What it means
Net worth is what is left after subtracting everything owed from everything owned. For a company that is total assets less total liabilities, which equals shareholders' equity; for a household it is savings, property and investments less mortgages and other debts.
The ratio divides income by that figure to see how productive the capital base is. The business reading is essentially a return measure.
If a company earns $180,000 on a net worth of $1,200,000, the owners are getting 15% on the capital tied up in the business, which they can compare against what the same money might earn elsewhere. A low percentage over several years suggests capital is trapped in assets that are not pulling their weight.
The personal finance reading is different but equally useful. Advisers use the ratio to see how far someone has moved from depending on a salary towards depending on assets, and a rising figure over time usually means investments are starting to carry more of the load.
Some advisers invert the calculation and look at net worth as a multiple of annual income instead, which is the same information viewed from the other end. The main nuance is deciding which income figure to use.
Net profit after tax, operating profit and total income before tax all give different answers, so the definition has to be stated and then kept consistent from year to year. Comparisons between two businesses are only fair when both are calculated the same way.
A second nuance is that net worth is a snapshot at one date while income accrues over a whole year. Where net worth has changed substantially during the period, for instance after a large capital injection, an average of the opening and closing figures gives a fairer denominator.
Without that adjustment a mid-year fundraising can make the ratio look artificially weak.
In practice
Real-world examples.
Example
A family-owned haulage business calculates the ratio at 4% and realises that the depot land it owns outright is worth far more than the profit it supports. The owners consider a sale and leaseback to release capital.
Example
A financial planner shows a client that his income to net worth ratio has fallen from 38% to 19% over eight years, because investments have grown while salary has stayed flat. The client is closer to financial independence than he assumed.
Example
A dental practice partnership compares its 22% ratio against a benchmark of similar practices at around 15%. The partners use the gap to support a higher asking price when one of them retires.
Think of it
“Income to net worth shows what return shareholders earn on their equity investment-basically ROE.
Formula
Calculation
The formula is: Income to net worth ratio = Annual income / Net worth x 100, where Net worth = Total assets - Total liabilities.
Consider an owner-managed engineering firm. It holds total assets of $2,000,000, comprising a workshop, machinery, stock and cash, and owes $800,000 in a mortgage and trade payables. Net worth is $2,000,000 - $800,000 = $1,200,000.
The firm reports net profit after tax of $180,000 for the year. The ratio is $180,000 / $1,200,000 = 0.15, or 15%. If the owners could earn 6% on a comparable low-effort investment, the business is producing a meaningful premium for the risk and work involved.
Suppose the owners then inject $400,000 of fresh capital halfway through the following year, ending with net worth of $1,600,000 and profit of $200,000. Using the closing figure gives $200,000 / $1,600,000 = 12.5%, while using the average of $1,200,000 and $1,600,000, which is $1,400,000, gives $200,000 / $1,400,000 = 14.3%. The averaged version is the fairer comparison with the prior year.Case study
Seen in the real world.
Pemberton Joinery is an invented business used for this illustrative example only. Its two owners had built net worth of $2,500,000 over twenty years, most of it in a large freehold workshop and a substantial holding of seasoned timber.
Annual profit after tax had settled at around $150,000, giving an income to net worth ratio of $150,000 / $2,500,000, which is 6%. The owners had never framed the number that way and were surprised, since they had always thought of the business as successful rather than capital-heavy.
Working through the illustrative figures, they sold a rarely used second yard for $600,000, cleared $200,000 of debt and returned the rest to themselves. Profit fell only slightly to $142,000 while net worth in the business dropped to $1,950,000, lifting the ratio to about 7.3%, and the released cash went into investments that produced income in their own right.
Watch out
Common mistakes.
- Using total revenue instead of profit as the income figure, which produces a large number that says nothing about return on capital.
- Forgetting to subtract liabilities, so the calculation measures income against gross assets and flatters nothing but the ego.
- Comparing the ratio across very different industries, where a service firm with few assets will always look stronger than an asset-heavy manufacturer.
Questions
People also ask.
Is this the same as return on equity?
For a company the two are closely related, since net worth and shareholders' equity are the same figure, though return on equity is normally calculated strictly on profit after tax.
What is a good ratio for a small business?
There is no universal figure, but owners usually want a clear premium over what the same capital would earn in a passive investment, given the risk and effort involved.
How should personal net worth treat the family home?
Many advisers exclude it, because it produces no income and cannot easily be spent, and including it drags the ratio down without changing anything useful.
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