Recently there had been some high profile reporting involving contractors in Singapore faced with financial problems that resulted in delays to infrastructure projects.
It was highlighted in the press that one of the companies involved has a positive net worth of a few million dollars.
What is net worth? Why is it that a company can still potentially become bankrupt in spite of having positive net worth?
How is net worth computed?
It's a fundamental principle of finance that all assets need to be funded. The two main sources of funding for a business are equity and liabilities. Equity is simply owner's money and liabilities are borrowed money, such as bank loans.
To express it simply: Assets = Equity + Liabilities
For example, if the business wished to purchase an asset of $100 and it only has $80 of equity, it needs to borrow the remaining $20 in order to have sufficient funds to buy the asset.
Alternatively, the above expression can also be stated as: Equity = Assets – Liabilities
The purpose of the above expression is to determine how much money would the owners be able to get back assuming if the business were to close down. Using the above example, if the business is able to dispose of its assets for $100 and pay off the borrowing that it owed of $20, the remainder cash of $80 then goes back to the owner.
Accountants also refer to equity as net worth.
As you can see from the second expression, since assets are larger than liabilities, the resulting residual net worth would be positive.
Solvency vs. Liquidity
A company with a positive net worth is said to be "solvent". This means it is able to pay off all its debts and still have money left over.
How then can a company with a positive net worth still run into financial difficulties?
A key factor is timing.
Assets can be further classified into current and non-current, likewise for liabilities.
Assets that are expected to be converted into cash within 12 months are known as current, likewise for liabilities expected to be repaid within one year.
Common current assets include cash, inventories, and trade receivables. Common current liabilities include bank overdraft, short-term bank loans, and trade payables.
Conversely, assets not expected to be converted into cash within 12 months are known as non-current, likewise for liabilities not expected to be repaid within one year.
Typical non-current assets include property, plant, and equipment. Usual common liabilities include long-term bank borrowings or bonds issued.
Here’s the thing.
If you take current assets to divide by current liabilities, the result is current ratio:
Current ratio = Current Assets/Current Liabilities
This metric measures the sufficiency of current assets to meet the payment of current liabilities.
If this ratio is higher than one, the company would be able to more than adequately pay off all its short-term liabilities with its liquid, short-term assets.
If this ratio is below one, the company has insufficient liquid, short-term assets needed to pay off its current liabilities.
If most of the company's liabilities are short-term in nature and the company does not have sufficient current assets to pay these, the business would experience a liquidity problem.
If the creditors insist on immediate payment on due date of all liabilities owed and the company does not have the means to raise sufficient cash to cover the shortfall either through sale of non-current assets or ability to raise equity or long-term borrowings, the company may face the risk of a going concern problem, which might spell bankruptcy.
This could happen when the non-current assets could not be sold quickly for cash or when they are unable to fetch prices that matched what is stated on their balance sheet due to fire sale condition or because the assets are so specialised that there is no ready market for it.
Hence, while the company might be solvent (overall assets are higher than liabilities resulting in positive net worth), it might still experience liquidity issues (where current assets are insufficient to cover current liabilities, implied by a current ratio of less than one).
The views expressed in this column are the author's own and do not necessarily reflect this publication's view, and this article is not edited by Singapore Business Review. The author was not remunerated for this article.
Do you know more about this story? Contact us anonymously through this link.
James Leong C. Foo is CEO and Chief Trainer of Visions.One Consulting Pte. Ltd. A chartered accountant and adjunct professor, he helps to improve financial acumen, profitability, and cash flow of businesses and individuals through his financial fluency workshops.