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.