Net Debt To Estimated Valuation

Net debt to estimated valuation is a leverage ratio mostly used by municipal bond investors. It differs from the most commonly used debt ratio, which takes total debt divided by total assets. Instead, net debt to estimated valuation compares the value of the underlying debt specifically associated with a municipal security and divides it by the market value of the issuer’s relevant assets.

The formula applies mainly to revenue bonds tied to specific projects, rather than general-obligation bonds, which are not backed by any specific assets.

The formula for net debt to estimated valuation takes total debt, which includes both short-term and long-term debt, minus cash and equivalents and divides this difference by the total estimated market value of assets. Note that the formula uses market value, and not assessed value, which is a different measurement.

Net debt to estimation valuation is one of many common metrics in fundamental analysis. Bonds that perform well over time tend to be issued by government entities that are financially healthy and tend to meet their obligations with relative ease.

In general, the lower the ratio, the less risk of default by the underlying entity, due to the lower amount of leverage. If an issuer couldn’t generate the funds to pay the debt, selling assets or using those assets to gain financing to repay the bond are options. This gives investors more confidence. Conversely, a higher ratio indicates that the issuer doesn’t have enough assets backing its debt. The government issuer has less financial wiggle room and it’s much more likely to default.

Say Tiny Town Turnpike has $10 million in short-term debt, $25 million in long-term debt and $5 million in cash and equivalents. It’s net debt is $10 million plus $25 million -$5 million, or $30 million. Now, say the Turnpike’s property, buildings and equipment is worth $25 million. Therefore, the Turnpike’s net debt to estimated valuation is $30 million divided by $25 million, or 1.2.

Net debt to estimated value is a useful ratio. However, as is the case with companies, reasons behind muni debt is important. Funding new projects that can expand resources usually is a good thing. Using new debt to keep paying off old debt is not a good thing, and in some cases spells real trouble.

As with other types of fundamental analysis, a single ratio does not constitute fundamental analysis. It’s important to consider the actual debt figures – both short-term and long-term – and what percentage of the total debt must be paid off within the coming year. For example, a government entity with high net debt relative to its estimated valuation is not troubled if the debt is long term and is covered by future tax receipts or, in the case of a revenue bond, associated fees.

For a muni issuer, the ability to raise revenue is important, as well. This is why muni-bond analysts also study population, transportation, income and property-value trends for cues regarding future revenues.