CMFAS RES5 Advisory Process & Skills question: net worth and solvency ratio

CMFAS RES5Advisory Process & Skills

A client's balance sheet shows total assets of $640,000 and total liabilities of $256,000. What do his net worth and solvency ratio tell the representative?

A His net worth is $896,000, so his solvency ratio is 140%
B His net worth is $384,000 and the solvency ratio is 60%
C His net worth is $384,000 and the solvency ratio is 40%
D He is technically insolvent because his liabilities exceed his assets

Show the answer and explanation

Answer: B. His net worth is $384,000 and the solvency ratio is 60%

Net worth = total assets − total liabilities = $640,000 − $256,000 = $384,000. Solvency ratio = net worth ÷ total assets = $384,000 ÷ $640,000 = 60%. So 60 cents of each asset dollar belongs to him outright after debts, and the market value of his assets could fall by about 60% before liabilities would exceed assets (technical insolvency).

Common mistake

Net worth subtracts liabilities from assets (not adds); the solvency ratio divides net worth by total assets ($384,000 ÷ $640,000 = 60%, not 40%); and with a positive net worth he is solvent now.

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