Tangible Net Worth: a Worked Example

Equity is the layer of a balance sheet that takes losses before creditors do. A lender wants to know how thick that layer is in a failure rather than in a going concern, and the two can differ sharply. Goodwill is a premium once paid for future earnings; when those earnings go, so does the premium. Software written for one company's systems, or a brand its customers have left, fetches little from a receiver. The balance sheet goes on showing such assets at their carrying value until someone writes them down.

A loan to a shareholder or a sister company is a different problem. It is an asset on paper, but collecting it depends on the same people whose business is in trouble, which is why many facility agreements remove it as well. It also catches something equity misses: money taken out as a loan to the owner does not reduce reported equity at all.

The facility agreement's definition decides the answer, and the details vary from deal to deal. Deferred tax assets are often deducted, since they have value only if the business makes future profits. A property revaluation surplus may be left out. Shareholder loans are sometimes added back as quasi-equity, provided they are properly postponed to the bank. Some covenants set a fixed floor; others raise it each year by a share of profits.

Accounting frameworks treat goodwill differently, but the test is indifferent. New Zealand and Australian groups on the IFRS-based standards keep goodwill unamortised and assess it for impairment each year; a UK group on FRS 102 amortises it over its useful life. Either way the charge reduces equity and the goodwill figure by the same amount, and the deduction takes out whatever carrying value is left.

A maker of agricultural sprayers, constructed for this page like every figure in it, has shareholders' equity of US$30m and borrowings of US$18m. Its covenant requires tangible net worth of at least US$20m, a level that belongs to the example and is not a market norm. It buys a smaller competitor for US$14m, paying with US$10m of new term debt and US$4m of its own cash. The competitor's net tangible assets are worth US$5m, its customer lists and brand US$3m, and the remaining US$6m is goodwill. Fees and deferred tax are left out.

Reported equity has not moved, because US$14m of acquired assets arrived against US$4m of cash spent and US$10m of debt taken on. Debt to book equity goes from 0.60 to 0.93 times, which looks manageable. Debt to tangible net worth more than doubles, and on the completion balance sheet the covenant fails with nothing wrong in trading. US$9m of the price bought assets the test does not count.

Now suppose the seller takes US$5m of the price in the buyer's shares, and the new debt falls to US$5m.

The deal now clears by US$1m. The business and the price are the same; what changed is how much of the price the owners funded.

Book equity, or net worth, is the accounting residual: assets less liabilities with everything left in. Tangible net worth is one layer of that. Net tangible assets, the phrase in many listed company reports, is the same idea, usually without the related-party deduction. Gearing can use either as its denominator, so a gearing figure means little until the reader knows which.

Debt to EBITDA asks a different question. Leverage compares debt with what the business earns; tangible net worth compares it with what would remain to absorb a loss. The second can look poor where the first looks fine, as it does for a business built by acquisition. A group bought largely with goodwill may have negative tangible net worth from its first day, and lenders to such a group tend to rely on earnings-based tests instead.

DEFINED IN ONE PARAGRAPH → · GEARING → · CAPITALISED COSTS →

The first place is the acquisition paper. A lender asked to fund a purchase works out the closing balance sheet before approving it, because the breach in the example could have been read off the sale agreement. The usual answers are more equity, part of the price paid in shares or in a subordinated vendor loan the definition counts, or a covenant reset to a lower floor that rebuilds over time.

The second is what the test ignores and what it catches. An impairment of goodwill hits book equity hard and leaves tangible net worth untouched, since that goodwill was already deducted. A business that begins capitalising development spending raises its reported equity and gets no credit here. And because a floor limits how much can leave, dividends and owner loans are read against it before they are paid.

LOAN COVENANTS, EXPLAINED → · RELATED-PARTY TRANSACTIONS → · FINANCIAL REPORTING, READ BY A LENDER →