What is the Tangible Common Equity Ratio?
The formula for tangible common equity ratio is:
Tangible Common Equity Ratio = (Common Equity - Intangible Assets)/Tangible Assets
Some analysts also subtract preferred stock from common equity when calculating this ratio.
How Does the Tangible Common Equity Ratio Work?
Let's say Company XYZ has $40 million of assets and $25 million of liabilities. Its common equity is $40 million - $25 million = $15 million. It has no preferred stock. However, $4 million of Company XYZ's assets are intangible assets -- mostly goodwill from previous acquisitions and trademarks. Another $1 million of its assets are patents on the products it sells, so we must subract those. Using the formula above, Company XYZ's tangible common equity is $15 million - $5 million = $10 million.
To calculate the tangible common equity ratio, we then divide this $10 million by $35 million (Company XYZ's tangible assets). Note that tax benefits from net operating loss carryforwards are generally also subtracted from tangible common equity.
Company XYZ tangible common equity ratio = $10,000,000/$35,000,000 = 0.2857
Virtually none of Company XYZ's intangible assets have value in a liquidation event (whereby Company XYZ is no longer a going concern). Notably, however, Company XYZ's patents (which are intangible assets) may indeed have value during a liquidation and are thus generally left in the assets total.
Why Does the Tangible Common Equity Ratio Matter?
The tangible common equity ratio is a common indicator of bank risk and capitalization in the banking industry. Essentially, it helps banks determine how much they can take in losses before the shareholder equity falls to zero.
Equity, in general, is the difference between a company's assets and liabilities. Intuitively, it represents what's left over if all the assets are sold and all the debts are repaid. However, some of those assets -- intangible assets -- can't really be sold for much during a liquidation even though they may contain tremendous value for their owners.
