What is Effective Net Worth
Effective net worth is shareholders' equity plus subordinated debt. From the viewpoint of senior creditors, adding subordinated debt, in effect, increases a company's net worth. Effective net worth is particularly useful in analyzing closely held corporations. Executive officers of these companies often have a significant ownership stake and have made loans to the company. These loans are considered subordinated debt, which ranks lower in priority than senior debt. Holders of subordinated debt are among the last to recover their investment if the company defaults. Subordinated debt can also include debentures.
BREAKING DOWN Effective Net Worth
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 shareholder's equity rank lower in priority in making a claim on assets in the event of default. 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.
If a closely held corporation with total assets of $10 million and total liabilities of $6 million, then the company would have or net worth of $4 million. Assume 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.
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