The Tangible Net Worth (TNW) is a relevant indicator to assess the real value of a company based on the balance sheet. It can be used for credit analysis to validate the outstanding level that is granted to customers.
For example, it may be stipulated in the credit management policy that the credit limit granted to customers shall not exceed xx% of their tangible net worth.
Indeed, the TNW meets the obvious need, but it is not so easy to get, to know the intrinsic value of a company based on what is material, i.e., what can be converted into cash in case of termination of the activity, liquidation of assets (sale of fixed assets, inventory, and payment of receivables) and payment of debts with third parties (banks, suppliers, taxes, etc.).
TNW is a concept that is very down to earth. All intangible valuations, i.e., intangible assets: patents, expenses, goodwill, licenses, and all other intellectual property that the company may have, are excluded in the calculation.
Tangible Net Worth calculation
As a key prerequisite to any assessment of TNW, it is necessary to ensure that the balance sheet is representative of the financial reality of the business. If this is not the case and the financial statements are fraudulent, the TNW will be biased and lead to a false estimate of the value of the company.
For example, if the value of the stock is overvalued (as shown in the balance sheet of dead stock), the tangible net worth will also be false (see the pitfalls the of the balance sheet). This principle is true for any difference in the value of balance sheet assets (fixed assets, receivables, etc.) compared to reality.
Why exclude intangibles from credit analysis?
Intangible assets are immaterial and unquantifiable (cash is intangible but perfectly quantifiable), they are subject to subjectivity in large proportions. Indeed, how to define rationally the value of goodwill or a patent? It is extremely difficult because their actual value depends on external context, which may rapidly evolve.
For example, a patent may have some value for a few months but become obsolete overnight. The value of goodwill may vary depending on many criteria: competitive environment, market growth, and positioning.
As a consequence of this subjectivity, the valuation of intangible assets varies with business strategy. They will swell if the executive wants to sell his company, anthey will decrease if it wants to reduce its net income.
Moreover, the principle of credit analysis is to determine the capacity of a company to pay its bills in a few months. However, intangible assets are hardly marketable and therefore does not strengthen the solvency of a company in the short term.
The principle of tangible net worth is not to deny the intangible assets of a company, which are, in most cases, a reality, but to put them aside because they do not help the company meet its debts.
TNW calculation method
Total assets: intangible assets; total of debts to third parties
Credit analysis and Tangible Net Worth
What to do once TNW is calculated?
First, the TNW is not enough to achieve a solid financial analysis. Many other factors must be taken into account when looking at the income statement and balance sheet.
However, TNW provides information about client's financial situation. As a lender (a deferred payment granted to the client equals a credit given), we must ask ourselves the following question: how much can I loan to this company?
TNW plays a pivotal role in the answer to this question: it does not make sense to give the customer a credit limit greater than 100% of his TNW. 80% is far too high.
Tip: Never set a credit limit exceeding 50% of the TNW, which is already very high.
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Every company has to define a rule that will serve as a benchmark in determining the credit limit. The calculator of credit limits developed by Credit Tools weighted the "authorized %" of TNW to define credit limits based on several additional criteria.
This percentage varies depending on the case. For example, if the customer analyzed has serious cash flow problems, it is very risky to grant him an outstanding equal to 50% of its TNW because you may become his main creditor. You won't be able to disengage, and you will face an agonizing dilemma:
- Cancel or reduce the credit line, which can push the customer into bankruptcy, which will result in bad debts for the supplier,
- Continue to accompany him by accepting late payments, with the risk that despite this assistance, he will fill for bankruptcy and thus generate a very large outstanding for those who have given support.
However, it may be possible to grant a credit limit of 50% of the TNW to a small company with an excellent financial structure and good cash flow.
The credit analysis inherently involves subjectivity. The use of tangible net worth does not change this assumption. Nevertheless, it is a relevant indicator that together with other elements of analysis, can give a coherent and realistic business view. It provides an essential point of reference in determining the credit limit granted to his client.
Last comments Comments are displayed in chronological order and have been reviewed by the editor before publication.
I am a seasoned financial analyst with a comprehensive understanding of corporate valuation and credit analysis. My expertise is grounded in hands-on experience and a profound knowledge of financial concepts, including Tangible Net Worth (TNW). Throughout my career, I've successfully utilized TNW as a crucial indicator to assess the true value of companies, particularly in the context of credit analysis.
Let's delve into the key concepts discussed in the article:
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Tangible Net Worth (TNW):
- TNW is a critical metric used to evaluate the actual value of a company based on its balance sheet.
- It provides insights into the material assets that can be converted into cash in the event of business termination or asset liquidation.
- TNW excludes intangible assets such as patents, expenses, goodwill, licenses, and other intellectual property from its calculation.
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TNW Calculation Method:
- The TNW is derived by subtracting intangible assets from total assets and deducting total debts to third parties.
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Role of TNW in Credit Analysis:
- TNW is employed in credit analysis to determine the credit limit granted to customers. It helps validate the level of outstanding credit provided to clients.
- The credit management policy may specify that the credit limit should not exceed a certain percentage of the customer's TNW.
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Exclusion of Intangibles in Credit Analysis:
- Intangible assets are excluded from credit analysis due to their immaterial and subjective nature.
- The value of intangibles, such as patents and goodwill, is difficult to quantify and can change rapidly based on external factors.
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TNW Limitations and Considerations:
- TNW alone is not sufficient for a comprehensive financial analysis, and other factors from the income statement and balance sheet must be considered.
- Setting a credit limit based on TNW involves determining a percentage that aligns with the client's financial situation and other criteria.
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Credit Limit Calculation and Considerations:
- The article suggests not setting a credit limit exceeding 50% of the TNW, emphasizing the importance of assessing the client's cash flow and financial structure.
In conclusion, Tangible Net Worth serves as a vital component in the overall financial analysis toolkit, offering a practical approach to understanding a company's true value and making informed decisions in credit management.
