Net worth ratio is the ratio that shows the net worth of the investment of an investor made within the company. This ratio depicts the return that the shareholder is going to receive on their investment assuming that all the profit earned by the company is passed directly to the investor. This ratio is calculated from the investor point of view and business doesn’t have a direct interest with this ratio. This ratio is an ideal figure to measure how efficiently a business is using its shareholders equity and how smartly it is creating returns for its shareholders.
In order to calculate the net worth ratio we need to compile the net profit earned by the company in that accounting period. All the costs and the taxes are deducted from the profit figure before using it for calculating net worth ratio. The profit figure is then divided with the shareholder equity or investment in the company adding the retained earnings of the company. The formula of net worth ratio can be shown as under:-
Net worth Ratio = Net Profit after paying taxes/ Shareholder equity + Retained Earnings
The high value of net worth ratio shows that the company is funding its operations with a large amount of debt and if losses occur the company won’t be able to pay the debt and trade payables to the investors that brought the funding. The inability of the business in paying the debt may lead to bankruptcy that indicates the loss of shareholder investment in the company.
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