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 calculationAs 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.
TNW calculation methodTotal assets: intangible assets; total of debts to third parties
Credit analysis and Tangible Net WorthWhat 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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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.