Effective Net Worth Details

Effective net worth is almost identical to net worth or shareholder/owner's equity, which is the owners' claim to a company that equals its total assets minus its total liabilities. The only difference is the inclusion of subordinated debts. When calculating effective net worth, analysts further add subordinated debts that have low settlement priority to the total shareholders' equity, increasing its value. With effective net worth, analysts that would normally classify some debt obligations as liabilities will instead consolidate them into the owner's equity.

To understand how the scenario above is possible, we must first understand two types of debts: senior debts and subordinated debts. Senior debts are obligations that a company must settle first and foremost in the event of default (a state where an entity fails to make timely payments or stops making payments altogether). On the other hand, subordinated debts are obligations that a company does not have to pay immediately in the event of default. In other words, subordinated debts have the same payment priority as shareholder equity.

An example of subordinated debts is a loan made by a firm taking the form of a debenture, which is a type of debt instrument with no collateral or security to back it up. Simply put, if the firm fails to make debenture payments, the bondholder—assuming the debenture is in the form of bonds—will be unable to compel the company to make the required payments as soon as feasible. This arrangement makes it so that the company doesn't need to settle the debt immediately as long as senior debts remain unpaid. Since debenture provides replayment leeway for the company, just like shareholder's equity, it's a part of effective net worth.

Example of Effective Net Worth

XYZ Company is a public corporation with a capital structure that includes both debt and equity. An analyst estimates the firm's entire assets at roughly $300 million. Liabilities account for around $120 million of total assets. If we calculate net worth with the usual approach, we simply subtract total liabilities from total assets: $300 million - $120 million = $180 million. However, to calculate the effective net worth for XYZ Company, we must distinguish between senior and subordinated obligations.

It turns out that $20 million of the company's debt is subordinated debt, which we take away from total liabilities. The effective net worth in this scenario would be as follows: $300 million - $100 million = $200 million.

Significance of Effective Net Worth

When trying to figure out a company's net worth, effective net worth is far more relevant for organizations with fewer shareholders. As these few owners often have a big ownership position, they are more inclined to lend their own money to the company without requiring any collateral or security, i.e., granting debentures. As the firm incurs the obligation, borrowed funds are still recognized as debt, even if they come from the owner, albeit as a subordinated debt with a lower payment priority.

There isn't much of a distinction between subordinated debt and owner's equity when you think about it. Both are often provided by the company's owners/shareholders and are useful to the company's operations. Furthermore, whether the owners take loans or investments under the business, the potential risk and return level are practically the same. It's not surprising that when a company defaults, creditors treat subordinated debt and owner's equity as the same as well.