The debt-to-net-worth formula is a good one to be familiar with, as it can shed light on how financially healthy you are -- for you or for anyone assessing your financial condition.
The formula -- and the ratio it creates -- is used in several contexts, so let's review them all.
Your personal debt-to-net-worth ratio
Before we start calculating your personal debt-to-net-worth ratio, let's calculate your net worth. The formula for that is:
New worth = total assets – total debts
Simple, right? All your assets include your home equity, the value of all your possessions (such as your car, your furniture, your clothing, your extensive board game collection, and so on), your savings and checking accounts, investment accounts, bonds, CDs, and any cash or cash equivalents you have. Add them all together.
Next up, total all your debts, which might include the balance owed on your mortgage, any car loan debt, student loans, and credit card debt. Subtracting debts from assets gives you your net worth. Ideally, this number will be large and growing. At a minimum, it should be positive – though many people carrying heavy debts are often net-worth-negative.
Next, use this formula to determine your personal debt-to-net-worth ratio:
Debt-to-net-worth ratio = total debts / net worth
So if you owe a total of $85,000 and your assets are worth $155,000, your debt-to-net-worth ratio will be 85,000 / 155,000, or 55%.
The lower the ratio, the healthier you'll appear to anyone assessing your ratio. A low number suggests minimal debt. Any result over 100% reflects someone who owes more than their net worth. That's not a portent of doom, but it might keep a lender from eagerly lending you any more money -- or it might lead the lender to levy a higher interest rate, to compensate it for the extra risk it's taking on.
Remember that these ratios reflect your condition at a point in time, and they can and will change over time, for better or worse. Many college students and recent graduates will inevitably have negative ratios because of having just started out in life on their own, often with substantial student-loan debt.
A business's debt-to-net-worth ratio
Businesses also have debt-to-net-worth ratios, which suggest how financially healthy they are. Just as the lenders we individuals borrow from will want to know about our debt-to-net-worth ratios (and, often, our debt-to-income ratios), businesses also face lenders or investors with similar concerns.
A high debt-to-net-worth ratio will suggest to a prospective lender or investor that the business has already taken on a lot of debt, and that it's therefore more risky than many other companies. After all, having debt means that it's on the hook for paying that debt off, and those debt obligations can render it less nimble, less able to weather tough times, and perhaps less able to make any more repayments on further debt. Again, the lower the ratio, the better.
Many investors will assess the debt burden of any company they're considering investing in, and a common metric evaluated is the debt-to-equity ratio, which is essentially a debt-to-net-worth ratio. Equity in this case, after all, is the company's total assets less its total liabilities. The result is typically labeled "shareholder equity" on the balance sheet.
The debt-to-net-worth ratio as an economic indicator
Finally, know that debt-to-net-worth ratios will also pop up occasionally as economic indicators in your financial reading. For example, in June of 2015, researcher Danielle Hale at the National Association of Realtors noted that the net worth of households and non-profits had hit a record high, though debt, which had been falling a while back, had started inching up again in the past few years. Realtors and others have a great interest in household debt and net worth levels, as rising net worth and falling debt levels can make for a population more able to buy homes.
Most of us don't know what our debt-to-net-worth ratio is or what formula to use to determine it. It's worth crunching the numbers now and then, though, in order to get an idea of our financial health and progress. It can come in handy when evaluating companies, too.
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