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.
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.