Fundamentals: Net Worth — the Big Picture
This article is part of a series on the fundamental aspects of financial planning.
If you pay attention to money, you are probably keenly aware of what you earn and how your investments are doing. You might also be aware of what you spend. Your earnings and spending are like the Income Statement for a business: income – expenses = profit. That’s your savings each year.
But for individuals and families, another very important number is: Net Worth. Its formula is:
Assets – Liabilities = Net Worth
Why is that so important?
The simple answer is that nearly everyone has to spend down some or all of their net worth in retirement. The higher your net worth is before retirement, the more likely you are to maintain your working-lifestyle into and throughout retirement.
Higher net worth can also be a cushion against unexpected costly events, although a good financial plan encompasses various ways to address those risks.
Net Worth isn’t your assets alone. Consider a $500K home with a $525K mortgage; the value of the home fell after the initial purchase. In that case, the home’s net value to the owner is negative $25K; it subtracts $25K from the owner’s net worth.
What are Assets?
Your assets include everything you own that has financial value: bank accounts, investment and retirement accounts, real estate, some insurance products, furniture, vehicles, collectibles, etc.
Not all assets are easy to convert into spending power. The value of your home might be high, but you cannot buy groceries or pay the utility bills with it. We sometimes hear stories of an older person who has to live a very thrifty life because her net worth is mostly in her home.
Liquidity is the financial term that describes how easily you can convert an asset into cash at its assumed value. A bank account is very liquid; an investment account is liquid (although its value fluctuates), a home or parcel of land is illiquid. A parcel of land might be appraised at a certain value, but finding a buyer could take a long time and transaction costs will reduce the net value. If the owner has to sell it quickly, he might have to discount it steeply. That’s why it is illiquid.
Future income from a pension or Social Security is not strictly considered an asset, although it’s very important when calculating retirement income.
Your future earnings from work are not considered an asset in the traditional sense, even though most younger people have far more future earnings than current assets.
What are Liabilities?
Generally, a liability is a loan: a credit card balance, student loan, home equity loan, mortgage. It could also be a court-ordered settlement, alimony or child support: mandatory claims against future income.
Although we might face the possibility of large future expenses, e.g., medical bills or long term care, we don’t consider those liabilities unless they become certain.
The Big Picture
So while it’s important to focus on income and expenses, the bigger picture is Net Worth. It provides a broader measure of your financial heath and is a key part of your retirement. Each year, make a list of your assets and liabilities so you can calculate your Net Worth; keep track, and compare it to past years.