rs 230 crore, the figure the two debt-like items produce, they take Rs 1,090 crore. At Rs 400 crore they take Rs 920 crore, and the buyer is still paying Rs 1,320 crore for the business by the only measure that describes the business. The enterprise value has not been touched at any point. It never is. Every rupee added to one side is a rupee removed from the other, and nothing is created anywhere. The fixed total is what makes the bridge worth arguing about.

What does paying for it do to the buyer's own net debt?

The price of Rs 1,140 crore has to come from somewhere. On this transaction it comes from two places: Rs 140 crore of cash the buyer was already sitting on, and a fresh Rs 1,000 crore borrowed at the buyer's own contracted rateThe interest rate written into this particular borrower's own facility. A contracted rate belongs to one borrower and one facility, so it says nothing about what rates are available anywhere else. of 9.0 per cent. The cash and the borrowing together are the Rs 1,140 crore, exactly. Before any of this began, leverage on the buyer's own books stood at 1.26 times, being Rs 600 crore of net debt measured against Rs 477 crore of earnings.

Now watch what each of them does to the buyer's net debt. The borrowing is obvious: Rs 740 crore becomes Rs 1,740 crore, and net debt climbs by Rs 1,000 crore. The cash is the part people get wrong. Cash of Rs 140 crore goes to nil, and because net debt is borrowings less cash, removing Rs 140 crore of cash raises net debt by Rs 140 crore. Add the two together. Rs 600 crore of net debt becomes Rs 1,740 crore, a rise of Rs 1,140 crore, and Rs 1,140 crore is precisely the price paid.

A buyer paying out of its own cash has not avoided leverage. The cash was the very thing netting against the debt, so a rupee of cash spent moves net debt by exactly as much as a rupee borrowed. The result feels wrong, and it is worth sitting with. Spending savings feels prudent and borrowing feels risky, and on the measure that most lenders write into their agreements the two are identical. The savings were only ever reducing a number by being there.

The household version is immediate. A household owes Rs 8,00,000/- on a loan and keeps Rs 1,50,000/- in the bank, so on balance it owes Rs 6,50,000/-. Spend the Rs 1,50,000/- on a new fridge and not a paisa has been borrowed, and yet on balance the household now owes Rs 8,00,000/-. The loan did not grow. The cushion went. Anybody measuring that household on the net figure sees a deterioration of Rs 1,50,000/- and is not being unfair.

Which EBITDA does the leverage ratio sit over?

The sharpest point here is not about the target at all. A leverage ratio has a company on top and a company underneath. Net debt in the numerator belongs to somebody. Earnings in the denominator belong to somebody. If the two somebodies are not the same somebody, the ratio is not a leverage ratio of anything, and it does not become one because both of its inputs are individually correct.

On this transaction there are exactly two honest ways to strike it, and no third. On a standalone basis the buyer stands alone: net debt of Rs 1,740 crore over the buyer's own Rs 477 crore of earnings, giving 3.65 times. On a consolidatedPresenting a parent and the companies it controls as though they were one entity, adding the assets, obligations and earnings together. basis the whole is taken together. The buyer's Rs 1,740 crore plus the target's own Rs 180 crore, still outstanding and still being serviced, gives Rs 1,920 crore. Over combined earnings of Rs 609 crore that is 3.15 times. The Rs 609 crore sits on combined revenue of Rs 4,060 crore. Both businesses trade at the same 15.0 per cent margin, so putting them together changes the size of the enlarged company without changing its shape at all.

Both are true. The two readings answer different questions, and a reader should be told which one is on the table. The standalone figure is what a lender to the parent alone cares about. The consolidated figure is what somebody looking at the whole obligation of the enlarged business cares about. Neither is more honest than the other, and both are more honest than what tends to appear instead.

The mismatch appears instead: the standalone Rs 1,740 crore put over the combined Rs 609 crore, giving 2.86 times. Nothing about that number is a leverage ratio. The numerator is missing an entire business whose earnings are sitting in the denominator, so the ratio has been handed extra earnings without the obligations that came attached to them. The mismatched ratio reads as the most comfortable of the three, and it is built to be, whether or not anybody built it deliberately.

What is the agreed figure actually for, and where is it settled?

All of this argument is aimed at one moment. The agreed net debt figure exists to fix the money that changes hands at completion, the day the shares transfer and the payment is made. The figure is not a description of the business, not a measure of financial health, and nobody consults it afterwards to understand how the company is doing. The agreed figure is a term in a bargain, and the moment the bargain completes it has done its work.

The purpose explains what otherwise looks strange: why the figure is negotiated rather than measured. A measurement is not negotiated. A payment is. Seen as the last variable in a payment rather than the first variable in an analysis, the figure makes the weeks of argument stop looking like accountants being difficult and start looking like the two sides deciding, item by item, who carries what.

Two things sit just past the edge of this subject and are worth naming. Where the definition is written down, and how tightly, is a documentation question that is covered separately. And the process by which the estimated figure at signing becomes a final figure after closing, alongside the working capitalThe everyday money tied up in running a business: what customers owe, what stock is held, less what suppliers are owed. Working capital moves week to week, so a transaction usually fixes a normal level for it. comparison that runs beside it, is a completion mechanics question that is also covered separately.

One caution about the number Rs 1,140 crore. The same amount carries three separate meanings in capital raising. Under net debt it means one thing only: the equity value that the sellers of Sundarban Polymers Private Limited receive once the bridge has been run. The same amount also stands for the size of a raise and for the consideration on a parcel of existing shares, and the overlap is not accidental: the raise exists to fund exactly this payment. Check which of the three is meant before carrying the figure anywhere.

Where the figures here came from

The reference price of Rs 300/- carries no as-of date, so a market capitalisation built on it has a shelf life and is not a standing fact about the company. The 9.0 per cent on the new borrowing is one borrower's contracted rate on one facility, and an Indian benchmark rate would sit somewhere else entirely. The Rs 30 crore of committed capital expenditure, the Rs 20 crore unfunded retirement obligation and the Rs 60 crore cash box are the amounts each argument is worked at, and each is named where it first appears. Both businesses report the same 15.0 per cent margin, on revenue of Rs 3,180 crore and Rs 880 crore, so neither one is simply better at trading than the other and the combined margin lands at 15.0 per cent as well.