Net worth is a basic measure of the value of a business. It can be defined as the difference between a company's assets and liabilities, as they are recorded on the balance sheet. Net worth is one of many terms used to describe the value of the equity held by owners of a business. The preferred term generally depends on the form of the business in question. Owner's equity is usually applied to the net worth of a sole proprietorship, partners' equity to that of a partnership, and shareholders' equity to that of a corporation. In contrast to these more specific terms, net worth can be used to describe the value of any business, as well as the financial position of an individual.
It is important to note that net worth measures only the book, or accounting, value of a business. This amount is not usually the same as the market value of a business, which is the amount an informed buyer would pay to acquire the business in an arm's-length transaction. Improving net worth is a matter of increasing assets or decreasing liabilities. If a business has liabilities in excess of its assets, it is said to have a negative net worth. This condition is considered detrimental for a business, and often prevents it from acquiring new funds through bank loans.
Elements of the Balance Sheet
Determination of a company's net worth comes from its balance sheet. The balance sheet outlines the financial and physical resources that a company has available for business activities at a particular point in time. It is important to note, however, that the balance sheet only lists these resources, and makes no judgment about how well they will be used by management. For this reason, the balance sheet is more useful in analyzing a company's current financial position than its expected performance.
The main elements of the balance sheet are assets, liabilities, and owners' equity. Assets generally include both current assets (cash or equivalents that will be converted to cash within one year, such as accounts receivable, inventory, and prepaid expenses) and noncurrent assets (assets that are held for more than one year and are used in running the business, including fixed assets like property, plant, and equipment; long-term investments; and intangible assets like patents, copyrights, and goodwill). The balance sheet also includes two categories of liabilities, current liabilities (debts that will come due within one year, such as accounts payable, short-term loans, and taxes) and long-term debts (debts that are due more than one year from the date of the statement).
The difference between assets and liabilities as reported on the balance sheet is recorded in owners' equity accounts. These accounts detail the permanent capital of the business, also known as its net worth. The total equity usually consists of two parts:1) contributed capital, or the money that has been invested by shareholders; and 2) retained earnings, or the money that has been accumulated from profits and reinvested in the business. In general, the higher the net worth of a business, the better the ability of the business to borrow additional funds.
Further Reading:
Anthony, Robert N., and Leslie K. Pearlman. Essentials of Accounting. Prentice Hall, 1999.
Bangs, David H., Jr. Managing by the Numbers: Financial Essentials for the Growing Business. Upstart Publishing, 1992.
Bragg, Steven M. Accounting Best Practices. Wiley, 1999.
Welsch, Glenn A., Robert N. Anthony, and Daniel G. Short. Fundamentals of Financial Accounting. 4th ed. Irwin, 1984.
