Tangible net worth (TNW) is an important financial metric that lenders use to assess a company’s financial health and ability to repay debt. It is a key component of loan covenants and ongoing compliance requirements for borrowers.
How Tangible Net Worth is Calculated
Tangible net worth is calculated by taking a company’s total assets and subtracting all liabilities and intangible assets. Here is the formula:
Tangible Net Worth = Total Assets – Intangible Assets – Total Liabilities
To break this down:
Total Assets
This includes all assets with an economic value that can be converted into cash. Examples include:
- Cash and cash equivalents
- Marketable securities
- Accounts receivable
- Inventory
- Property, plants and equipment
- Any other liquid asset
Total assets are calculated based on the book value or fair market value of these items. Book value is based on the original or amortized cost on the balance sheet, while fair market value represents what the assets could be sold for.
Intangible Assets
These are non-physical assets such as patents, trademarks, copyrights, goodwill and brand recognition. While these have value, they cannot be easily converted into cash. Intangible assets must be subtracted to calculate tangible net worth.
Total Liabilities
This represents the total amount of money owed, financial obligations, debt financing and other legally binding lending obligations. Common examples include:
- Accounts payable
- Long-term debt
- Short term borrowing
- Other debts and obligations
Subtracting total liabilities provides a clearer picture of tangible net worth.
By subtracting intangible assets and total liabilities from total assets, you’re left with tangible assets that connect directly to net worth. This provides a snapshot of liquidity.
Why Lenders Care About Tangible Net Worth
Lenders want to see solid tangible net worth for several reasons:
1. Measures Payback Ability
Tangible net worth focuses on liquid assets that can repay debts and loans. A higher TNW provides more assurance that the borrower can pay back their obligations without relying on intangibles.
2. Assesses Risk
A declining TNW over consecutive periods may indicate financial problems and rising risk. Lenders can identify unhealthy trends and balance sheet issues sooner.
3. Evaluates Collateral
Tangible assets like property, inventory, accounts receivable etc. can potentially be claimed as collateral if the borrower defaults. TNW gives lenders a snapshot of how much collateral coverage they have.
Why Ongoing Covenant Calculations are Needed
Loan covenants require periodic TNW calculations to ensure the borrower remains compliant over time. Examples include:
Minimum TNW Covenant
Sets a base level TNW threshold the borrower must maintain. Quarterly calculations affirm they stay above the minimum.
Maximum Debt/TNW Ratio
Caps the total debt level relative to TNW. Prevent overleveraging.
Current Ratio Based on TNW
Requires a minimum level of current assets to current liabilities, with intangibles removed.
Minimum Fixed Charge Coverage Ratio
Measures the ability to cover fixed expenses based on earnings without intangibles included.
How to Calculate Tangible Net Worth
Calculating tangible net worth requires a company’s balance sheet, income statement and statement of cash flows. With proper data, the calculation process includes:
Step 1: Determine Total Assets
- Obtain balance sheet listing all assets
- Sum fair market value of cash, A/R, inventory, PP&E etc.
- Include adjustments like appraisal gains/losses
- Report non-cash items under intangibles
Audited statements provide the most accurate asset valuation. However, internal reporting may suffice for covenant testing.
Step 2: Identify and Sum Intangible Assets
Common intangibles:
- Patents
- Trademarks
- Copyrights
- Goodwill
- Brand recognition
Tally all intangibles and segment them out from tangible assets.
Step 3: Sum Total Liabilities
- Gather list of total current and long-term liabilities
- Include items like A/P, debt, deferred taxes
- Sum all liabilities into one figure
Audited statements ensure appropriate categorization and capture of liabilities for TNW purposes.
Step 4: Subtract Intangibles and Liabilities from Total Assets
With all data gathered, the TNW formula can be calculated:
TNW = Total Assets – Intangible Assets – Total Liabilities
Double check figures across all categories to confirm calculation accuracy.
Step 5: Compare TNW to Loan Covenants
Finally, compare the TNW result to any minimum or maximum covenant levels related to:
- Minimum TNW
- Maximum debt/TNW ratio
- Current ratio covenant
- Fixed charge coverage covenant
Providing covenant test results to the lender demonstrates ongoing compliance or flags a potential default.