What is Tangible Net Worth?
The tangible net worth is an estimate of the net worth of an entity that excludes all intangible assets such as trademarks, patents, and intellectual property.
A lot of people believed that wealth is all about owning that shiny new car, the penthouse condo, and designer clothes.
Honestly speaking, most financially independent people have a lifestyle that is far less flashy, preferring a more prudent approach and planning for the long term.
According to the Longman dictionary, Tangible Net Worth is a net worth that is calculated without considering assets that do not have clear and easily measured financial value, such as goodwill Tangible net worth is a key measure of a company’s financial health.
How to calculate tangible net worth
As a key prerequisite to any assessment of Tangible Net Worth, it is necessary to ensure that the balance sheet is representative of the financial reality of the business because if this is not the case and financial statements are fraudulent and do not represent the reality of the business, the Tangible Net Worth will be biased and lead to a false estimate of the value of the company.
For example, if the value of the stock is overvalued (valuation in the balance sheet of dead stock), tangible net worth will also be false (see the pitfalls of the balance sheet).
This principle is true for any difference in the value of balance sheet assets (fixed assets, receivables, etc.) compared to reality.
The Tangible Net Worth Calculation Method/Formula
Total assets – intangible assets – total of debts to third parties (Total liabilities)
The Tangible Net Worth provides information about the financial base of the client, as a lender (a deferred payment granted to the client equals a credit given), we must ask ourselves the following question: how much can I loan to this company?
Tangible Net Worth plays a pivotal role in the answer to this question: it does not make sense to give the customer a credit limit greater than 100% of his Tangible Net Worth. 80% is far too high.
What are Debt Covenants?
Debt covenants are promises or agreements entered into by the borrowing party to comply with the terms agreed upon while discussing the loan agreement. Debt covenants are generally restrictions or certain parameters imposed by the lending party that the borrowing party agrees to in exchange for a loan.
Furthermore, they are certain benchmarks that the borrowing party agrees to adhere to in exchange for a loan. Debt covenants are also generally referred to as “bond covenants.
Tangible Net Worth: Use in Debt Covenants
Tangible net worth is an important component of debt covenants, It is considered very important by most lending parties because, as mentioned earlier, it can be used to assess a company’s actual physical net worth, while not having to include all the assumptions and estimations involved with the valuation of intangible assets.
This calculation of the tangible net worth allows the lender to evaluate the borrowing party’s ability to support and settle its debts.
But if a lender puts forward a condition in their loan agreement stating that the agreement will only be valid as long as the borrowing party maintains a certain minimum percentage level of tangible net worth over the borrowing period, it is an example of one being used as a debt covenant.
Also, note that the Tangible Net Worth (TNW) is a relevant indicator to assess the real value of a company based on the balance sheet and it can be used for credit analysis to validate the outstanding level that is granted to customers.
For example, it may be stipulated in the credit management policy that the credit limit granted to customers shall not exceed x% of tangible net worth.
However, the Tangible Net Worth meets the obvious need, but not so easy to get, to know the intrinsic value of a company based on what is material, ie that can be converted into cash in case of termination of the activity and of liquidation of assets (sale of fixed assets, inventory, and payment of receivable) and the payment of debts with third parties (banks, suppliers, taxes, etc.)
Tangible Net Worth is a concept very down to earth. All intangible valuations, for instance, intangible assets such as goodwill, licenses, patents, expenses, and every other intellectual property that the company may possess, are excluded in the calculation of tangible net worth.
What is Net Worth? – How to Calculate Net Worth of a Company
The tangible net worth comes into play when money lenders and investors want to look at the company’s credibility.
A balance sheet portrays both liabilities and assets of a company. Among them, is the value earned from tangible assets. The tangible assets of a company include the following:
- Account receivable
- Company equipment
True wealth comes down to net worth, a measure of not only what you truly own (your assets) but also of your debt (your liabilities) once you determine your net worth, you can make the reimbursement of your loans and unpaid bills a priority, after which you can get started on the saving path.
Three Steps to Calculating your Net Worth
- First, calculate your total liabilities by adding up all your current debt amounts: outstanding credit card balances, mortgage loans, car loans, student loans, line of credit, personal loans, and so on.
- Another thing is to add up your assets: bank accounts, savings (RRSP, TFSA, RESP, stocks, bonds), potential pension funds, shares of a company, the value of a parcel of land, the cash surrender value of an insurance policy, etc.
- Lastly, minus your total liabilities from your total assets. The result is your net worth.
Take, for instance, if you own a house with a market value of $200,000, a $20,000 vehicle, and $5,000 in bank savings, your total assets amount to $225,000, if you owe $215,000 on your mortgage, $15,000 on your car loan, and have unpaid student loans and credit card balances of $20,000, your liabilities add up to $250,000. Your net worth is therefore negative: -$25,000.
There are things to keep in mind when you calculate your total assets: 1. Make sure you are not fooled by certain numbers that give the illusion of having more than you do.
Take for instance, when it comes time to wind down your RRSPs, funds that had accumulated tax-free will now be subject to tax.
So, each $100 withdrawn will be worth only $70, perhaps even as little as $50 gains from shares held outside a TFSA are also taxable.
Why are Intangibles Excluded from Credit Analysis
Intangible assets are immaterial and unquantifiable (cash is intangible but perfectly quantifiable), they are subject to subjectivity in large proportions. Indeed, how to define rationally the value of goodwill or a patent?
It is extremely difficult because their actual value depends on the external context which may be rapidly evaluated.
Take, for example, a patent may have some value for a few months and become obsolete overnight. Also, the
value of goodwill may vary depending on many criteria: competitive environment, market growth, positioning.
As a consequence of this subjectivity, the valuation of intangible assets varies with the business strategy, they will swell if the executive wants to sell his company, and they will decrease if it wants to reduce its net income.
Note: the principle of credit analysis is to determine the capacity of a company to pay its bills in a few months. Furthermore, intangible assets are hardly marketable and therefore do not
strengthen the solvency of a company in the short term.
What is the difference between tangible and intangible assets?
- The assets that could be physically touched and seen.
- Tangible assets are depreciated.
- It can be easily liquidated.
- Cost can be easily determined.
- Intangible assets cannot be physically touched or seen; however, their impact could only be felt.
- These assets are amortized.
- Intangible assets cannot be liquidated easily.
- Difficult to determine cost.