The net worth ratio states the return that shareholders could receive on their investment in a company, if all of the profit earned were to be passed through directly to them. Thus, the ratio is developed from the perspective of the shareholder, not the company, and is used to analyze investor returns. The ratio is useful as a measure of how well a company is utilizing the shareholder investment to create returns for them, and can be used for comparison purposes with competitors in the same industry.
To calculate the return on net worth, first compile the net profit generated by the company. The profit figure used should have all financing costs and taxes deducted from it, so that it accurately reflects the profit available to shareholders. This is the numerator in the formula. Next, add together the capital contributions made by shareholders, as well as all retained earnings; this is the denominator in the formula. The final formula is:
Net after-tax profits ÷ (Shareholder capital + Retained earnings) = Net worth ratio
For example, ABC Company has generated $2,000,000 of after-tax profits in its most recent fiscal year. It now has $4,000,000 of shareholder capital, as well as $6,000,000 of retained earnings. Its net worth ratio is:
$2,000,000 Net after-tax profits ÷ ($4,000,000 Shareholder capital + $6,000,000 Retained earnings)
= 20% Net worth ratio
An excessively high net worth ratio may indicate that a company is funding its operations with a disproportionate amount of debt and trade payables. If so, a decline in its business could result in the inability to pay back the debt, which increases the risk of bankruptcy; this means that the shareholders may lose their investment in the company. Thus, an investor relying upon this measurement should also examine company debt levels to see how excessive returns are being generated.
The net worth ratio is also known as the return on shareholders' investment.