Agribusiness Library

LESSON L060087: CALCULATING NET WORTH

Objectives1. Demonstrate the ability to develop a net worth statement.

2. Describe how the analysis of net worth statements can be used to determine the financial health of a business and identify situations in which a net worth statement might be useful.

Objectives3. Calculate measures of liquidity to determine the availability of cash to pay current debts.

4. Calculate business solvency or debt ratios to determine the ability to repay long-term debt.

Terms•Assets

•Current ratio

•Debt ratio

•Debt to assets ratio

•Debt to equity ratio

•Liabilities

•Liquidity

•Net worth

•Net worth statement

•Solvency

•Working capital

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. It is sometimes referred to as a balance sheet or a

financial statement. A net worth statement is comprised of two major

categories.

A. Assets —items that an individual or business owns. These can be subdivided into current assets

and non-current (or long-term) assets. B. Liabilities —money owed for a product or

service. These can also be subdivided into current liabilities and

non-current (or long-term) liabilities.

Net worth statements are very beneficial for business and financial institutions when determining the financial health of a business. Financial institutions will often use net worth statements

to determine whether or not they will provide a loan. Businesses and accountants can also use them to

develop a budget. They can use net worth statements to determine this by

following a few simple calculations.

Some calculations that could be used are: A. Net worth —a calculation that shows the total

value of a business. It is calculated by taking total assets minus total

liabilities. It is a value that gives a snapshot of the business and its

ability to pay off loans.

B. Solvency —a calculation that shows a business’s ability to pay off long-term expenses for expansion and growth. If a business is insolvent, it can no longer operate and may

be facing bankruptcy. 1. The higher the solvency value, the more stable a business is

and able to pay off long-term debt. 2. Solvency is calculated by taking

total assets divided by total liabilities. When written, solvency is often expressed in a ratio to one. A solvency of 3 to 1 (3:1) means that a business has three

dollars of solvency for every dollar of potential debt.

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. A. Current ratio is a calculation that expresses a

business’s ability to pay short-term debts and obligations. 1. Currency ratio is calculated

by taking current assets divided by current liabilities.

2. The higher the ratio value, the more stable a company is in its ability to pay off its immediate obligations. When written, the current ratio value is expressed to one. For example, a ratio of 2 to 1 (2:1) means for every two liquidity

dollars, there is one dollar of debt.

B. Working capital estimates the amount of liquid assets a company has to build its business in the more immediate future. It is calculated by taking current assets minus current

liabilities.

Solvency and debt ratios reflect a business’s ability to meet both short- and long-term financial obligations.

A. Debt to assets ratio reflects the amount of assets a business has financed toward their debt. 1. This ratio is calculated by taking the total number of

liabilities and dividing them by the total assets. 2. If the value is greater than one,

then the business is said to be highly leveraged. In other words, most of the business’s assets are financed

through debt. A lower number in relation to one means that most of the

business’s assets are financed through equity, or its net worth.

B. Debt to equity ratio is the measure of a business’s financial leverage.

It takes into account the business’s long-term debt and a common shareholders equity. 1. This ratio is calculated by

taking total liabilities and dividing these by the net worth, or equity.

2. From a consumer’s perspective, it is important to look at 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, then most of the assets are

financed through debt of the business. If the ratio is smaller than one, then most of the assets are

financed through equity.

C. Debt ratio is an indication of how much a business relies on debt to finance its assets. 1. This ratio is calculated by taking debt capital (dollars

of debt) and dividing it by the total assets. 2. The higher the number, the more likely the business

relies heavily on its debt to finance the operations of its business.

REVIEW•What is a net worth statement and how do you complete one?

•How can a net worth statement be used to determine the financial health of a business?

•How do you calculate liquidity?

•How do you calculate different types of solvency or debt ratios to determine the ability of a business to repay long-term debt?