Debt to Tangible Net Worth

How is it calculated?

Debt to Tangible Net Worth = Total Liabilities / (Equity - Intangible Assets)

Goal of the Ratio

The goal of this ratio is a see the amount of leverage present if intangible assets are removed.

When is it used?

This ratio is generally reserved for businesses that include a large amount of intangible assets on their balance sheet.  Intangible assets could have been created through business acquisition or even expensive licensing/certifications the business received.  In the case of a business acquisition, the amount of money they purchased the business for that exceeded the total tangible assets owned by the business will create an intangible asset on the balance sheet.  It creates an item on the balance sheet because it was something that was purchased, but it has no direct tangible asset to tie back to.  The reason a creditor may look at a Debt to Tangible Net Worth ratio is because the value of intangible assets can be volatile.  In the case of the intangible asset from a business purchase, the business likely had that additional “value” when things were going well, but a bank generally wants to look at the worst case scenario (liquidation).  If the borrower is going through liquidation, it likely means the business is not running well, and what value was present is now gone.  By looking at this ratio at the front end of the relationship, we can know what our downside risk is, and we can factor that into our initial decision.

Rules of Thumb

Lower is better.  As total liabilities increase relative to equity, the amount of risk in a business increases as well, and that shows up through a higher leverage ratio.  The higher the ratio the higher the risk, the lower the ratio the lower the risk.

Please note all ratios should be viewed in relation to industry norms to determine overall adequacy.

What changes in the ratio could mean:

Some example reasons why the Leverage Ratio can change:

1. Profitable (or unprofitable) operations
2. New expansion or purchase financed largely with debt
3. Repayment of long term debt
4. Building of working capital
5. Capital Contributions or Distributions 

Other Relevant Terms

• Capital
• Balance Sheet
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