In the business universe, a debt-to-worth ratio is commonly called the “acid test” because of its importance to the display of the health (or illness) of a company. The ratio of total debt to total equity (worth, ownership) is a valid snapshot of a company's (or person's) ability to exist successfully. However, simply making a calculation without understanding what the resulting number means is useless. Here is how to meaningfully interpret a debt-to-worth ratio.
Interpret Debt-to-Worth Ratio
Gather the information needed to compute a debt-to-worth ratio. This data is the critical basis for ratio computation. The formula is simple. Simply divide total debt by total tangible net worth. This number carries the same meaning whether analyzing a company or an individual financial situation. For example, a company or person with $200,000 in debt and $50,000 in tangible net worth has a debt-to-worth ratio of 4.
Include only “tangible” items in the net worth figure. This is important because most companies and people also have accumulated “intangible” net worth items that they believe have value but are inappropriate for this calculation and interpretation. For example, a company that has a successful operational history usually has a “goodwill” factor, which estimates the value of their “brand” or image in their industry. Unfortunately, unless estimated by a financial professional preceding a sale of the company, goodwill is an intangible and cannot be turned into cash if necessary.
Analyze the resulting number after the debt-to-worth calculation. The higher the number, the less stable and strong the company or person. For example, a business or person with a debt-to-worth ratio of 1 is much stronger than those with a ratio of 6. A debt-to-worth ratio of 1 indicates that the company or person has sufficient tangible net worth to pay off debt immediately if necessary. Conversely, one with a debt-to-worth ratio of 6 has many more debts than could be eliminated by liquidating their current net worth and assets.
Estimate projected borrowing needs in the near-term and compare the debt-to-worth ratio to comparable companies or individuals. Typically, entities with low debt-to-worth ratios enjoy current and future borrowing ability because their financial standing is in a strong position. However, interpretations of a higher number can greatly restrict one’s ability to borrow. As a debt-to-worth ratio moves higher than 1, the company or person becomes a much larger risk for lenders. There is simply insufficient tangible net worth to project repayment ability should cash flow be interrupted.
Listen to experienced analysts who examine potential investments based on their interpretation of debt-to-worth ratios. When considering corporate investments, avoid the natural tendency to simply interpret a higher than normal debt-to-worth ratio as an automatic negative. While this number is important, as witnessed by its characterization as the “acid test,” there may be good reasons for this unwelcome ratio. For example, companies sometimes generate large short-term borrowing for solid reasons. Experienced analysts can correctly interpret this ratio to help you with investment decisions.