A New Method to Calculate Net Worth Which No One Will Tell You

Do you know your net worth?

Why is it important to know your net worth?

Let me tell you.

Net worth is a crucial financial metric that indicates the difference between your total assets and liabilities. It offers a quick overview of your financial status and is essential in assessing your financial health. Although calculating net worth is relatively simple, it demands a thorough evaluation of all assets, liabilities, and liquidity factors.

In this article, we’ll discuss how to calculate net worth, the factors that impact it, methods for enhancing it and the common calculating mistakes.

Table of Contents:

1.)Understanding what is an asset and its liquidity:
2.)How to classify the types of Assets?
3.)Appreciating and Depreciating assets
4.)Dispelling the Myth: Loans as a Liability
5.)How to calculate your net worth by using basic and new formula?
6.)What insights do we draw from this exercise?
7.)Avoid These Net Worth Calculation Mistakes
8.)Bottomline

Understanding what is an asset and its liquidity:

Let’s dive deeper into the topic by examining common assets and their liquidity levels. Based on that, we shall compute a formula to calculate the net worth.

• Cash and cash equivalents:
  • Cash is the most liquid asset.
  • It is utilized directly for investments or purchases.
• Fixed-Term and Retirement Plans:
  • The fixed-term plans include post office deposits, National savings certificates (NSC), Public provident funds (PPF), and retirement accounts.
  • Your PF account and national pension schemes (NPS) come under your retirement accounts.
  • These financial instruments are fixed for a specific period and cannot be redeemed earlier.
• Stocks and Mutual funds:
  • These are also considered liquid assets.
  • They can be sold quickly and easily.
• Bonds and Debt instruments:
  • These are considered semi-liquid assets.
  • Their liquidity of debt and bond instruments depends on various factors such as their credit rating, issuer reputation, maturity period, and market.
• Real estate:
  • Selling large or unusual properties may take time to find a buyer willing to pay the asking price.
  • Real estate commissions and closing costs can be expensive.
  • Commercial properties may be more liquid than residential properties.
• Commodities:
  • Commodities like gold and oil are highly liquid assets when traded on futures exchanges.
  • Prices are market-determined.
  • Future contracts are easy to buy and sell.
• Art and collectibles:
  • Paintings and antiques are highly illiquid assets.
  • It is due to a small consumer base, specialised appraisal criteria, and expensive selling costs like auction fees.

How to classify the types of Assets?

Now let’s group all these assets and segregate them based on the ease of liquidity and the time to redeem them.

• Marketable Assets (Highly Liquid Assets):

Most liquid assets can be redeemed or used immediately, or securities like stocks, mutual funds, bonds, and even maturing fixed-term plans and real estate, depending on the demand/supply. These types of assets include in net worth calculations. There are no major liquidity issues associated with them.

• Hypothetic Assets (Semi Liquid Assets):

These assets have some liquidity concerns and take time to redeem. The time may vary up to several months. The assets under Hypothetic securities include specific real estate, inheritances and collectibles. They incorporate with one’s net worth calculation, but the time period for redemption may vary.

• Frozen Assets (Illiquid Assets):

These are the ones that are not liquid and may be locked in. Some of them include your NPS, PPF, EPF, collectibles if there are no genuine buyers, and real estate in some cases. Even if these are factored into the net worth calculation, they must be long-term investments and shouldn’t be used for short-term needs.

But is that all? Is there anything more we should consider when determining our assets’ valuations, such as if we should account for the possibility that their values may change over time? Absolutely, and let’s examine our assets and liabilities from a different perspective.

Appreciating and Depreciating assets:

When you buy an appreciating asset, you are investing in an asset that has the potential to increase in value over time, such as stocks, real estate, or a business. By contrast, when you buy a depreciating asset, you are acquiring an item that loses value over time, such as car, furniture, or electronics.

In terms of calculating net worth, buying an appreciating asset can increase your net worth if the asset increases in value over time. For example, if you purchase a piece of real estate for 50,00,000 and it appreciates to 1,00,00,000 over a period of years, then your net worth will increase by 50 lakhs.

On the other hand, buying a depreciating asset can decrease your net worth over time. For example, if you buy a car for 10,00,000 and it depreciates to 7,00,000 after a year, then your net worth will decrease by 3,00,000.

Therefore, it is generally recommended to focus on investing in appreciating assets, as they have the potential to increase your net worth over time.

When calculating your net worth, it’s important to include both your appreciating and depreciating assets. By regularly tracking your net worth, you can monitor your financial progress and make adjustments as needed to achieve your financial goals.

Dispelling the Myth: Loans as a Liability

Just like the assets, we will also have to make a comparative study about the liabilities that one may incur in his/her life. While these liabilities may appear to decrease the net worth when viewed as strict liability, they may prove to be beneficial in the long run.

Firstly, loans can be a valuable tool in achieving long-term financial goals. For example, a home loan enables individuals to purchase their own home, an asset that can appreciate in value over time.

Similarly, a student loan can provide access to higher education, which can lead to better-paying jobs and career advancement opportunities.

Another advantage of taking on loans is that it can help establish and build a credit history. By making timely payments, borrowers can demonstrate their ability to manage debt and improve their credit scores.

In addition, some loans can offer tax benefits. For example, in India, home loan interest payments are tax-deductible up to a certain amount, which can reduce an individual’s taxable income.

On the flip side, Bad debt is the one that is accumulated for items or services that do not appreciate in value or generate any income. This type of debt includes credit card debt for unnecessary expenses, loans for luxury vehicles, and personal loans for non-essential expenses. Unlike good debt, bad debt does not contribute to improving one’s financial situation in the long run.

So, to put it in simple words, any debt which may not add value to your net worth is bad, and the same has to be avoided.

How to calculate your net worth by using the basic formula and the new formula?

Let’s calculate your net worth by using the basic formula:

Having spoken about the sub-classification of the assets and liabilities, let’s include the same in our calculation and see how this segregation can make a difference.

We all know the basic formula for net worth which is

Net Worth = Total Assets – Total Liabilities

Calculating your net worth using the new formula:

But let’s make a small change to this formula. Let’s split the assets based on the liquidity, as mentioned before, and the liabilities into good and bad liabilities.

Net Worth = Marketable Assets+Hypothetic Assets +Frozen Assets – Good Liabilities- Bad Liabilities

Using the aforementioned formula, you obtain the same results as the previous method, but with an asset and liability-specific breakdown to analyze liquid and illiquid assets and good and bad liabilities.

What insights do we draw from this exercise?

Let’s say you re-evaluate your net worth after a year and we compute all the segmented values. These newly computed values will tell you how you performed in the last 1 year.

• If your Assets (Marketable and Hypothetic) and good liabilities have contributed positively to your net worth, then you’re on the right path.
• If your bad liabilities have taken the upper hand, it’s time to review what went wrong and make the necessary adjustments.
• We can also infer which type of liability could be closed out first by comparing the outstanding liabilities between the years. The right approach would be to close off the high-interest bad liabilities.
• We can also infer how we have worked on reducing the liabilities in the past year and where exactly an improvement can be made to close out them faster.
• This calculation will also aid in concentrating on improving our appreciating assets and reducing the depreciating assets over the longer run.
• This exercise will also help us understand to add to our marketable assets and reduce the frozen assets in the subsequent period.

The main aim of splitting this net worth calculation is to see what is working for us and what is not. A comprehensive analysis will help to continue our good investment strategies and correct our investment mistakes, thereby achieving higher net worth.

Avoid These Net Worth Calculation Mistakes

Now, we have completed the basics of Net worth calculation from Assets, Liabilities, and the types of net worth. However, it is crucial to be exact and avoid common errors. Now, let’s discuss some typical mistakes we make while calculating the net worth.

1. Not Including All Assets

One common error is forgetting to account for all of your assets, such as property, investment accounts, and retirement accounts. Make sure to accurately account for all of your assets.

2. Overvaluing Assets

Another mistake is overvaluing assets, such as overestimating the value of your car or house. It can lead to an inflated net worth calculation and inaccurate financial planning. So, it is advisable to get it done by experts for accurate results.

3. Ignoring Liabilities

Every human on this planet thinks he doesn’t have any liabilities; some youngsters treat their expensive devices as assets. Your net worth calculation is the difference between your assets and liabilities. Failing to account for all of your debts can significantly fail you.

4. Not Updating Regularly

Now, you are promoted and got yourself a new car worth 20 lakhs, but you did not update its value to your calculation. To account for changes in your financial condition, it’s critical to update your net worth assessment on a regular basis. Failure to do so can result in incorrect assessments and lost revenue opportunities.

By bearing these considerations in mind during the net worth calculation process, we can attain a higher degree of precision in the final net worth calculation.

Bottomline:

Net worth is an important financial measure used to evaluate one’s financial well-being. To calculate net worth, total liabilities are subtracted from total assets. Liquidity of assets should be taken into account when computing net worth, as it affects one’s capability to meet financial responsibilities. Therefore, it is crucial to comprehend the various types of assets and their liquidity to make informed financial decisions.