Any business keeps seeing a constant churn of money, with some coming in and some going out. With this, it is often hard for the business to tell or its investors to gauge whether it is operating efficiently. Every stakeholder in the business would like to know if it is making a profit or losing money. So, how does one get to know this? One way to check the business’s financial strength is to review net worth of the company.
Here, we will discuss the net worth of an entity and how to calculate it.
What is business net worth?
In the context of business, net worth means the total book value of a company’s equity owned by the company’s shareholders. It also means the net value of a company that its shareholders can claim in the event of liquidation of all of the company’s assets and repayment of all its debts. In accounting terms, it tells us the value of assets that a company has left after all the liabilities are paid off. Thus, a company’s net worth can also be called stockholder’s equity or shareholder’s equity.
Read more: Difference between book value and market value of shares
How is net worth of an entity calculated?
Net worth can be calculated as: Net Worth = Assets – Liabilities
If an entity has more assets than liabilities, it is said to have a positive net worth and therefore good financial health. In case the liabilities are more than assets, it means the company has a negative net worth and may be perceived as its inability to settle liabilities.
Let’s break down the concept of net worth into assets and liabilities.
Understanding assets
To know a company’s net worth, we must first estimate the current value of its assets. The total assets of a company can comprise cash and cash equivalents, inventory, machinery, property, and buildings. If it’s a bank, assets can include loans lent to borrowers. A manufacturing company, on the other hand, will have the majority of its assets comprising inventory, plants and equipment, etc.
Understanding liabilities
A company’s liabilities include what it owes to someone else or its debt outstanding. This can include loans borrowed from a bank, bonds issued, outstanding payments to creditors or even a line of credit from a bank. For banks, liabilities include the amounts owed to depositors.
Read More : What is Debt equity ratio? How is it used?
Why is a business net worth important?
To check a business’s net worth, one can refer to its book value or shareholders’ equity through the company’s balance sheet. A company’s equity is the difference between its total assets and total liabilities.
For lenders, a business’s net worth is important to understand if it is financially healthy. If its total liabilities are more than its total assets, the lender may not be confident about the company’s ability to repay the borrowings.
For shareholders, if a company has been consistently profitable, it should ideally have a rising net worth which may sometimes be distributed to shareholders in the form of dividends. For public limited companies, an increase in net worth will likely be accompanied by rising stock prices.
How can an entity ensure increasing net worth?
A company can work towards increasing its net worth by either increasing its assets or reducing liabilities by paying off debt. Also, a company can ensure positive earnings at the end of the year to increase its net worth through retained earnings. If a company wants to ensure a higher net worth in a certain year, it should cut down on paying out dividends.
Conclusion
Net worth is a good metric to understand the health condition of any business entity. If an investor or stakeholder only considers the entity’s assets, they may only get half the picture about the company since assets are often offset by liabilities, for example, debt. Stakeholders must also check for the progress in a company’s net worth and whether it has been increasing over the years.
FAQs
To check the net worth of a business, one can look at the company’s balance sheet and subtract net liabilities from net assets. If the result is positive, the company has a positive net worth and is financially healthy. A negative net worth indicates poor financial health since the business may be owing more than what it owns.
There are many ways that investors can evaluate a company. One of the common methods is by going through some of the key ratios using the company’s financial statements. These include quick ratio, current ratio, earnings per share, return on equity, earnings growth, etc.
Some of the common modes to determine the financial health of a company are by checking whether the company is achieving consistent revenue growth, whether it is able to pay its debt, what are its gross profit margins, etc.
The financial strength of a company tells us about its ability to earn revenue, whether it has sufficient cash flow, and whether it is able to return money to creditors and investors. Financial strength is often a determinant of how successful the company can be in the long run.
