Net Worth Ratio – How to Know if Your Business is Sustainable!

Did You Know that Net Worth Ratio was the Biggest Fear during covid-19 for businesses?

In other words, businesses had to find out whether they were sustainable.

Or, would they survive the covid-19 pandemic?

Let me ask you a question.

Would You Know how to quickly find out if your business is sustainable?

If not, is it not something you should be concerned about.

Well, relax, I have done the homework for you.

So that you need not worry your head off about sustainability.

I will lay out a strong case on how to discover if your business is sustainable in the long run.

However, let us take a step back to understand concepts related to this mysterious net worth ratio.

Begin with Assets

What are assets?

Assets are What the Business Owns.

They are the resources of the hotel.

The primary function of an asset is to generate revenue.

Without assets, a business cannot generate revenue.

Assets are an index of strength of a business.

This is because assets are used to generate revenue.

So, you could say that the capacity of a business to generate revenue will be based on the:

• type and
• extent of

assets owned by it.

What are Long Term Assets?

Assets can be short term or long term.

Long term assets are those whose life is more than a period of 12 months.

These are also commonly known as Fixed Assets.

Why should we talk about fixed assets?

I am getting to that.

Before that, take a look at the Long Term Assets of Paradise Hotel below.

Long Term Assets Examples

See the Paradise Hotel Balance Sheet below:

Long Term Assets are only one part of the Net Worth Ratio.

We will visit the other part shortly.

However, before that, take a look at the infographic below.

Now let us learn what a Net Worth Ratio is and some related concepts.

This Blog Post will cover

What is a Solvency Ratio?

Take another look at the infographic above on Solvency Ratios.

Solvency Ratios are indicators of the long term health of a business.

They give you hints at the sustainability of a business.

You saw in earlier posts in this series about liquidity ratios.

Liquidity Ratios are indicators of the short term health of a business.

In the same way, Solvency Ratios play the role for the long term.

That most times will mean relating to assets, liabilities and owner equity.

One of the most powerful solvency ratios for a business is the Net Worth Ratio.

Let’s see what it is about.

Net Worth Ratio

We learned about long term assets earlier.

However, what is Net Worth Ratio?

Let me use a metaphor for this.

Assume you are driving an automobile.

Suddenly, the car stops running.

You check and find out your fuel tank is full.

However, the car will not start.

You take it to a nearby garage.

They tell you that the car’s engine has packed up.

It will take some time to fix it and it will cost a lot.

Your engine is the central part of your automobile.

Without it functioning well, your car cannot run.

Net Worth Ratio is similar to that.

It is the long term capability to meet your obligations.

That capability comes from fixed as well as current assets.

Your Obligations are commonly known as Liabilities.

Liabilities can be long and short term.

Take a look at the Long Term Liabilities of Paradise Hotel.

Now you realize why we needed to know fixed assets and long term liabilities before net worth ratio.

Net Worth compares long term capability with long term obligations.

Or in other words, fixed assets with long term liabilities.

It also considers current assets and current liabilities

We will understand specific types of long term liabilities shown above later in this post.

We will also see why as a hotel manager you must know what this Net Worth ratio is about.

Net Worth measures the extent of total assets to total liabilities.

Refer to the image below showing:

• What the Business Owns [Assets] and
• What the Business Owes [Liabilities

In other words, the ratio (not exactly a ratio though) of:

• Property and Equipment, Cash, Accounts Receivables, Inventories and
• Mortgage Payable, Accounts Payable, Notes Payable etc.

See Paradise Hotel Balance Sheet below for this depiction.

Higher the Net Worth Ratio, the better will be its capability to meet obligations.

In other words, higher the ratio, the better the solvency.

Hotel Owners prefer a higher ratio since this means better chances of sustainability.

It of course means balancing capability (assets) with obligations (liabilities).

Hotel Management needs to balance:

• healthy total assets situation with
• moderate total liabilities.

Net Worth Ratio Formula

Net Worth is simply the difference between Total Assets and Total Liabilities.

The formula is:

Total Assets LESS Total Liabilities

Total Assets include Fixed and Current Assets.

Total Liabilities include Long Term and Current Liabilities

Take a look at the Total Assets and Total Liabilities of Paradise Hotel below:

We have already seen what long term assets are.

Let us explain what long term liabilities shown are.

• Mortgage Payable - these are long term loan or borrowings from lenders known as debt
• Deferred Income Taxes - these are liabilities for any long term tax amount due.

In a way you could say you are measuring the extent of solvency Vs obligations.

Let us now see the example using the Paradise Hotel shown above.

Net Worth Ratio Example

The Total Assets and Total Liabilities for Paradise Hotel as of 12.31.2018 & 12.31.2019 are:

• Total Assets: 2018 - $1,065,000 2019 - $1,176,300
• Total Liabilities: 2018 - $645,000 2019 - $659,000

The Net Worth Ratio for Paradise Hotel as of 12.31.2018 is:

Total Assets LESS Total Liabilities OR

$1,065,000 Less $645,000 = $420,000

Net Worth Ratio of $420,000 amounts to 1.65 which is a healthy ratio.

How did we get 1.65?

By dividing Total Assets by Total Liabilities.

And for 12.31.2019 is:

$1,176,300 Less $659,000 = $517,300

Notice how Net Worth Ratio improves from $420,000 in 12.31.2018 to $517,300 in 12.31.2019.

Notice that this improvement is contributed by higher total assets.

The Net Worth is thus a barometer of the balance between total assets and liabilities.

These are assets whose solvency (+ liquidity) and levels have to be managed.

The indication is that 12.31.2018 shows net worth ratio to be healthy.

Let us now see how it is useful to calculate net worth ratio.

More importantly, how you can avoid some alarming situations shown below.

Want to know more how Net Worth is Built up?

Click the Ribbon at the Top of this page for Free 7 Step Visual Guide on how Profit Builds Assets & Owner Equity.

How is Net Worth Ratio useful?

For Paradise Hotel, you found the that Net Worth Ratio on 12.31.2018 is 1.65.

This is a healthy ratio.

What does “healthy” mean?

Healthy means that say, Paradise Hotel disposed off all their total assets to pay total liabilities.

They will then still be left with $420,000.

The Ratio of 1.65 tells you that Paradise Hotel has a cushion of 65% between total assets and liabilities.

This is what “healthy” means.

It means that there is a good cushion against unforeseen obligations.

If such an obligation were to arise, Paradise Hotel will be able to pay it easily.

If you remember, we said that higher the ratio the better the solvency.

Net Worth is one of the best indicators of solvency.

Solvency is one of the key measures of long term sustainability.

In other words, the ability to pay long term liabilities with fixed assets.

Is the hotel able to cover its long term liabilities with its long term assets?

Or, how solvent are the hotel’s fixed assets?

So, they are able to provide the cash necessary to pay liabilities.

This is the reason the Net Worth Ratio is critical.

Reasons Your Hotel Net Worth May Become Alarming

What are some reasons you could avoid being in a situation of low Net Worth?

First, manage your accounts receivables well.

Accounts Receivables being uncollected sales is critical for liquidity.

While they boost liquidity, it also helps in solvency.

Second, manage your debt or borrowings, which are simply long term liabilities.

For Paradise Hotel, as of both 12.31.2018 and 12.31.2019, the hotel managed its long term liabilities well.

This is not causing any pressure on the net worth which is healthy.

Third, do not have too much of money locked up in inventories.

In the case of Paradise Hotel, Inventories in both years are quite good.

Further you must ensure that you do not fall prey to some traps stated below.

Traps You Must Avoid with the Net Worth Ratio

As we have said earlier, financial ratios are mere indicators.

It is critical that we understand how they are calculated.

Total Assets and Total Liabilities play a part in this ratio.

So, both liquidity (current assets) and solvency (fixed assets) must be taken into account.

Similarly, movement in liabilities must also be considered.

These movements have to be monitored each month and year.

You must therefore monitor the current/fixed assets and current/long term liabilities closely.

This is to ensure they do not spiral out of control.

Big Picture of the Hotel Net Worth Ratio

At the end of the day, you must step back and take a big picture overview of solvency.

Meaning, look at the solvency picture in entirety.

And not just look at current or fixed assets and current or long term liabilities individually.

The big picture will be how solvent the business is.

This means a healthy Net Worth Ratio.

That will allow you to run your hotel operation without any sustainability doubts.

Chapters in this Ultimate Guide on Hotel Financial Ratios

This Ultimate Guide is a twelve part series which will cover the following key areas:

• CHAPTER 1 of 12 - Hotel Financial Ratios - Why should you care? [Already Published]
• CHAPTER 2 of 12 -Liquidity Ratios Intro - Acid Test Ratio [Already Published]
• CHAPTER 3 of 12 -Liquidity Ratios - Accounts Receivable Turnover Ratio [Already published]
• CHAPTER 4 of 12 -Liquidity Ratios - Working Capital [Already Published]
• CHAPTER 5 of 12 -Solvency Ratios - Net Worth Ratio [This Post]
• CHAPTER 6 of 12 -Solvency Ratios - Debt Equity Ratio
• CHAPTER 7 of 12 -Activity Ratios - Inventory Turnover Ratio
• CHAPTER 8 of 12 - Profitability Ratios Intro - Gross Operating Profit
• CHAPTER 9 of 12 - Profitability Ratios - Return on Investment Ratio
• CHAPTER 10 of 12 - Profitability Ratios - Return on Equity Ratio
• CHAPTER 11 of 12 - Asset Management Ratios Intro - Asset Turnover Ratio, RevPAR
• CHAPTER 12 of 12 - How to Identify Warning Signs in Hotel Financial Ratios

Next Week

We will dive into the fifth of hotel financial ratios - Debt Equity Ratio

We will see:

• What debt is and what equity is.
• What is a Debt Equity Ratio?
• Why is Debt Equity Ratio considered so critical?
• How do you read and use debt equity ratio?

and more…

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