Meaning
Financial ratios in a loan or investment agreement that require a company to maintain a minimum level of assets excluding intangible items provide a conservative measure of the liquidation value of a business. These tangible net worth covenants focus on physical property, equipment and cash while ignoring goodwill and patents. They ensure the borrower retains a specific equity cushion.
Exclusion List
Intangible assets are removed from the calculation because their value is difficult to realize in a forced sale. Items like brand names, trademarks, licenses and deferred tax assets are subtracted from the total equity to arrive at the figure required by tangible net worth covenants.
Breach Consequence
Falling below the agreed threshold is a technical default that allows the creditor to take action. The bank might increase the interest rate, demand immediate repayment or take control of the collateral.
Operational Impact
Maintaining this ratio limits the ability of a company to take on excessive debt for acquisitions. Because intangible assets from a purchase do not count toward the target, the firm must fund its growth with a higher proportion of cash or tangible gear. This constraint keeps the financial structure of the company within the risk tolerance of its investors.
The covenant acts as a brake on aggressive expansion that might compromise the stability of the core business.
