Effective Net Worth
A figure used by senior creditors to determine a company's ability to pay them back, if they make a loan.
In general, here's how you figure out your net worth: you total your assets, like the equity in your house, the cash you have in your bank account and the gold doubloons you have buried in the backyard under the big "X." Then you subtract your liabilities, like the remaining mortgage on your house, your college loans, and the amount you owe your brother for the time he spotted you $20 for hot dogs at the ballpark. That gives you your net worth...assets minus liabilities.
For effective net worth, though, some of the debt gets added back in.
First, a little about classes of debt. There are two general types of debt a company can have: senior debt and subordinated debt.
Senior debt gets precedence. If things go bad (like a bankruptcy), senior debt gets paid back first. People holding subordinated debt just have to get in line and hope for scraps.
It's like your brother and the $20 you owe him for hot dogs. He'll get the money when he gets it. You're going to pay the mortgage first, then your student loans. Then, if there's money leftover...well, you still might stiff your brother. You might buy yourself a new pair of shoes instead. He can wait. Subordinated debt.
When a company calculates its effective net worth, its subordinated debt gets added into the net worth figure, rather than subtracted. The effective net worth figure is used by senior debt holders to determine their ability to recoup if times get bad.
Senior debt gets paid back first. So the amount of cash a company's holding from subordinated debt can get used to pay back senior debt holders. Subordinated debt holders will just have to wait their turn.
Here's the formula: shareholder equity + subordinated debt = effective net worth
Your doubloon burying business has $8 million in assets. It also has debts of $3 million. Traditional net worth equals $5 million: $8 million minus $3 million. But that debt is split, $2 million in senior debt plus $1 million in subordinated debt (mostly loaned by your brother..the sucker). That subordinated debt gets added back in. So $5 million plus $1 million gives you effective net worth of $6 million.
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Finance: What is Net Worth?185 Views
Finance a la shmoop what is net worth?
well net worth refers to the value of something like if you have 10 million
bucks in assets and 2 million in debt your net worth is 8 million 10 months -
bigger example you're a wealthy real estate mogul different kind of mogul [person skiing down a mountain]
this kind you have 3 billion dollars worth of buildings so how do we know
there were 3 bill well we have a bevy of active buyers willing to pony up cash [buyers cuing up to buy a building]
for the marquee trophy real estate between 5th and central park we also
know it's worth this much just by using a discounted cash flow analysis anyway
the buildings show profits of 200 million bucks a year and the going rates [Building with a fore sale sign of 3 billion dollars]
for these buildings is about 3 billion or 15 times that unleveraged number
there's a new term unleveraged well unleveraged means that the buildings [a bird swooping into the buildings window]
carry no debt which is unusual for real estate because with such steady
recurring predictable revenues and profits on long term leases there are
generally good candidates for taking on lots of relatively cheap debt you know [A building being compressed by debt]
in banks generally like lending to real estate projects so the three billion
gross or total worth of these buildings is the net worth as well because there's [Dollar signs raining from the sky onto the buildings]
no debt to subtract they're unleveraged but what if the mogul decided he wanted
to buy 2 billion dollars worth more of buildings and he decided to pledge his [mogul attempting to buy more buildings]
existing unleveraged 3 billion dollars worth of building as collateral so he
can take out loans that are bigger right well then he went to Vegas put all 2 [Mogul with a wheelbarrow of cash gambling in vegas]
billion on 17 black and lost well the good news he just made a lot of new
friends at that casino the bad news well he's lost a whole 2 billion and he still [Mogul losing 2 billion dollars on the roulette]
has to pay it all back his net worth just went down to 1 billion because you
take the 3 billion dollar value of his real estate subtract the 2 billion in
loans he still has to pay off now and yeah we know he never bad on [White roulette ball landed in 17 black]
everything's everything black but this guy did and well you know the dance [Owner of the casino victory dancing in front of the mogul]