Debt to Net Worth Ratio
The debt to net worth ratio is a financial metric used in comparing the level of debt of a company with its net worth. It is an indication of the financial health of a company. The ratio helps investors to determine how much of a company’s financing involves debt. Also, the debt to net worth ratio is used to determine if the company can use its assets to pay its debt if things go wrong.
The accurate name for debt to net worth ratio is tangible debt to net worth ratio. This is because, when calculating the net worth of a company, intangible assets are excluded. They cannot be readily converted to cash.
For companies, net worth is the amount of money that will go to shareholders if the company is liquidated and all liabilities are paid.
Intangible assets, such as a company’s logo, patents and copyrights will only have value if another company is willing to use them. Hence, money from an intangible assets sale cannot be used to pay liabilities. This conservative approach to debt to net worth ratio by eliminating intangible assets is important for analysts when calculating the actual debt-paying ability of a company.
The net worth is not limited to companies. A person may want to know his debt to net worth ratio, especially if you’re getting approved for a loan. Lenders want to know if you will be able to pay back the loan amount. An individual’s debt to net worth ratio will inform them if the borrower’s assets can cover for the loan if things go south.
Debt to Net Worth Ratio Formula
The debt to net worth ratio is obtained by dividing the total liabilities by the net worth. The total liabilities is the sum of all the monies owed to creditors. The net worth is the difference between the sum of all assets and the liabilities.
When considering companies, intangible assets are also subtracted from the total assets, since they cannot be easily liquidated during insolvency.
From the formula, a decrease in the net worth will increase the debt to net worth ratio. Also, a decrease in the total liabilities will result in a decrease in the debt to net worth ratio. To reduce the debt to net worth ratio, one should reduce the liabilities and increase the net worth.
For individuals, the net worth is the sum of all assets minus the sum of all liabilities. For example, if you own a car that can be sold for $10,000 but you are still owing $2000 on the car, the net worth of the car is $8,000.
The same thing applies to all assets you own. The sum of all liabilities divided by the total net worth will give your debt to net worth ratio.
Debt to Net Worth Ratio Example
A winemaking company, Compty, is seeking to attract new investors and also obtain new loans if possible. Compty is required to submit information so that its debt to net worth ratio can be calculated. This year, Compty’s production machinery is worth $2,000,000.
However, Compty still owes $500,000 on the machinery. The loan used by Compty to buy the added land for storage is remaining $200,000. Compty’s logo and its recently acquired patent last year are both worth $115,000. Other assets owned by Compty amount to $1 million, whereas its other liabilities total $600,000.
For Compty to calculate its debt to net worth ratio, they need to know the net worth, assets, and liabilities.
Total liabilities combine their machinery debt ($500,000), land debt ($200,000), and other liabilities ($600,000).
Total assets can be calculated by adding their assets, including machinery ($2,000,000), patent value ($115,000), and other assets ($1,000,000).
Net worth can be calculated by taking total assets ($3,115,000) and subtracting liabilities ($1,300,000) and intangible assets ($115,000).
- Total liabilities = $1,300,000
- Total assets = $3,115,000
- Net worth = $1,700,000
We can now substitute the values for the variables using the formula:
The debt to net worth ratio for Compty is 76.47%. This means that for every dollar in assets there are 77 cents of debt.
Since the value of the ratio is less than 1 (100%), it means that the value of assets is greater than the debt. This means creditors should not be too worried, as the assets can pay the company’s debt.
Debt to Net Worth Ratio Analysis
The debt to net worth ratio is used to gauge how much of a company’s assets are financed by debt. The higher the ratio, the higher the percentage financing by debt.
A ratio above 100% is not good as it means that the company cannot use its assets to pay off its debt. A ratio below 100% means that a company can use its assets to settle its debt.
Investors should note that the debt to net worth ratio should not be the only metric used to choose a company to invest in because debt financing is sometimes cheaper when interests are low.
Some companies might refuse to obtain loans to maintain a low ratio and, instead, miss out on expansion opportunities that would have paid for the debt with enough to spare.
Debt to Net Worth Ratio Conclusion
- The debt to net worth ratio is a metric used to compare the level of debt of a company to its net worth.
- This formula requires two variables: total liabilities and net worth
- A ratio above 100% means a company will not be able to pay its debt by selling its assets
- A ratio below 100% means that a company can settle its liabilities using its assets.
- Investors and lenders use the ratio to determine their level of risk.
Debt to Net Worth Ratio Calculator
You can use the debt to net worth ratio calculator below to quickly calculate the debt to net worth ratio of a company by entering the required numbers.
1. What does the debt to net worth ratio mean?
The debt to net worth ratio is a metric that measures how much of a company's assets are financed by debt. It is the sum of all liabilities divided by net worth.
2. What is a good debt to net worth ratio?
A debt to net worth ratio of less than 100% means that the company's assets are more than its liabilities, because it can use assets to settle liabilities.
A negative debt to net worth ratio is possible but only in the case of companies with significant intangible assets like brand value or intellectual property.
3. How do you calculate debt to net worth ratio?
The debt to net worth ratio can be calculated by dividing total liabilities by net worth.
The formula is:
Debt to Net Worth = Total Net Worth / Total Liabilities
4. What percentage of net worth should be debt?
Debt to net worth ratio of less than 100% is considered a good debt level. A higher percentage goes against common wisdom that suggests corporations should limit their debt below a certain amount, usually 30%.
5. Is debt to net worth the same as debt-to-equity?
No, debt to net worth ratio is different from the debt-to-equity ratio.
Debt to net worth measures a company's financial leverage by comparing its total liabilities to its total assets. Meanwhile, the debt-to-equity ratio measures a company's financial leverage by comparing its total liabilities to its total shareholders' equity.