Effective Net Worth: What It Means, How It Works

What Is Effective Net Worth?

Effective net worth is shareholders' equity, the amount that would be returned to stockholders if all of a company's assets were liquidated and all its debts repaid, plus subordinated debt, unsecured loans or bonds that rank lowest with respect to claims on assets or earnings. Adding subordinated debt, in effect, increases a company's net worth and is used by senior creditors to determine a company's ability to pay them back, should they loan it money.

How Effective Net Worth Works

Net worth, perhaps the most common metric to gauge a company's or individual’s financial health, is calculated by subtracting all liabilities, or outstanding balances owed, from assets, or resources owned with economic value. Effective net worth then goes one step further by adding some of these debts back in.

Debt can generally be broken down into two types. There is senior debt, borrowed money that a company must repay first if it goes out of business, and subordinated debt, loans that, in the case of a default, will only get repaid once every other debt has been cleared.

When calculating effective net worth, less urgent debt obligations, such as loans made to the company by an owner or debentures, a type of debt instrument unsecured by collateral, get added to the net worth figure, rather than subtracted.

Effective Net Worth and Subordinate Debt

Subordinate debt, also known as subordinated debt or junior debt, is a type of debt that ranks lower in priority or repayment priority compared to other forms of debt. This is especially important in the event of liquidation or default.

As defined earlier, subordinate debt has a lower priority of claim on a company's assets or cash flows than senior debt. In a company's capital structure, subordinate debt falls below senior debt in terms of repayment priority. This means that in the event of bankruptcy or liquidation, senior debt holders have a higher claim on the company's assets and are paid first before subordinate debt holders.

This tier system of debt increases the risk associated with subordinate debt and typically offers higher interest rates to compensate for this increased risk. For instance, an investor may understand they have less of a chance to recover funds should the company go bankrupt; in exchange for taking on that risk, they expect higher earning potential.

More specific examples of subordinate debt instruments include subordinated loans, subordinated bonds, mezzanine debt, convertible debt, and preferred stock. It is important to note that subordinate debt may have covenants or terms that provide protection for lenders such as limitations on additional debt issuance or restrictions on dividend payments.

Benefits of Effective Net Worth

Why bother adding subordinated debt to the equation? Effective net worth is particularly useful when analyzing closely held corporations, companies that have only a limited number of shareholders.

Executive officers of these companies often have a significant ownership stake and lend the company their own money. Usually, these loans will fall under the category of subordinated debt, meaning that the owners agreed that any bank loans will take priority and be repaid first should the company run into trouble. Including these loans when analyzing net worth is a more conservative approach that more accurately reflects the financial position of the company.

For senior creditors, loans to the company by its owners are considered, in effect, as an addition to the company's net worth because as subordinated debt held by the owners, it does not appear much different from equity. From the perspective of a senior creditor, both subordinated debt and shareholders' equity rank lower in priority in making a claim on assets in the event of default. This results in the added benefit that analysts can't discriminate against certain types of debt.

In addition, for company owners who have also made loans to the company, the risk of loss is also similar on both the loans and the equity. Adding in subordinate debt is simply a conservative move that strives to not overstate the company's health.

Example of Effective Net Worth

Company ABC has total assets of $10 million and total liabilities of $6 million. Subtract $6 million from $10 million and you end up with a net worth of $4 million. Now, let’s assume that the company’s total liabilities include subordinated loans such as debentures and loans from owners of $1 million. Effective net worth in this case would be: $4 million + $1 million = $5 million.

The Bottom Line

Effective net worth is a key measure of financial health for individuals and companies. It is calculated by subtracting liabilities from assets. Effective net worth considers additional debts, like owner loans or debentures, and adds them to the net worth figure instead of subtracting. Debt can be categorized as senior or subordinated with subordinated debt being repaid after other debts in case of default.