The net worth ratio is one of the simplest ways to gauge your financial progress. It will give you a snapshot of what your household’s net worth is relative to your income.
With this ratio, you can quickly determine if your finances are healthy or if they need work. This post will discuss the net worth ratio and how you can use it to measure your financial health.
What is Net Worth Ratio?
Net worth ratio is calculated by taking the net income for the period and subtracting any preferred stock dividends. This result is then divided by the number of common shares outstanding.
The net worth ratio can be used to determine the amount that a shareholder would receive if all net income were distributed to them, as dividends.
Net worth ratio, also known as return on net worth, is a measure of how much profit a company makes for every dollar of shareholder capital. The net worth ratio is primarily used by those who have invested in the company, and it is calculated by taking into account the total equity contributed by shareholders and retained earnings, both of which are components of a company’s balance sheet.
Thus, if a company has a 5% net worth ratio, it means that it generated a 5% return on the shareholders’ investment in that year.
How to Calculate Net Worth Ratio
In order to calculate the net worth ratio for a given fiscal year, you will need to obtain the financial statements for that year.
The return on net worth ratio is a percentage that indicates how much profit the company made per dollar invested by shareholders. Net worth is the term used to describe the value of a business after all debts have been paid off. It is also known as owner’s equity or stockholder’s equity.
The ratio shows you exactly what percentage of profit was made from shareholder funds, and will tell you whether or not you are making the best use of your resources.
Net worth ratio = Net after-tax profits ÷ (Shareholder capital + Retained earnings)
Net Worth Ratio 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
Importance of Net Worth Ratio
The net worth ratio is another important financial metric. It is a measure of your personal financial success, and the higher the better. If you have a high net worth ratio, you are in great shape financially, but if it is low, then you need to take some serious action.
The net worth ratio measures how much you have paid for your home and car versus how much money you have invested in your retirement account. A high ratio indicates that you are making good progress toward achieving financial independence, but a low ratio indicates that you need to make some changes in order to reach that goal.
What is a good Net worth Ratio?
A good net worth ratio is subjective. For example, if you were to ask a financial planner what your ideal net worth should be, they would first ask about age and income. Most would then tell you that having a net worth of seven times your annual income is a great place to be.
This means that if you earn $60,000 per year, you should have a net worth of $420,000 (7 x $60,000). If you earn $100,000 per year, you should have a net worth of $700,000 (7 x $100,000). This is not a hard rule but it’s a good starting point for many households.
What Does Net Worth Ratio Tell You?
The higher the net worth ratio in an industry, the better returns are for shareholders. Companies with a high net worth ratio have more earnings available for distribution to shareholders through dividends and buybacks, as opposed to reinvesting them into operations.
In general, companies with a net worth ratio of 1% or higher are considered to be in good shape from a shareholder perspective.
How to increase your Net Worth Ratio?
The higher the net worth ratio then the better off you are financially. Typically you want a net worth ratio of at least 1.0 meaning that your assets equal or exceed your liabilities. The average net worth ratio for Americans is 0.6 which means that most Americans have more liabilities than assets so they are in debt.
If you currently have a low net worth ratio because you have too many liabilities then there are a few things you can do to improve this important financial ratio:
1)Reduce your debts by paying more than the minimum payments each month on credit cards and other debt obligations
2)Cut back on expenses to free up extra money each month to pay down debts faster
3)Save and invest more money to increase the value of your assets
Conclusion
As you can see, calculating your net worth ratio is an easy task. The net worth ratio gives you a good idea of whether you are living within your means and for those beyond their means, if it shows the ratio going down then the person is able to manage well with the income generated