Creditors and investors have different considerations when they evaluate a business. Investors are usually interested in a company's ability to increase profits on a long-term basis. Creditors, on the other hand, want to ensure that they'll be paid back for any loans issued. Creditors use the Debt-to-tangible-net-worth ratio to gauge the resources a company has to pay back debt.
About the Ratio
Debt to tangible net worth is a derivative of the debt-to-equity ratio. The debt-to-equity ratio is used by potential investors and creditors as a way to gauge the proportion of debt to available company assets. Normally, equity represents both tangible and intangible assets. Investors find intangible assets relevant to the calculation because they're potential sources of revenue for the company. However, it can be hard to sell or liquidate intangible assets. Creditors are particularly concerned with the liquidation value of a company in case it defaults on debt. For that reason, banks and lenders often exclude intangible assets and use the debt-to-tangible-net-worth ratio instead.
Calculating Total Debt
In the context of the debt-to-tangible-net-worth calculation, debt includes all company liabilities. This means that short-term liabilities -- like wages payable, accounts payable, and short-term loans and notes -- along with long-term notes, bonds and loans are all included in total debt. However, sometimes financial institutions use a narrower definition of debt and include only formal financing agreements in the calculation. Either way is acceptable as long as the ratio is calculated consistently for all customers.
Calculating Tangible Net Worth
The calculation for net worth -- also known as total equity or net assets -- is total assets minus total liabilities. Tangible net worth is calculated the same way, but only tangible assets are included. A company's tangible assets include cash, savings, accounts receivable, equipment, property and real estate. As a rule of thumb, anything that's a cash-equivalent or has a physical presence is a tangible asset. Intangible assets are items you can't physically touch, like patents, logos, trademarks and goodwill. To find tangible net worth, subtract intangible assets and total liabilities from total assets.
Computing and Interpreting the Ratio
The formula for debt to tangible net worth is total debt divided by tangible net worth. In general, a lower ratio is better. A low ratio means the business has lots of tangible assets relative to the amount of debt it holds. If the ratio is increasing, that means either the company is taking on more debt and liabilities or is losing cash and assets. Creditors are hesitant to lend to a business with a high ratio because that means they are less likely to recoup their loan value in the event of a liquidation.
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