Net Worth is a measure of one’s current financial position. In this guide, we help you get a better understanding of how to calculate your net worth and how to interpret it. It goes beyond the established formula of Assets - Liabilities = Your Net Worth by discussing how the formula applies to individuals and businesses. It also talks about the different types of assets and liabilities in order for you to be in the best position to calculate your net worth.
Net Worth in Businesses
For businesses, Net Worth is also referred to as book value and can be found in the business’ balance sheet. The balance sheet shows total assets and total liabilities of the business. The balancing value which is usually the difference between total assets and the liabilities is the net book value of the business/ net worth. However, unlike in net worth for Individuals, the values in a balance sheet are mostly historical values rather than market values.
Net worth in businesses is used to indicate the financial health of a business. Many financiers are interested to know the Net Worth of a business while evaluating the credibility of the business and its ability to repay loans. Shareholders are also concerned to know the business’ Net Worth since it indicates the equity attributable to them.
Net Worth for Individuals.
Net worth provides a quick overview of an individual’s current financial status. It is an important measure of your financial health. A positive and rising net worth is a good indicator of good financial health while a diminishing one may be cause for worry.
When you know your Net Worth you can make informed financial decisions. This can help you evaluate your progress towards achieving your goals. That way, you are able to plan and adjust accordingly. Also, in the event of your demise, your net worth can be used as a guide to valuing and managing the distribution of your estate in probate.
An individual’s Net Worth is derived in the same way as what was detailed for businesses earlier in the guide - subtracting one’s total liabilities from total assets.
As mentioned earlier on, unlike in businesses, the value of individuals Net Worth relies on current market values of both the assets and debts. To get a better understanding of how net worth works for individuals, check out this 5-minute video from Tru Financials:
How to calculate Net Worth
Net Worth is derived by getting the difference between total assets and total liabilities. Simply put, determining what one owns less what is owed gives the Net Worth. What you will get is not a static figure; it keeps on changing with time.
An asset is any item in the present or future ownership and in the control of an individual/corporation, has an economic value and can be used for future benefits or to meet future obligations.
Typically, the four main asset classes are cash, equities, bonds and alternatives. However, for the purposes of calculating Net Worth, this guide will classify assets in three categories:
- Liquid Assets
These are assets that can be easily converted to cash within a short period (one year or less) without losing value. This includes cash available at hand or in bank accounts.
Examples of items to include as liquid assets when measuring Net Worth are;
- Cash in hand
- Current and savings account balances
- Money market instruments
- Treasury bills
- Certificates of deposit
2. Investment Assets
This class is primarily comprised of equities and bonds. They are acquired for generating further future income mainly through expected future increases in value.
Examples of investment assets include:
- Life Insurance value
- Mutual fund shares
- Redeemable shares of stock
- Commercial Real estate
- Retirement savings plans e.g. 401(k)s and IRAs
3. Personal assets
Personal assets are tangible items with financial value and are individually owned. Most of these items are not held to generate income. They are mostly status items but can realize income once sold. Examples of personal assets are:
- Residential homes
- Antique Furniture
- Vacation homes
- Art pieces
- Boats and crafts
- Motor vehicles and motorcycles
- Valuable personal items e.g. jewelry, musical instruments, collected coins, antique items, family heirlooms, rare wine collections etc.
These items are measured either using the market value (which is the price the item would fetch if sold in the market currently) or using an appraised value which takes into consideration future price benefits.
It must be noted that you do not need to measure the value all items of personal nature since they can be too many. For example, it makes sense to only include personal items with a value of $500 and above. Also, one should not list down anticipated inheritance items since these might not be realized. Items in one’s immediate ownership take priority.
Liabilities are obligations owed to other parties arising from past transactions and are yet to be completed. These can be short term(current) -to be completed within one year or long-term liabilities whose settlement extends beyond one year.
When calculating Net Worth, examples of liabilities are;
- Personal loans
- Car loans
- Student loans
- Credit card balance
- Tax dues
- Any other outstanding bills e.g. medical bills
When valuing liabilities, you should consider the outstanding amount (including interest if applicable) not the whole debt amount. For example, if you have a mortgage initially valued at $50,000 but have paid 40%, then your liability is 60% of $50,000 plus any additional interest. To better understand liabilities in detail, check out this video from Accounting Stuff where the speaker breaks down the full technical definition of liabilities and shows how it applies to you or your business.
Once you have listed and valued all your liabilities and assets, you subtract the liabilities from the assets to get your Net Worth.
Can you have a negative net worth?
When the total value of assets exceeds that of liabilities, that means your net worth is positive. However, the contrary can also happen. When the total value of liabilities is more than the assets, the result is a negative net worth. Well, while this is not desirable it does not spell doom either.
Net worth tends to improve with time and age if one makes sound financial decisions. For example, in your 20’s you probably have a huge balance on student loan with little or no personal wealth. However, over time you are able to pay off the loan and acquire some assets which then improves your net worth.
What to do to improve your Net Worth.
The most appropriate way to improve your Net Worth is through decreasing your liabilities without affecting your assets or increasing your assets while maintaining a constant/decline in your total liabilities.
However, this may not be as easy as it sounds. The following tips can help to significantly improve your Net Worth.
- Keep a record of all your assets, income, bills, expenses, debts, savings and repayments. Everything money-related should be in an accessible file either on a logbook or on a computer. The ease of accessibility is essential for regular updates. This will help you know clearly what you own and owe. A handy tool for this Intuit's Quickbooks. This is particularly useful if your personal finances are already complex. However, if you are just starting out is also possible to save money and do things yourself in Excel. Check out this 10-minute video guide on how to maintain a personal finance sheet in Excel by Michelle Mangen.
2. Analyze the record to clearly know how much inflows you have compared to your outflows. This way, you will be able to maximize your repayments and savings while minimizing your expenses. This may entail a paradigm shift in terms of how you view your personal finances.
3. Come up with a budget to help you consciously plan your finances up to the last cent. This will eliminate unnecessary expenditure, especially of small recurring expenses while keeping you focused on your long-term financial goals. In the previous tip, it was mentioned that a paradigm shift in terms of how you view money and acquiring it is essential to improving your net worth. Check out this video by Matt D'Avella on a Minimalist Approach to Personal Finance to learn how you can get rid of debts and develop a strategy to improve your net worth.
Prioritize your debts. This is through paying off first those debts with high interest rates to make sure you are not losing out on paying high interests before principal amounts hence taking too long to clear your debts. Also, once some debt items such as mortgage are paid off, these increase the value of your assets.
You can also look out for available options on debt restructuring/ consolidation.
- Exercise frugality. Being frugal does not mean you have to live a boring life but will ensure you are conscious of your small spending habits. When added up, these small expenses make a huge difference if cut down where possible. E.g. eating out less often, minimizing expensive hobbies such as gambling, etc.
- Find new/alternative sources of income. For example, taking up a second job, investing in high yield investment choices. This will improve your assets and consequently your Net Worth.
- Invest. Other than having lots of cash in hand or in current accounts, you can scout for investment options to fetch you extra interest or dividend income. E.g. investing in stocks, money markets, etc.
- Taking insurance. Insurance could be in the form of you insuring your property to cushion you in the event of damage or loss hence saving you the cost of repairs or legal charges. It could also be in IRA and 401K for your retirement. The benefit of this is that you are able to save up for retirement while also enjoying tax benefits.
- Consult an expert.
Do not shy away from seeking advice from an accountant or a financial advisor. They will help you in budgeting, keeping and maintaining financial records, advise you on how to enjoy tax benefits and how to invest wisely. A professional will also guide you in valuing your property so that you are as accurate as possible.
How often should you calculate your Net Worth?
As mentioned before in this guide, net worth is not static. It keeps on changing since, with time, your assets and liabilities will keep on increasing or decreasing.
However, we will keep on emphasizing the need to know your net worth as it is very crucial in the planning of your future financial goals. Calculating your net worth should therefore be a regular activity instead of a one-time thing. It is recommended therefore that you calculate your net worth every six months. This should then be compared with your net worth from previous periods. Doing this will help you plan your financial moves better and will help you monitor how much closer you are getting towards achieving your financial goals. Explore ways you can update your net worth in real time such as Excel and Quickbooks.
Mistakes people make when calculating Net Worth
The first and biggest mistake people make when it comes to net worth is not bothering at all to know it at all. This should be avoided at all costs together with the following:
- Relying on estimates/guesses when valuing total assets and liabilities. This may lead to overestimating/ underestimating the net worth hence misleading making financial decisions. If one has no expertise in determining the accurate value of their assets and liabilities, they should consult a professional to help them out.
- Calculating net worth only once. Once is not enough; one needs to obtain net work calculations over time to monitor the extent to which you are approaching your financial goals.
Why is knowing your net worth important?
- Your net worth gives a clear snapshot of your financial status. This is crucial when making financial decisions.
- Your net worth sets a good measure of your progress towards achieving your financial goals. Periodic review and comparison of your net worth from one period to another indicates growth/ a lag. This puts your mind to work in determining the necessary adjustments to be made.
- Knowing your net worth can help you plan on what investments to make, savings plan to start or assets to acquire e.g. before retirement.
- Keeping the record of your calculated net worth makes it easy for you when accessing credit. Since you are conscious of your financial position, it is hard to be misled in the process.
Calculating and knowing your net worth is one of the best things one can ever do with regards to personal finance goals. As mentioned before, this is more than just knowing what you have. Net worth is the best measure of your financial health and progress over time. This will greatly help in keeping track of your short term and long-term financial goals.
You should exercise caution while valuing your assets and liabilities. Overestimating your assets while underestimating your liabilities may be pleasing to the eyes but does not give the correct status of your finances. If all of this is confusing to you, consider having a minimalist personal finance system. Learn how to have a minimalist 4-part financial management system through this video by Mike D'Avella and simplify things for yourself.
It helps when you have a well-maintained record of your assets and liabilities. This goes a long way in making your work of calculating net worth easier. Periodic analysis of your Net Worth over time will enable you to identify trends in your financial situation. This can make you proactive about making necessary adjustments before it is too late. Always keep in mind that the best financial decisions will always improve your net worth.
Do not beat yourself too hard if you have a fluctuating net worth. Your net worth will keep on changing. There is a very high likelihood you will start out with a negative one. What matters is progress and that you have clear financial goals that you are working to achieve.