Understanding Net Worth Ratios
Net worth represents the owners' share of the total resources of a business. The net worth figure and its ratio to sales, debts, and fixed assets is of crucial importance in a thorough financial statement analysis. But what do these ratios mean? What exactly do they reveal about the credit strength of a company? Just as the ratio of net sales to inventory indicates a company's inventory turnover, its ratio of net sales to tangible net worth shows its net worth turnover. The rate of a company's net worth turnover, like its rate of inventory turnover, is an important index of its financial condition.
Financial analysts usually look upon a high net worth turnover rate as an indication that a company is using its assets efficiently. They figure that, other things being equal, a company with a high turnover rate is earning a greater rate of income on its net worth than a company with a low turnover rate. The difficulty is that "other things" seldom are equal and that a high rate may bejust as easily a bad sign as a good one. A high ratio of sales to net worth, after all, can result either from booming sales or from meager net worth. If high sales are the cause, chances are that the business is in good shape and its credit is strong. But if the cause is low net worth, the company is probably a poor credit risk.
Net worth, you must remember, consists of those assets that are not already obligated to the company's creditors. Consequently, it represents the margin of protection that you as a prospective creditor would have if the company failed.
Tangible Net Worth - Computed by subtracting intangible assets (i.e., anything nonphysical, such as goodwill, trademarks, and patents, that have value for a company) from stockholders' equity.
The purpose in calculating the net worth turnover is not to determine how efficiently the credit applicant is using assets, but rather to determine whether net worth is adequate to finance the operation. A creditor wants to know whether the applicant can safely assume the debt for the credit it is being asked to extend. If the turnover rate is much above average for the line of business, it may mean that net worth is not adequate and that you will have little or no protection.
For example, consider the net worth of The Wood Company, a furniture manufacturer. The Wood Company's net sales during the reporting period ran 5.88 times its tangible net worth: ($1,000,000 ± $170,000 = 5.88). Comparing this figure with ratios for the furniture manufacturing line, The Wood Company stands above the upper quartile (4.78). This leads to one of two conclusions. Either sales are high and the business is relatively efficient and successful, or net worth is low, and the business is somewhat of a "shoestring" operation. To determine which of these conclusions is correct, simply calculate the ratio of current liabilities to tangible net worth.
Current Debt to Tangible Net Worth Ratio
The current debt to tangible net worth ratio measures the extent to which a firm depends on its creditors' funds to finance its operations. A low ratio indicates adequate net worth and little dependence on creditors; a high ratio indicates that net worth is low and creditors are already carrying a heavy burden. The Wood Company does poorly on this test, falling considerably below the lower quartile (74.8%): ($130,000 ÷ $170,000 = 76.5%). This tends to confirm the second conclusion made after calculating the sales to net worth ratio. The Wood Company indeed appears to be a shoestring operation.
But there is still not enough information to warrant a flat rejection of credit. This may be a developing firm, under energetic and capable management that is in the process of growing into a sound, large-volume purchaser. If this is the case it should show up in the form of a rapid inventory turnover ratio. In this example, the inventory turnover is 5.9, well below the median (7.1) for other furniture manufacturers. This indication of sluggish inventories, which may be further support by a credit report showing the company to be past due on a substantial part of its accounts payable. This tends to mark this applicant company as an unacceptable credit risk.
Fixed Assets to Tangible Net Worth
A company's credit position also tends to be weakened if too large or too small a proportion of its net worth is tied up in fixed assets. A high ratio of fixed assets to net worth may indicate either excessive investment in fixed assets or inadequate net worth for an otherwise balanced enterprise. On the other hand, a low ratio, in a line where heavy investment in expensive equipment is normal, may be a danger sign, indicating that the firm's income will be drained by high equipment rental or subcontracting costs. The median figure of the fixed assets to net worth ratio in the furniture manufacturing line is a comparatively low 35.2%. So the Wood Company's ratio of 64.7%: ($110,000 ÷ $170,000 = 64.7%) indicates critical over investment in fixed assets.
The net worth ratios tell creditors how well and how wisely a company is financed. They may indicate conservative financing and considerable credit strength, or a shoestring operation and extremely high risk, or any position between these two poles. Remember, however, that they are only indicators and that they do not constitute a complete test of a company's financial position. Credit analysts should be careful to use them in conjunction with other ratios- those already discussed in the previous topics and those that will be covered later.
Edited by Michael Dennis. Michael is a business consultant with more than 10 years experience helping companies reduce risk.