Calculate net worth to know the real position of what assets, liabilities and income mean together
If you had to select one number that would tell you how strong your financial situation is, which would it be? Would it be your income that has increased manifold since you first started earning, or would it be the assets that you have accumulated over time, or all the debt you have paid off? But each of these will tell only an incomplete story.
Your income may be high, but if you are not saving enough, then your assets will be low and you may not be on track to meet your financial goals. Or, if you have acquired assets with loans because you are unable to save enough from your income, your liability will be high and there will be stress on your income. You need one number that considers the relationship between your income, expenses, assets and liabilities and then helps you decide if you have managed your finances well so far and what you need to do going forward. That number is your net worth.
“At the end, this is the number (net worth) that matters as it gives a better sense of your combined assets,” said Uday Dhoot, a Bangalore-based financial planner.
Calculate your net worth
Simply put, your net worth is the value of all your assets less the sum total of your liabilities. In other words, it calculates what you would have left for yourself after you settle all your dues.
To calculate your net worth you need to list out your assets. And this includes any cash you hold, bank deposits, investments, gold, jewellery, real estate, the car... in short, anything that you own that you can sell and realize its value.
“It should include all your financial assets but not consumable goods,” said Ranjit Dani, a certified financial planner with Think Consultants, a financial advisory and wealth management firm.
The liabilities include all your loans, credit card dues, borrowings from friends and relatives—anything that you owe. The difference between the two is your net worth.
You should take the current market value of your assets in calculating your net worth since that is what you are going to realize if you sold it. Similarly, take the outstanding debt in estimating the liabilities and not the original loan amount. This is what has to be met out of the assets. “What matters is the current value—both for assets and liabilities—as of today because that is your real worth,” added Dani.
Your net worth is positive if what you own (assets) is more than what you owe (liabilities). If your liabilities are higher, then your net worth is negative.
A positive net worth that is steadily increasing over time is a sign of financial security and freedom. It gives you the confidence that you are on track to meet your goals. You know you have the assets to fall back on even if there was any hiccups in your current income.
“The number of assets does not give you the correct picture, rather it is the nature of assets that matters,” added Dhoot.
A negative net worth indicates that you are technically facing bankruptcy. It implies that you need to take immediate action to manage your expenses so that more savings are available to pay off your debt.
Story behind the number
While the number tells you if you are on the right track, a closer look at what constitutes your net worth will tell you what you are doing right or what needs to be changed.
“Net worth can be looked at as an individual’s balance sheet. Looking at it may tell you a different story than what you really think. It may turn out that you are asset-rich but cash-starved,” said Dhoot.
An ideal situation is when all your assets have been created from your savings. In that case, your assets are free from encumbrances and yours to enjoy. It adds to your wealth and financial strength.
However, it may not always be possible to avoid debt. For example, you may have a home loan to fund the purchase of a house. The house is an asset that will typically appreciate over time even as the loan comes down. In other words, the value of your assets go up while the liabilities come down. This is good use of debt and adds to your net worth.
But if most of your assets are funded with loans, it may not really add to your financial strength because your liabilities will be high. It indicates that you have not been saving much and are dependent on loans for all large purchases.
Corrective action would be for you to cut back on expenses to save more, and reduce your loans. Your net worth will benefit both from the reduction in liability as well as the additional investment that you can make from the freed-up income. “The traditional way of paying off loans as quickly as possible stands true even today. So, if you have a liability with a 11% rate of interest, and an asset with returns of 9%, you have an arbitrage of two percentage points. Add the taxation and it becomes worse,” said Dani.
If your list of assets primarily comprise of cars, televisions and the like, whose value decreases over time, then your net worth will not really benefit from it. If you have taken loans to fund these, then you are doing your finances more harm. You need to focus on reducing consumption spending, and change the nature of assets you are acquiring to those that appreciate and add value to your financial situation.
If your net worth is low because of liabilities such as credit card dues and personal loans, then it indicates a lack of control on your expenses and spending habits. This is the area that you need to focus on to get your net worth on track.
Protect and preserve
When you track your net worth each year (or even each month if you want to) it will tell you what you are doing right or wrong. You will see how too much of spending or new debt reduces your net worth while using excess income to pay off debt and acquire appreciating investments boosts your net worth.
“Reviewing your net worth periodically gives you an insight on how spread out your investments are and will help you in taking further financial decisions,” said Dhoot.
Your net worth will depend significantly on the way your assets are appreciating or depreciating in value, which is not within your control. Diversify your investments to protect the value of your assets.
For example, if all your investments are in equity, then a fall in stock markets will deplete your net worth. Instead, if you held some investments in debt, some in gold, some in real estate, then a fall in one asset may be compensated by gains in others and your net worth may see a smaller erosion. “You may start worrying if your equity portfolio goes down from, say, Rs.10 lakh to Rs.9.5 lakh. But if you combine it with your other investments, it may even out,” said Dhoot.
Make sure your savings are invested to earn returns and not left idle. On the liability side, pay off your high-cost debt as soon as possible and refrain from taking additional debt unless absolutely necessary. “Delaying consumption and instant gratification, and using the saved money to pay back liabilities is the way to go about it,” said Dani.
A bonus or sudden windfall can be used to pay off debt and you will see an immediate improvement in your net worth. However, when doing this you must also have the discipline to wisely invest the excess income that you will now have because your debt repayment has come down. Your net worth will benefit doubly.
Your net worth is what you have to show for your earnings so far. Don’t despair if you have not dealt with your money well so far, particularly if you have many earning years ahead of you. “It is a long process and requires a lot of discipline for many years,” said Dani.
You can use what the net worth tells you to guide your action in future so that you can catch up. Ideally, your net worth must have an upward trajectory. If there is a dip or stagnation explore the reason. For example, when you have just started earning, you will have only a few assets but may have student loans and other borrowings. Your net worth may even be negative. But as you build your savings and assets, and repay your loans, this will correct itself.
Watching your net worth grow over the years is motivating and will help you make the right choices. It is a good starting point for a long-term focus on building wealth.
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