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Definition: Effective Net Worth
Effective net worth of a company represented by the sum of the shareholder’s equity and the subordinated debt or junior security, i.e. loans that rank below others with respect to the nature of claims. In the event of default, subordinated debt creditors would be the last to claim repayment until senior debt holders are paid in full, leading to greater flexibility in paying off the subordinated debt and thus, adding to the company’s net worth. Subordinated debt can in of the form of debentures or loans provided to corporations by its owners.
Effective net worth is a useful measure for corporations where the executives have a significant representation in the ownership of the entity. Loans to the firm by such owners constitute subordinated debt and as such, are considered as part of the company’s net worth unless a subordination agreement was already in place.
For example, suppose that the total assets of a corporation amount to $10 million and the total liabilities amount to $7 million. If $1.5 million of the total liabilities were subordinated loans of the form of debentures or as loans granted by its owners, the effective net worth of the corporation would be $3 million + $1.5 million = $ 4.5 million.