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New Look at Equity

I have been giving some thought to the use and abuse of customer financial ratios in which Equity is the denominator. One such ratio is the Debt to Equity Ratio calculated using this simple formula: Total Liabilities divided by Equity.

I think that credit professionals need to keep in mind that Equity is a residual number meaning that Equity is nothing more than Assets minus Liabilities… but Assets include Intangible Assets. The best known example of an Intangible Asset is Goodwill. The value of all Intangible Assets in a business failure is uncertain. I think that the most appropriate measurement of equity involves the use of Tangible Net Worth. Tangible Net Worth (TNW) where TNW = Equity minus Intangible Assets.

Tangible Net Worth is obviously a far more conservative calculation of Equity than using the Equity figure presented on the customer’s Balance Sheet. In my opinion, TNW is a more reliable measure of credit risk. I prefer TNW because it is a more conservative calculation of Equity rather than the more commonly used Asset – Liabilities = Equity.

Michael Dennis, MBA, CBF, LCM

That’s my opinion. What’s yours?

Michael Dennis’ Covering Credit Commentary. Michael’s website is  www.coveringcredit.com

The opinions presented are those of the author.  The opinions and recommendations do not necessarily reflect the views of CMA, or their Officers and Directors.  Readers are encouraged to evaluate any suggestions or recommendations made, and accept and adopt only those concepts that make sense to them.

4 Responses to “A New Look at Equity – Michael Dennis, CBF”

  1. laurel matthews says:

    HI, I use the debt/equity ratio when scoring my customers. Unfortunately
    the financial info I usually get doesnt break out intangible assets. Is there another ratio that would mitigate the risk like the TNW does?

  2. Name (required) says:

    paul anderson The asset ratio is the inverse ratio of Total Liabilities/TNW. It’s Tangible Assets / Total Liabilities. Either one works and can be compared to industry or customer database averages. What is more important is how you weight the ratio, compared to other ratios that measure liquidity, profitability, and operating ratios. For a growing, profitable company that is not likely to liquidate, leverage ratios are almost meaningless compared to measuring cash flow and the ability to cover expenses.

  3. Margaret Spencer says:

    I read Laurel’s comments. It appears her customers are providing some form of consolidated Balance Sheet in which the specific accounts that make up the Current and Non Current Asset sections of the Balance Sheet are not presented in detail.

    In my opinion, receiving and using customer financial information that is shortened (truncated) or does not follow GAAP requirements is a recipe for trouble.

    Also, I would be concerned about any customer that either cannot break out the individual Asset accounts, or refuses to do so for me as a creditor, or knows so little about the accounting process that they do not know how to identify intangible assets. These are some pretty significant red flags.

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