Net worth definition
/What is Net Worth?
Net worth is the difference between the assets and liabilities of a person or business. It is an essential measurement of the financial circumstances of the party in question. A business with a high net worth will find it easier to obtain loans from lenders, since they perceive the entity to be a safe credit risk. A person with a high net worth can place money in investment vehicles that require a large initial investment, but which present the opportunity to earn an above-average return over the long run.
The concept is defined somewhat differently, depending upon whether the term applies to a business or an individual. The definitions are noted below.
Net Worth for a Business
The net worth for a business is the total amount of all assets minus all liabilities, as stated in the balance sheet. The information in the balance sheet may be stated at the original price of the asset or liability, which may differ from the amount at which it could potentially be disposed of. The asset and liability components of net worth typically include:
Assets: Cash
Assets: Marketable securities
Assets: Accounts receivable
Assets: Inventory
Assets: Prepaid expenses
Assets: Fixed assets
Liabilities: Accounts payable
Liabilities: Accrued liabilities
Liabilities: Debt
Net worth can be used to derive the value of a business, though other factors may be included in the derivation of the sale price of a company, such as the value of its brands and intellectual property. It is not a good measure of the liquidity of a business, since the assets that comprise the measure may be difficult to liquidate, such as inventory and fixed assets.
How to Increase the Net Worth of a Business
There are several ways to increase the net worth of a business, which include the following:
Generate consistently positive cash flow. The classic way to improve the net worth of a business is to increase its sales and lower its costs, so that it consistently generates positive cash flow.
Avoid distributions. A business can increase its net worth by avoiding distributions to shareholders (such as dividends), since that reduces the cash balance, which is part of the assets in the net worth equation.
Experience increased asset values. A company may increase its net worth if the assets it owns increase in value. For example, if a business owns a corporate headquarters building in a high-demand area, it may find that the value of the building has increased, which increases the firm’s net worth.
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Net Worth for an Individual
The net worth for an individual is total assets minus total liabilities. The information may be compiled from a number of sources, and typically includes the following:
Assets: Cash in the bank
Assets: Personal investments
Assets: Resale value of house
Assets: Resale value of automobiles
Assets: Resale value of furnishings and jewelry
Liabilities: Credit card debt
Liabilities: Mortgage debt
Example of Net Worth
A business has $50,000 of cash, $200,000 of accounts receivable, and $400,000 of inventory, which gives it total assets of $650,000. The business also has $80,000 of accounts payable and a $350,000 loan, which gives it total liabilities of $430,000. Thus, its net worth is the difference between the assets and liabilities, which is $220,000.
What is Negative Net Worth?
It is also possible to have a negative net worth, which arises whenever liabilities exceed assets for either a business or an individual. In this situation, it may be necessary to enter bankruptcy proceedings, which wipes out or at least reduces certain types of debt.