What is the Net Worth Ratio?

The net worth ratio states the return that shareholders could receive on their investment in a company, if all of the profit earned were to be passed through directly to them. Thus, the ratio is developed from the perspective of the shareholder, not the company, and is used to analyze investor returns. The ratio is useful as a measure of how well a company is utilizing the shareholder investment to create returns for them, and can be used for comparison purposes with competitors in the same industry.

How to Calculate the Net Worth Ratio

To calculate the return on net worth, first compile the net profit generated by the company. The profit figure used should have all financing costs and taxes deducted from it, so that it accurately reflects the profit available to shareholders. Thus, it should not be based on just the profits generated from a company’s core operations. This is the numerator in the formula. Next, add together the capital contributions made by shareholders, as well as all retained earnings; this is the denominator in the formula. The final formula is:

Net after-tax profits ÷ (Shareholder capital + Retained earnings) = Net worth ratio

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Understanding the Net Worth Ratio

An excessively high net worth ratio may indicate that a company is funding its operations with a disproportionate amount of debt and trade payables. If so, a decline in its business could result in the inability to pay back the debt, which increases the risk of bankruptcy; this means that the shareholders may lose their investment in the company. Thus, an investor relying upon this measurement should also examine company debt levels to see how excessive returns are being generated.

Example of the Net Worth Ratio

ABC Company has generated $2,000,000 of after-tax profits in its most recent fiscal year. It now has $4,000,000 of shareholder capital, as well as $6,000,000 of retained earnings. Its net worth ratio is:

$2,000,000 Net after-tax profits ÷ ($4,000,000 Shareholder capital + $6,000,000 Retained earnings)

= 20% Net worth ratio

Disadvantages of the Net Worth Ratio

There are a number of problems with the net worth ratio, which are as follows:

Subject to accounting manipulation. The accounting staff of the reporting entity could alter its accounting policies or make other adjustments that allow it to alter the amount of reported income. This can result in changes to the net worth ratio that do not reflect the actual operating performance of the reporting entity.
Subject to tax rate. The calculation uses after-tax income in the numerator, which means that the tax rate to which the reporting entity is subjected has a profound impact on the outcome of the ratio. Since the tax rate can change substantially from one reporting period to the next, this means that the ratio can provide results that are heavily impacted by the relevant taxing authorities, rather than the outcome of its own internal operations.
Limited view of financial stability. This ratio only represents a snapshot of the value generated for investors by a business as of a specific point in time. It does not report on the broad financial health of the entity, which requires a mix of several reporting measures.