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The term net worth has a special place in every discussion related to personal finances. From finance experts to experienced elders, most people would advise you to calculate your net worth frequently and work for its betterment. And almost everything comes back to maintaining a positive and healthy net worth – from savings and spending to investments. This bodes the question – what is net worth and why is it so important to calculate it? Let’s examine the concept in detail and understand the importance of calculating net worth for personal financing.
In the simplest of terms, your net worth is the difference between what you have and what you need to give. The things you have are considered your assets. It can include your savings, your bonds, the property you own, your car and other vehicles, etc. What you need to give is the things or money that you owe to an individual or an institution, also known as liabilities. It can be your credit card bills, a home loan that you took, personal loans or any other kind of expense that leads to the outflow of money. When your assets are more than your liabilities, your net worth comes out to be positive. And when your liabilities are more than your assets, your net worth is negative. Remember how corporate entities make financial statements for every year? Calculating your net worth is exactly like that, but on a personal level.
Calculating your net worth is not as technical as it is in the case of businesses. You simply need to determine the current value of the fixed assets you own, add it to the value of liquid assets and subtract your liabilities from the resulting number. Your assets can be the house you own, the funds in your savings account, retirement fund, investments or your car – basically anything that can be turned into cash sooner or later. Make a list of all your loans and debts to find out your total liabilities. You will find that your net worth will be lower in your younger years, which is pretty normal. Assets and income are lower than liabilities in the early years of our lives since it takes time to build assets and pay off debts like student loans. Your ultimate goal should be to increase your net worth as you get older.
Calculating your net worth can help determine where you stand financially and where you need to be. If your net worth comes out to be a negative number, it is high time you straighten your back and work extra hard and smart to pay off the outstanding debt. If your net worth is a positive number but still not enough to make your personal finances healthy, it is time for you to re-visit your personal budget and make some significant cuts. No matter where you stand currently, having a fair idea of your net worth can help you design a better future for yourself. It is both a steady breeze of encouragement and a swift wake-up call, depending on what you need at the moment.
There is no limit to the number of times you can or should calculate your net worth. However, estimating net worth at least once every year is a good rule to live by. Calculate how much you have earned and how much you owe for the year and note down any significant changes that occurred during that time. Another rule you can adopt is calculating your net worth after you make a huge purchase or sale. For example, re-visit your assets and liabilities after you buy a car or sell a property.
Seemingly similar, it is quite common to get confused among these three terms. One must have a clear understanding of the differences between net worth, net income and liquid net worth to efficiently handle their finances. Net worth is simply the difference between your assets and liabilities. Net income, on the other hand, is what you earn in a month or a year after paying taxes and other similar deductibles like social security. Liquid net worth is a concept similar to the term liquid assets. Liquid net worth is the part of your total net worth that can be easily converted into cash when required. The cash you have saved at home or deposited in a savings account is a good example of liquid net worth.
Fluctuations in net worth are frequent and constant. Throughout your life, you buy and sell several things. Your responsibilities decrease as well as increase during different stages of your life. Given the fact that we see several changes throughout our lives, it can get quite confusing to set a target net worth for yourself. To make things a bit easier, use this formula to define your targets for the upcoming years –
Target Net Worth = (Your Current Age – 25) * (Gross Annual Income/5)
Naturally, the number you get after using this formula is not a definite target. But it can be considered a decent starting point for the foreseeable future. Your target net worth will change over the years or even months depending on the necessary expense you have to handle at any given point in time. Lifestyle and life goals make a huge impact and bring about subsequent changes in your net worth. Make sure you take such factors into account as well.
Once you know where you stand with your net worth, there comes a time to take measures in order to improve it. Just a few changes in your daily or monthly habits can bring about significant changes in your net worth and, hopefully, bring it back on the right track. Given below is a small list for you to consider:
Calculating your net worth is important – not only to find out where you stand currently with your finances but also to figure out the path you need to take in the future. The key is to get a realistic idea of your financial health and then move forward for its betterment. Just a few simple steps and a change of habits is all it takes to improve your net worth. Make sure you estimate the correct value of your fixed assets and keep revisiting the prices to track the changes. Calculate your net worth annually to stay on top of your finances.