What it means
Net worth is total assets minus total liabilities, which is the same figure as the owners' equity on the balance sheet. Setting all liabilities against it gives the broadest possible view of how much of the business is funded by other people.
Credit insurers and trade credit teams tend to prefer this version precisely because it counts them in. The distinction from a debt-based ratio matters more than it sounds.
A company can have almost no bank borrowing and still be heavily obligated, because it has stretched payment terms with suppliers, deferred tax bills and taken large customer deposits. A debt to net worth ratio would show that company as conservatively financed, while this ratio would not.
In practice it is used to set credit limits. A supplier deciding whether to ship $200,000 of goods on 60 day terms wants to know how many claims already rank alongside its own, and a ratio of 4.0 or 5.0 says the queue is long.
Many trade credit policies set a threshold above which orders must be paid for in advance. The ratio also flags a specific fragility: obligations that fall due soon against an owner stake that cannot be topped up quickly.
A business can be profitable and still fail if its short-dated obligations exceed what it can realise, which is why the ratio is normally read alongside the current ratio and a cash flow forecast. As with other net worth measures, lenders and insurers often adjust the denominator.
Goodwill and other intangibles are commonly stripped out to give tangible net worth, and amounts owed to directors may be moved from liabilities into net worth if they are formally subordinated. Ask which version you are being shown before comparing anything.
In practice
Real-world examples.
Example
A specialist tool distributor with total liabilities of $1,200,000 and net worth of $2,400,000 posts a ratio of 0.5. A new supplier reviewing the accounts grants a $250,000 credit limit without requiring a personal guarantee.
Example
A construction subcontractor shows $9,000,000 of liabilities against $3,000,000 of net worth, a ratio of 3.0, with much of the total representing retentions and amounts owed to its own subcontractors. Its credit insurer halves the cover available to suppliers, which quickly tightens the terms it is offered.
Example
A food importer running at 2.5, with $6,250,000 of liabilities and $2,500,000 of net worth, wants to double its order book. Its bank agrees to a larger facility only on condition that the owners leave profits in the business until the ratio falls below 2.0.
Think of it
“Liabilities to net worth shows total obligations relative to what shareholders own.
Formula
Calculation
Total Liabilities to Net Worth Ratio = Total Liabilities / Net Worth, where Net Worth = Total Assets - Total Liabilities
Worked example. Dunmore Fasteners has total assets of $9,100,000 and total liabilities of $5,600,000, made up of $3,000,000 of bank debt, $2,100,000 owed to suppliers and $500,000 of accrued tax and wages.
Net worth = $9,100,000 - $5,600,000 = $3,500,000
Total liabilities to net worth = $5,600,000 / $3,500,000 = 1.6
Outside claims are 1.6 times the owners' stake. A ratio based only on bank debt would read $3,000,000 / $3,500,000 = 0.86, which makes the same company look far more conservatively financed than it is.Case study
Seen in the real world.
Aldergrove Textiles is a fictional fabric wholesaler presented here as an illustrative example. It had almost no bank debt, which its directors regarded as prudence, but it had extended supplier terms to 90 days and deferred a tax instalment, leaving total liabilities of $4,800,000 against net worth of $1,600,000, a total liabilities to net worth ratio of 3.0.
The directors were surprised when their largest supplier cut its credit limit. The supplier's credit insurer had looked past the absence of borrowing and seen that outside claims were three times the owners' stake, with most of those claims falling due within three months.
The owners injected $800,000 of personal funds, lifting net worth to $2,400,000 and bringing the ratio to $4,800,000 / $2,400,000, or 2.0. Credit limits were restored, and the illustrative lesson is that owing money to suppliers is still owing money.
Watch out
Common mistakes.
- Assuming a company with no bank borrowing is lightly obligated, when supplier terms, tax deferrals and customer deposits can add up to far more than a loan would.
- Using net worth straight from the accounts when the counterparty calculates tangible net worth, which strips out goodwill and can turn a comfortable ratio into an alarming one.
- Comparing this ratio with a published debt to equity ratio as though they measure the same thing, since the numerators are quite different.
Questions
People also ask.
What is a safe level?
Many trade credit teams grow cautious above 2.0 and restrictive above 4.0, though sectors with heavy customer prepayments routinely run higher.
Is this the same as the debt to equity ratio?
Not quite, because the classic debt to equity ratio uses interest-bearing debt while this ratio uses every liability on the balance sheet.
What if net worth is negative?
The ratio becomes meaningless, and the relevant question shifts to whether the business is solvent and who is prepared to support it.
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