Net debt and debt-like items: what acquirers add back.
Our FDD practice, in detail.
1. The cash-free, debt-free mechanics.
Most M&A transactions are priced on an enterprise-value basis: the buyer agrees what the business is worth on a debt-free basis and reduces the equity payment by the net debt at closing (and increases it by any cash). Net debt is debt minus cash; debt-like items are additions to debt that meet the criteria of being like debt even though they may not be technically debt on the balance sheet.
The FDD's job is to schedule, classify and quantify each item so that the SPA can reflect them precisely. A few crores misclassified between "debt-like" and "operating working capital" can move the deal price by the same amount.
2. True debt: the easy items.
True debt items are routinely uncontested:
- Bank borrowings (working-capital loans, term loans, cash credit, overdrafts).
- Debentures, bonds, and other long-term debt instruments.
- Lease liabilities (under Ind AS 116 / IFRS 16) - both current and non-current.
- Inter-company loans (treated separately depending on whether they will be settled at closing or transferred).
- Bills of exchange, commercial paper.
For each, the FDD verifies the outstanding amount at closing, accrued interest up to the closing date, and any pre-payment penalties that would apply on early repayment.
3. Debt-like: the contested items.
Debt-like items are economic obligations that behave like debt but are not classified as debt on the balance sheet. They become debt-like because the buyer will inherit them and must fund them post-closing, beyond what would normally be expected from operating working capital.
- Unfunded gratuity and pension obligations. The actuarial liability less plan assets. The buyer inherits the obligation.
- Long-term warranty provisions. Provisions for warranty claims beyond the next year.
- Litigation provisions. Provisions for pending lawsuits, treated as debt-like to the extent they exceed normal operating provisions.
- Tax exposures. Pending income-tax assessments, transfer-pricing exposures, contingent GST liabilities. Often the largest debt-like items in Indian deals.
- Customer advances above the operating threshold. Advances the buyer must deliver against beyond the normal working-capital level.
- Earn-out or deferred consideration owed to past sellers. If the target has acquired other businesses with earn-outs.
- Restructuring provisions. Severance, facility closures, contracts to be terminated.
- Off-balance-sheet financial guarantees. Guarantees issued by the target to third parties.
- Capex commitments. Contractually committed but not yet paid; typically treated as debt-like if material.
4. Worked examples.
Two common situations illustrate the classification logic.
Example 1: Customer advances. The target has ₹8 Cr of advances from customers for orders to be delivered post-closing. The recurring operating level of customer advances (based on the trailing 12 months) is ₹3 Cr. The ₹5 Cr above the operating level is debt-like; the ₹3 Cr is operating working capital. The buyer pays the equity value less ₹5 Cr; the buyer will fund the future delivery using the proceeds at closing.
Example 2: Tax exposure. The target has an income-tax assessment dispute of ₹4 Cr at the CIT(A) stage, with no provision in the accounts. The FDD assesses the probability of an adverse outcome at 70%. The debt-like value is ₹2.8 Cr (70% of ₹4 Cr). The SPA either reflects this as a debt-like reduction in the price, an indemnity from the seller, or an escrow against the eventual outcome.
5. Where disputes happen.
Three categories of dispute recur:
- Provisions vs reserves. Items management presents as "general reserves" but which are economic obligations dressed up. The FDD looks behind the label.
- Probability-weighted contingents. Litigation, tax and warranty exposures where the probability assessment determines the debt-like amount. The seller argues lower probability; the buyer argues higher.
- Items the seller treats as operating but the buyer treats as debt-like. Customer advances above operating level, accrued bonuses for the closing period, dividend declared but unpaid.
The discipline is to list every potential item, classify it with reasoning, quantify it, and let the SPA negotiation play out item by item.
6. The schedule that survives the SPA.
The deliverable is a single schedule:
- Each item, with the GL account or document reference.
- Classification (true debt / debt-like / operating).
- Reasoning for the classification.
- Quantum at the FDD reference date.
- Mechanism for updating at closing (closing-statement true-up, indemnity, escrow).
The schedule is annexed to the SPA. If items are mis-scheduled, the SPA price calculation goes wrong; if items are missed, the buyer carries the obligation without compensation.
Frequently asked
Is the debt-like classification standardised?
There is broad market convention but no formal standard. Each FDD applies the convention to the specific facts. Sophisticated PE buyers have internal playbooks that define their position on specific items; strategic acquirers vary more widely.
Are operating leases included in debt under Ind AS 116?
Under Ind AS 116, operating leases are recognised as lease liabilities on the balance sheet. In deal economics, lease liabilities are commonly treated as debt for valuation purposes, with the corresponding right-of-use asset treated as an operating asset. Some deals exclude both from EV calculations; the treatment is documented in the SPA.
What about contingent assets - are they added to cash?
Almost never. Contingent assets (refunds receivable, claims under negotiation) are typically excluded from cash unless they are realised before closing. The asymmetry favours the buyer.
How are tax exposures negotiated?
Three main mechanisms: (a) reduce the price by the probability-weighted exposure; (b) seller indemnity for the specific exposure, capped at a quantum; (c) escrow a portion of the price for a defined period (typically 1 to 3 years) to be released if the exposure does not crystallise. Combinations are common.
What is the impact of debt-like items on the working-capital target?
They are excluded from working capital and accounted separately. If a customer-advance item is treated as debt-like, it is removed from the working-capital calculation to avoid double-counting. The FDD's working-capital schedule and debt-like-items schedule are constructed to be mutually exclusive.
