What Is Effective Net Worth?
Effective net worth is shareholders' equity, the amount that would be returned to stockholders if all of a company's assets were liquidated and all its debts repaid, plus subordinated debt, unsecured loans or bonds that rank lowest with respect to claims on assets or earnings. Adding subordinated debt, in effect, increases a company's net worth and is used by senior creditors to determine a company's ability to pay them back, should they loan it money.
- Effective net worth looks at shareholders' equity in light of senior and subordinated debt obligations due.
- A company's net worth is increased when debts are segmented by seniority of outstanding loans—because, like equity, certain debts rank lower in priority in the event of default.
- Effective net worth is useful when analyzing companies whose executives have a significant ownership stake and loan the entity money.
How Effective Net Worth Works
Net worth, perhaps the most common metric to gauge a company's or individual’s financial health, is calculated by subtracting all liabilities, or outstanding balances owed, from assets, or resources owned with economic value. Effective net worth then goes one step further by adding some of these debts back in.
Debt can generally be broken down into two types. There is senior debt, borrowed money that a company must repay first if it goes out of business, and subordinated debt, loans that, in the case of a default, will only get repaid once every other debt has been cleared.
When calculating effective net worth, less urgent debt obligations, such as loans made to the company by an owner or debentures, a type of debt instrument unsecured by collateral, get added to the net worth figure, rather than subtracted.
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Benefits of Effective Net Worth
Why bother adding subordinated debt to the equation? Effective net worth is particularly useful when analyzing closely held corporations, companies that have only a limited number of shareholders.
Executive officers of these companies often have a significant ownership stake and lend the company their own money. Usually, these loans will fall under the category of subordinated debt, meaning that the owners agreed that any bank loans will take priority and be repaid first should the company run into trouble.
For senior creditors, loans to the company by its owners are considered, in effect, as an addition to the company's net worth because as subordinated debt held by the owners, it does not appear much different from equity. From the perspective of a senior creditor, both subordinated debt and shareholders' equity rank lower in priority in making a claim on assets in the event of default.
Effective net worth is a useful measure for corporations whose executives have a significant representation of ownership.
In addition, for company owners who have also made loans to the company, the risk of loss is also similar on both the loans and the equity.
Example of Effective Net Worth
Company ABC has total assets of $10 million and total liabilities of $6 million. Subtract $6 million from $10 million and you end up with a net worth of $4 million. Now let’s assume that the company’s total liabilities include subordinated loans such as debentures and loans from owners of $1 million. Effective net worth in this case would be: $4 million + $1 million = $5 million.