Calculating Net Worth YOU WERE POSITIVE you had enough money to pay for that new truck! After visiting with the loan officer, she quickly informed you that you would probably not be able to repay your loan because of your solvency and liquidity ratios. So you ask yourself, What are those? and Why can t I just borrow the money? Objectives: 1. Demonstrate the ability to complete a net worth statement. 2. Calculate analysis factors for liquidity, solvency, and debt. Key Terms: assets current ratio debt ratio debt to assets ratio debt to equity ratio liabilities liquidity net worth net worth statement solvency working capital Net Worth Statement A net worth statement is a form that shows the financial health of a business at a given point in time and determines the ability for a business to pay all debts. Sometimes it may also be called a balance sheet or a financial statement. A net worth statement is composed of two major FIGURE 1. Net worth statements are an essential part of any business. Page 1 www.mycaert.com
parts. Those two parts are assets, which are items that an individual or business owns, and liabilities, which refers to money owed for a product or service. Assets and liabilities can each be subdivided into current or non-current (or long-term) assets and liabilities. NET WORTH STATEMENTS Net worth statements are extremely important for businesses and financial institutions when determining the financial health of a business. Financial institutions use net worth statements and other information to decide whether or not they will give an individual a loan. Businesses and accountants can also use net worth statements to develop a budget. Besides listing assets and liabilities, they can use calculations from a net worth statement to determine if an individual can repay a loan in a timely manner. Calculations to Determine Financial Health Net worth is a calculation that shows the total value of a business. It is calculated by taking total assets and subtracting total liabilities. Net worth gives a quick snapshot of a business and its ability to pay off a loan. Another way to determine the financial health of a business is to calculate solvency. Solvency is a calculation that shows the business s ability to pay off long-term expenses for expansion and growth. When a business asks for a loan, the money is often used to increase the size of the business, purchase more machinery or equipment, or expand the inventory. Solvency is calculated by taking total assets and dividing it by the total liabilities. The higher the solvency value, the more stable a business is and the more able it is to pay off long-term debt. If a business is insolvent, it can no longer operate and may be facing bankruptcy. When written, solvency is often expressed in a ratio to one. A solvency ratio of 3 to 1 (3:1) means that a business has three dollars of solvency for every dollar of potential debt. FIGURE 2. Loan officers will determine your solvency and liquidity based on a financial statement. Page 2 www.mycaert.com
DETERMINING LIQUIDITY If you sold everything you owned, how much money would you have? Liquidity is the measure of a business s ability to turn assets into cash quickly. Liquidity is figured by calculating current ratio and working capital. Current Ratio Current ratio is a calculation that shows a business s ability to pay short-term debts and obligations. Your parents may have short-term debts and obligations like the electricity, water, and phone bills. Current ratio is calculated by taking current assets and dividing those by current liabilities. The higher the number, the more stable a company is in its ability to pay off its immediate debt. Just like other ratios, the value is written to one. For example, an answer of two should be written as 2 to 1 (2:1). This means that for every two dollars of liquidity (possible cash), there is one dollar of debt (money owed to someone else). Working Capital Working capital is an estimate of the amount of liquid assets a company has to build its business in the more immediate future. It only considers the things that can be sold quickly to get cash and the bills that must be paid in the current year or immediately. It is calculated by taking current assets and subtracting current liabilities. A higher number is good because it indicates that you have more cash value of inventory than you do bills to pay. A negative number would imply that you may need to have a loan to pay your bills. SOLVENCY AND DEBT RATIOS In order to receive a loan from a bank or other financial institution, you must be able to show your ability to repay the loan on a net worth statement. Solvency and debt ratios reflect a business s ability to meet both short and long-term financial obligations. Debt to Assets Ratio The debt to assets ratio reflects the amount of assets a business has financed toward its debt. This ratio is calculated by taking total liabilities divided by total assets. Since it is a ratio, it should be written to one. If the debt to assets ratio is greater than one (>1:1), then the business is said to be highly leveraged. In other words, most of the items the business owns are financed through debt. A number lower than one (<1:1) means most of the business s assets are financed through equity, or its net worth. Debt to Equity Ratio Debt to equity ratio is the measure of a business s financial leverage. If a business is highly leveraged, that means it has borrowed a lot of money to pay off other bills and loans. Page 3 www.mycaert.com
The debt to equity ratio takes into account the business s long-term debt and a common shareholders equity. It is calculated by taking total liabilities divided by net worth, or equity. If you were thinking about purchasing stock in a company, you might want to examine a company s debt to equity ratio to determine whether or not to invest in the company or purchase stock. If the ratio is greater than one (>1:1), then most of the assets are financed through previous loans, or debt, of the business. If the ratio is smaller than one (<1:1), then most of the assets are financed through equity. Debt Ratio Debt ratio is an indication of how much a business relies on debt to finance its assets. It is calculated by taking debt capital (dollars of debt) divided by total assets. The higher the resulting number, the more likely the business relies heavily on its debt to finance the operations of its business. FIGURE 3. Several analysis calculations must be completed on a net worth statement. Summary: You will be required to complete a net worth statement when you want to obtain a loan. Assets and liabilities are listed on a net worth statement. Several different analysis calculations are also on a net worth statement to determine the financial health of a business. Net worth, solvency, liquidity, and debt ratios are all important values for you and the lender to examine in order to determine whether or not you will receive a loan and your ability to repay the loan in a timely manner. Checking Your Knowledge: 1. List the two main parts of a net worth statement. 2. Explain how to calculate solvency. 3. List two ways to calculate liquidity. 4. Describe the difference between solvency and liquidity. 5. Evaluate the importance of determining debt and solvency ratios. Page 4 www.mycaert.com
Expanding Your Knowledge: Visit a loan officer at a bank or other financial institution. Ask the loan officer to explain the process of obtaining a loan. Discuss with the individual the importance of analysis calculations for solvency and liquidity. Web Links: Farm Financial Management Your Net Worth Statement http://www.extension.iastate.edu/publications/fm1791.pdf Family Financial Planning: Preparing and Using a Net Worth Statement http://extension.oregonstate.edu/catalog/html/fs/fs331-e/ Agricultural Career Profiles http://www.mycaert.com/career-profiles Page 5 www.mycaert.com