The net worth of a company is what is left for the shareholders after settling all obligations. It can be termed as net assets of a company after adjusting for all types of liabilities.
Return on net worth is the ratio that links the net income with the net shareholders’ equity. This figure closely resembles return on equity with a few exceptions.
Let us discuss the return on net worth method with the help of an example and see its important interpretation points.
What is Net Worth of a Company?
The net worth of a company is the amount of assets minus liabilities. It is the book value or shareholders’ total equity of the company.
In simple words, net worth equals assets of a company left after settling all of its obligations. It means it is the amount that is purely for the use of shareholders.
The net worth of a company increases as its assets grow. Conversely, if the company can reduce its liabilities, its net worth will increase. It will remain positive as long as assets exceed liabilities.
The net worth is measured in dollar terms. It can be a positive or negative figure. The net worth figure is then used to calculate the return on net worth ratio.
How to Calculate the Net Worth of a Company?
The concept of net worth derives from the basic accounting equation. The basic accounting equation is given below.
Assets = Shareholders’ Equity + Liabilities
Thus,
Shareholders’ Equity = Assets – Liabilities
Important Note:
Net Worth of a company includes total shareholders’ equity plus the retained earnings figure. It is for the fact that retained earnings are accumulated profits that can be distributed in the form of dividends or reinvested in the business.
Thus,
Net Worth = Assets – Liabilities
Or Net Worth = Shareholders’ Equity + Retained Earnings
Shareholders’ equity includes all types of equity including common and preferred stocks issued.
Assets include all types of assets owned by the company. These can be categorized either as tangible and intangible or as current and long-term assets. Similarly, the total liabilities of a company can be included as current and long-term liabilities.
What is Return on Net Worth and How to Calculate It?
Return on net worth is the return shareholders can expect to make on their investment in a business. This ratio considers net income that is distributable to the shareholders. Thus, it concerns shareholders more than the company’s perspective.
The formula to calculate the return on net worth is:
Return on Net Worth = Profit After Tax ÷ (Shareholders’ Equity + Retained Earnings)
As we can see, there are three line items in the calculation.
First, we need to calculate the net profit of the company. It is the operating profit after paying taxes and interest obligations. Net income figures can be directly taken from the income statement of a company.
Next, we calculate the shareholders’ capital. It is the total equity figure that includes common and preference shares. It also includes any share premium or additional paid0in capital amount.
Lastly, we can add the retained earnings figure to the formula. This is the accumulated profit figure of the company over the years. It is also a readily available figure that can be taken from the balance sheet of the company.
Example
Let us consider a couple of examples to understand the return on the net worth concept.
Suppose the following data is available for the ABC Co. For its latest completed financial year.
| Cash and Cash Equivalents | $ 150,000 |
| Accounts Receivable | $25,000 |
| Net Inventory | $50,000 |
| PPE and Other Fixed Assets | $ 400,000 |
| Goodwill and Intangibles | $ 200,000 |
| Long-term investments | $ 300,000 |
| Total Assets | $ 1,125,000 |
| Accounts Payable | $ 70,000 |
| Accrued Expenses | $ 65,000 |
| Other short-Term Liabilities | $ 130,000 |
| Long-Term Liabilities | $ 300,000 |
| Total Liabilities | $ 565,000 |
| Shareholders’ Equity | $ 300,000 |
| Retained Earnings | $ 260,000 |
The company earned a net profit of $ 165,000 for the latest financial year.
As we know the formula:
Return on Net Worth = Profit After Tax ÷ (Shareholders’ Equity + Retained Earnings)
Return on Net Worth = $ 165,000 / (300,000 + 260,000)
Return on Net Worth = 0.2946 or 29.46%
Let us consider a real-world example of Amazon inc.
The following is data is extracted from the Income statement and Balance sheet of Amazon inc. for the year ended 2020.
| Item | Amount $ (in millions) |
| Total Shareholders’ Equity | 30,840 |
| Retained Earnings | 31,220 |
| Net Income After Taxes | 10,073 |
We can use the same formula again:
Return on Net Worth = Profit After Tax ÷ (Shareholders’ Equity + Retained Earnings)
Return on Net Worth = 10,073/ (31,220+30,840)
Therefore, Return on Net Worth = 0.1623 or 16.23%
Interpretation of Return on Net Worth
The net worth closely resembles the total equity figure of a company. It only adds the retained earnings figure to the share capital of a company. Thus, the return on net worth is the rate of return for shareholders’ net wealth from the company.
Like any other financial ratio, it should also be analyzed with the help of trend analysis. A standalone figure cannot reveal the actual financial performance of a company. Thus, it’s important to understand the declining or rising trends of the return on net worth ratio.
Net worth of a company increases if the assets grow and liabilities stay under control. That in turn is achieved through operating efficiency. Thus, efficient use of the resources provided (assets) to the company keeps the liabilities in check.
Another way of understanding this important metric is to link the net profits with the net worth of shareholders. If a company generates consistently lower profits or incurs losses, its return on net worth will fall.
Conversely, retained earnings and shareholders’ equity will increase with an increase in profits. The company will be able to retain more out of profits and use the amount for reinvestment purposes.
Negative Net Worth
It is important to mention that the net worth of a company can be positive or negative. A negative net worth results if the total liabilities of the business exceed total assets.
In terms of profits, if the company incurs net losses, its return on net worth ratio will decline to negative as well.
Negative net worth arises due to operating inefficiency. It means the business failed to utilize the assets to generate sufficient revenues.
Impact of Leverage on Return on Net Worth
Shareholders’ net worth increases as a company accumulate more profits. If a company is generating more profit, its return on net worth will increase.
However, it is important to understand that the company may use a high leverage level to generate that income. Higher profits generated this way will boost shareholders’ return on equity. That in turn will push the return on net worth higher.
In reality, the company may incur higher interest costs. Also, it will put pressure on the total cost of capital of the company beyond a certain leverage level. Thus, a balanced leverage level ensures healthy growth and a stable return on the net worth of a company.
Return on Net Worth and ROE
In practice, return on net worth and return on equity represent the same thing. Both of these terms are used interchangeably.
Return on equity is calculated by dividing the net income by the shareholders’ equity. In the net worth calculation, we deduct all liabilities from the total assets of the business. We’ll arrive at the same figure both ways.
A minor distinction in some cases can be the adjustment for the retained earnings, surplus reserves, and other such income that should be included in the net worth calculations.
From shareholders’ perspective, it is important to analyze the return on net worth comprehensively. As it may show a higher ratio due to accounting adjustments. For example, a share buyback program will change the shareholders’ equity figure that will temporarily change the return on equity as well as return on net assets.
Concluding Remarks
Return on net worth of a company represents the rate of return on the shareholders’ investment. Net worth is calculated by deducting all liabilities from total assets held by the company.
It means if a business utilizes its assets effectively, its return on net worth will increase. Otherwise, if its liabilities exceed the total assets, it will result in a negative figure.
Interpretation of this metric is also important. Accounting adjustments for increased profits or a change in assets or liabilities can manipulate results. Thus, it’s important to keep an eye on that factor.
Similarly, it is important to analyze this ratio with the help of trend analysis. It should be compared with the industry standards for a similar-sized company. For internal benchmarking, the ratio should be analyzed by comparing the results for the previous years.
