Net Worth – Definition, Equity, Calculate, Meaning and Analysis
Net Worth Definition
It is mainly made up of own funds (the money contributed by the partners plus the reserves saves by the company and the profits it generates). Previously, own funds and net worth were considering synonyms. However, according to the new international criteria, net worth includes other items, such as accounting adjustments caus by errors or changes in accounting criteria.
The net worth of a company considers the value of that company. The higher the net worth, the higher the value of the company. When a company makes an income, that money is includ in the company’s assets, so the primary mission of the directors of a company is to increase the net worth.
Equity and Net Worth
When discussing net worth, we must not forget that equity refers to an organization’s assets and liabilities, including investments, rights, obligations, and debts.
On the other hand, the net worth comes to represent this after having discount expenses, obligations and debts (liabilities) from the equity of a company to then determine its absolute and total value.
How to Calculate Net Worth?
To calculate the net worth, the following formula must follow. It should be noted that assets are all those goods, properties or rights owned by a natural or legal person. At the same time, liabilities represent all the obligations that an organization must meet in the future: debts.
All assets (current and non-current) must be present in assets, and in liabilities, all liabilities must be present, whether current or non-current.
Meaning and Analysis of Net Worth
The very name of equity or own funds tells us that the elements it collects form, as a whole, the economic resources of the company that are its own, that it does not owe to third parties to whom it has to pay or return.
A consequence of this is the concept of capitalization of the company; in a healthy and normal company, the net worth must be positive.
However, it may, in some instances, not be positive. Suppose the company accumulates losses that it cannot offset, and they are computer in surplus accounts, negative results or results pending application. In that case, these subtractions can reach a figure that exceeds the own resources themselves, with which the net worth could assume a negative amount. We speak of the decapitalization of technical bankruptcy.
Characteristics of Net Worth
It is also known as a non-claimable liability since it does not need to be repaid to another person or organization other than the company.
Equity is responsible for financing fixed assets and a small part of current assets.
The company’s profits include in the net worth, so the benefits of all the shareholders come from there.
The net worth, accounting, considering a debt that must be paid to the company’s partners; however, it has no actual financial cost.
Importance of Net Worth
The net worth is significant for the company in the following aspects:
- If this equity is equal to zero, the assets and liabilities have the same value, so everything in the company belongs to other organizations; it owes it to third parties.
- If, on the other hand, equity is positive, it means that all assets and rights belong to the company, and it does not owe them to third parties.
- If the equity is negative, the company will be in trouble since the assets will not be sufficient to pay off the debts and obligations that acquire in the past, for which there will be a risk of bankruptcy.
How is Net Worth Made up?
It is significant to recollect that this type of equity is a substantial part of its balance sheet since it is responsible for representing the shareholders and their benefits. It composes of:
- The economic contributions of each shareholder.
- Profits and reserves, whether generated or distributer by the company.
According to that, the net worth brings together all the donations or aid that the company and its funds have to admit. In addition, it contemplates the modifications in the price of the company.
Net Worth by Entities
In each entity, the net worth can vary according to various reasons. It is an integral part of the balance sheet in companies, along with assets and liabilities. For the other entities, net worth is:
It is the net economic position of a person, so it obtains by subtracting the liabilities from the assets owned by that individual.
For example, a person may have vehicles, retirement accounts, and other investments in their assets. In contrast, his liabilities will be secure debt and unsecured debt.
The Net Worth as a Patrimonial Element
Equity is one of the three equity items on the balance sheet, along with assets and liability:
- Assets are pardoning your own, liabilities are what you owe, and net worth is the financial resources that belong to the business. Net worth can calculate as assets minus liabilities:
- It is essential to know its to see if it works correctly. If the company has a greater than zero, it finances with its own money and has no debt or obligation to pay it back to anyone.
- A company that increases its year after year thanks to profits is a healthy company with a future. On the other hand, if it has a net worth equal to zero, everything the company has been bought with debt, and if the company has a negative net worth.
- The company is in a situation in which it owes more than it has so that we can say that the company is technically bankrupt.
- However, it is a situation that can also occur in startups, which can request a lot of debt to finance a business with a lot of growth.
- They go into technical bankruptcy initially because they have a negative net worth, but they have a good chance of getting out because they are a significantly growing business.
The Net Worth also Contains the Following Characteristics:
It is required; it must not return to third parties outside the company. Hence, It is also known as a non-demandable liability.
Despite being considered, it has no financial cost, from an accounting point of view, a debt (to the partners).
It has to finance the non-current assets and part of the current or circulating assets of the company.
The net must appear clearly distinguish in the balance sheet, an accounting report that reflects the company’s assets at a given time.
The Negative Situation of Net Worth can Affect Several Aspects:
Mandatory capital reduction; provide for in art. 163 of the old Corporations Law, the current Capital Companies Law, does not include it so explicitly but regulates it in its articles 320 et seq. This operation must have a previous study, in the last six months, by an accounts auditor and agree.
It is the General Meeting of the Company; it must respect the privileges or particularities of shareholders, if any, affect all partners. In the same way and cannot applies while reserves are available (voluntary or legal if it exceeds 10%).
Mandatory dissolution of the company occurs automatically if the company must reduce. Its share capital is below the legal minimum and, after one year. It has increased its capital or transformed the company to meet the requirements of the Law.
Likewise, the company if it liquidate in the context of bankruptcy. This liquidation agreement is necessary because the mere existence of the contest does not imply the dissolution of the company.
Types of Net Worth
As we have indicated is significant because it means the company’s health. When we look at this indicator, three possibilities can occur:
Greater than zero: in this case, we can see that the finance with its own money and has no debts.
Equals zero: this tells us that everything the has bought, it has acquire with debt, that is, financing.
Less than zero: when this situation occurs, the owes more money than it has, and therefore, we can speak of bankruptcy.
Example: The company Active SA buys a new oven for 30 thousand euros. The purchase has been made in two ways:
Request a loan from the bank: in this case, the PN will be equal to zero since the company owes it. The money to the bank but, at the same time, has an asset that has the same value.
The partners put the money: in this case, the PN would be greater than zero since the oven. It bring with the company’s money. Therefore, there would be no liability. And, in addition, the company wins a good that is worth 30 thousand euros.
It gives you your company’s value quickly and straightforwardly. On the other hand, let’s not forget that these three indicators together help us get the balance sheet. It which is very important to calculate the annual accounts.
The company asks for a loan and buys it. In this case, the company has an asset of 20,000 euros and a liability of the same amount. Therefore, the company does not contribute anything. It does not change since it has a van whose value it owes to the bank.