What is "Net Worth?"
Basically, Net worth is the difference between what you own and what you owe. What you own is referred to as assets, and what you owe is referred to as liabilities. Therefore, your net worth is equal to the total value of your assets minus the total of your liabilities.
The report that lists your assets and liabilities, and the difference between the two, is called a statement of net worth -- which is also referred to as a "personal balance sheet."
Typically, assets are broken down into 3 separate categories:
- Liquid or Current Assets: Cash and assets that can be quickly and easily converted into cash.
- Investment Assets: Stocks, bonds, CDs, mutual funds, retirement accounts, business interests, investment real estate, and so on.
- Personal Assets: Personal belongings that have a resale value, such as a personal residence, automobiles, recreational vehicles, appliances, tools, furniture, etc..
In order to be realistic, when assigning a value to a personal asset it's important to use market value (what the item will actually sell for) rather than the amount you paid for the asset.
Also, since the value of personal assets tends to diminish with time and use, it's important to adjust their values down as they get older and/or become obsolete.
Liabilities are usually broken down into 2 or 3 separate categories:
- Current Liabilities: Amounts owed that are expected to be paid back within one year (credit cards, lines of credit, charge accounts, personal loans, notes payable).
- Long-Term Liabilities: Amounts that are owed that will take longer than one year to pay off (mortgage, home-improvement loans, auto loans).
- Contingent Liabilities: Amounts you may or may not owe depending on future events (taxes, co-signed loans, pending lawsuits).
Why is Calculating Net Worth Important?
In order to get where you want to go financially, you first need to know where you are and in which direction you're heading.
By calculating net worth on a regular basis you will be able to see where you are at in relation to your goals, and whether you're heading toward your goals or moving away from them.
Unfortunately most people are so afraid of seeing how bad things might be, they avoid calculating net worth altogether.
The problem with having that fear is that they have no basis from which to set small, achievable goals. They also miss out on opportunities to celebrate the small victories that come when they manage to meet their bite-sized net worth goals.
How Often Should You Calculate Net Worth?
The wise among us who do take the time to calculate net worth on a regular basis, usually do so on an annual basis.
Personally, I feel it's best to create a new personal balance sheet on a quarterly basis. Not only does this allow you to set short term goals, it also affords you the chance to take corrective action instead of waiting a whole year to see if what you're doing is working.
Then again, since I take the time to log all of my financial transactions into my personal finance software, it is quite easy to generate and print a net worth statement any time I wish to do so.