Net Worth Law & Legal Definition


The "net worth" of a business is the remainder after total liabilities are deducted from total assets. If total assets are $1 million and total liabilities $800,000, net worth will be $200,000. On a balance sheet Assets are typically shown in the left column, Liabilities in the right column. Beneath total liabilities in the right column will be listed the Net Worth. Thus liabilities ($800,000) plus net worth ($200,000), will equal assets ($1 million). Both columns will have $1 million on the last line, "Total Assets" on the left and "Liabilities and Net Worth" on the right. Let us now assume that the situation shown above is reversed: the company has $800,000 in assets and $1 million in liabilities. In that case, net worth will be −$200,000 so that this negative number, when added to liabilities, will produce $800,000 also. Again we have balance. But now, with a negative net worth, the company is insolvent. If that condition cannot be rapidly reversed, the company will fail.

In the usual case, Net Worth is made up of two figures. One is labeled "capital," "owner's equity," "partner's equity," or "shareholder equity." This line is the equivalent to the money initially received for shares sold in the company to all investors (or paid in by partners); in a privately held company it includes the owner's initial capital contributions along with that paid in by other investors. The second line is labeled "retained earnings." This represents profits (net income after tax) retained by the company for future investment or debt retirement after deducting dividends paid out (if any). Capital and retained earnings together are Net Worth.

A company has three different values, of which its net worth is just one. Every company has a "liquidation value," the money that its owners are likely to realize if the business stopped operating, all of its liabilities were satisfied, and all of its assets were sold off. The liquidation value will largely depend on the nature of the company's assets and what they will fetch when sold separately. Cash is worth exactly what it is, and the higher the cash, the higher the liquidation value. Land and buildings will normally sell above or at acquisition costs. Equipment, however, is rarely worth as much in separate pieces as it is when integrated into an up-and-running system of production. If the equipment is highly modified for a special purpose it will fetch least. Major machine tools transferable to another operation will fetch most. On furniture, fixtures, and excess inventories owners are likely to realize only pennies on the dollar.

The business also has a "market value." This is the amount of money a knowledgeable buyer of the company is likely to pay for it. Market value is based on a company's projected future earnings as an "on-going" business. A profitable company with low debt, a well-established history of steady earnings, and good cash flow will fetch the highest price. Other factors play a role, including its technological know-how, market share, and the presence or absence of competing buyers. In the case of a service business where the most important asset is represented by individuals with special skills and knowledge, the willingness of such people to continue on with the business will play a major role.

A company's liquidation value is almost always the lowest, its market value the highest, and its net worth represents a value between these two polarities. Net worth serves as an on-going measurement of the company's health, analogous to a blood-pressure measurement of a individual. Management and investors watch this figure closely. It is also of great interest to potential lenders to the company (along with other measures). Companies with high net worth relative to sales and good cash flow histories have the most success in attracting lenders.

BIBLIOGRAPHY

Heintz, James A., and Robert W. Parry. College Accounting. Thomson South-Western, 2005.

Pratt, Shannon P., Robert F. Reilly, and Robert P. Schweis. Valuing a Business, 4th Edition. McGraw-Hill, 2000.

Warren, Carl S., Philip E. Fess, and James M. Reeve. Accounting. Thomson South-Western, 2004.

                                              Darnay, ECDI