Sometimes it is worth knowing if your net worth is good enough or not. But how do you know if it good? And what if you don’t even know how to calculate your net worth? These are some of the questions I am trying to address in this post. Simply put net worth is the sum of all your assets minus the sum of all your liabilities.
An asset is something you own and has a value. Your watch, TV, jewelry, car, house etc come under assets. A liability is something that you owe to others. For example if you have a home loan, car loan or credit card bills to pay, they all come under liabilities. Net worth will tell you how much you really own. Because a house under loan is only partly owned by you. The bank that lent you money owns the rest of it. Similarly, if you buy a TV on credit card, the TV is not yours. The credit card company owns it until you have paid out your credit card bill in full.
How to calculate net worth
The easiest way to calculate net worth is by adding up the value of everything that you own and subtracting all your outstanding loans and bills. That is your net worth at that moment in time. You don’t have to value every small thing. Just the things of high value like a investments, real estate, FDs, PF etc. Also I don’t encourage including assets that depreciate over time. For example cars or electronics no matter how valuable, are depreciating assets and should not be included in your net worth.
Why is it important
Net worth will tell you if you are assets are funded by excessive liabilities. You may have a big house, but if it is funded by a huge loan then you are not as much worth as you might imagine. Some people like to flaunt their assets like big car or house, but they may be struggling to pay the bills. Strive to increase net worth, not assets at the expense of liabilities.
What is a good number?
According to The Millionaire Next Door, your net worth should be your age times your pretax annual income from all sources except inheritances divided by ten. By the way, it is an excellent book that I would recommend every one to read. While Nassim Taleb raises some concerns about the way the research was done in the book, it still is a good read.
Anyway, going back to the formula, lets say you are 40 years old and earning Rs. 20 lakhs per year (pretax) from all your sources (salary, rent, FDs etc). Then your net worth according to the book should be 40 x Rs. 20 lakhs / 10 = Rs. 80 lakhs. If you have more than what the formula suggests then you are a wealthy. If you have twice as much net worth then you are a prodigious accumulator of wealth. You are on your way to early retirement.
Another formula to calculate net worth is to multiply your working years with your average gross income and divide by 4. For example if you have been working for 10 years with an average pretax salary of Rs. 10 lakhs, then your net worth should be 10 x Rs. 10 lakhs / 4 = Rs. 25 lakhs.
The net worth formulas are just indicators of good wealth accumulation. They may not necessarily mean a possibility of early retirement. Both the formulas are based on American lifestyle, income and investment returns. So I am not sure how applicable they are in India. Nonetheless it is a good goal to aim for when accumulating wealth. If you are not meeting the goal, then your focus should be to reduce debt and increase investments. Again, everyone is not expected to accumulate wealth. It is just a life choice. In my case, the net worth was better than what is required using either formula by a decent margin.