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Completing a personal net worth statement at least once a year is important from a financial planning perspective. It is, in essence, a financial report card that helps in the evaluation of your current financial health. Once completed there are various factors to consider when analyzing your net worth.
Before delving into the factors to consider when analyzing your net worth, I stress that the maximization of net worth is not the 'be all and end all'. High net worth does not automatically translate into happiness. There is little point in sacrificing family and friends at the expense of achieving the highest net worth possible.
What Is A Net Worth Statement?
A Net Worth statement is akin to a company's Balance Sheet. It is a snapshot of Assets and Liabilities at a specific point in time.
Assets are what you own and liabilities are what you owe.
The difference between the total of these two categories is Net Worth. Net Worth provides a wake-up call or confirms if the right things are being done.
It is preferable to review a series of Net Worth statements to gauge progress. Also, it is important to:
- assess the quality of the assets and liabilities;
- review your net worth statement in conjunction with a Cashflow Statement.
A Cashflow Statement reflects cash inflows and outflows over a specific timeframe. In my The Secret to Making Money – Positive Cash Flow I touched upon the importance of:
- ensuring more dollars come in than go out;
- continually focusing on widening that positive variance and eliminating any negative variance.
I also expounded on the concept of positive cash flow in my recent Avoid Making Poor Financial Decisions post.
Assets Defined
Assets are either current or fixed; intangible assets are difficult to quantify and I purposely exclude them for present purposes.
Current assets have the potential to be converted to cash within a year. Examples of current assets include cash, marketable securities, equities, and promissory notes due to you within the year.
Fixed (long-term) assets are long-term tangible pieces of property such as real estate, vehicles, boats, shares in privately held companies for which there is no liquid market in which to sell the shares.
Liabilities Defined
Liabilities are either current or long-term.
Current liabilities are due within the year. Examples include:
- charge and credit card debt;
- loans payable on demand;
- the portion of term debt due within the next 365 days.
Suppose 32 months remain outstanding on a car loan. The amount due in months 13 - 20 is a long-term Liability. The sum of the payments due within 12 months is the current portion of long-term debt (CPLTD).
Twelve months of payments will always be a current liability until only 11 months remain. Once only 11 months remain outstanding, the CPLTD will be 11 months of Term loan payments. The entire balance of the Term Loan will be classified as a CPLTD in the final year but the amount will reduce monthly.
Loans payable on demand are a current Liability because the lender can demand payment at any time. In most cases, demand for payment is not made if the borrower meets the terms and conditions of the loan.
Sometimes loans have cross-default provisions. This means the holder of the demand note can demand payment to protect their interests if the borrower defaults on obligations to other lenders.
Structure of Assets and Liabilities
A factor to consider when analyzing your Net Worth is the structure of the Assets and Liabilities.
Consider the life expectancy of the Asset and Cash Flow forecasts when taking on a Liability. It makes more sense to repay a Liability over a period of years if the acquired Asset's life expectancy is several years. Financing the purchase of a vehicle, for example, is structured over a period of years since the vehicle's life expectancy is in terms of years and not months.
A Demand Loan might be the optimal method of financing, however, if a sudden influx of money is expected shortly after funds are borrowed. Suppose a $30,000 loan is extended to purchase a vehicle and the Borrower expects receipt of $25,000 shortly. It might make sense to borrow by way of a Demand Loan. Upon receipt of $25,000, apply the proceeds against the $30,000 to reduce the outstanding loan balance to $5,000. The remaining $5,000 could then be repaid at any time without penalty or bonus. The borrower, however, must be sufficiently disciplined to repay the principal and not just the interest.
The critical point about the structure of Assets and Liabilities is to appropriately match the liability to the life expectancy of the asset.
Assets and Liabilities and Margin of Safety
The underlying nature and quality of the assets and liabilities are factors to consider when analyzing your net worth.
Some assets are financially productive and other assets are more like 'expenses'.
Positive Free Cash Flow producing rental properties or a pool of common shares in high-quality companies which deliver an ever-increasing stream of dividend income are very different from a motorcycle or pick-up truck for recreational purposes. The first two assets help increase your net worth. The second two are cashflow negative and are unlikely to contribute to an improvement in Net Worth.
Factor a margin of safety when negotiating the terms and conditions of a Liability. Term financing should be structured so the loan is fully repaid well in advance of the life expectancy of the asset. This allows the borrower to redirect the monthly Term loan obligations toward savings. Building a pool of savings can aid with the purchase of a replacement asset when the time arises and reduce borrowing requirements.
Regrettably, many borrowers find themselves in an endless cycle of payments. The life expectancy of many dependable vehicles is often less than 84 months. Borrowers, however, finance a vehicle purchase over 84 months. If the vehicle is upgraded before 84 months elapse, there is often a shortfall between the value of the vehicle and the outstanding loan balance. In such instances, this shortfall might be added to the loan negotiated to finance the replacement vehicle. The value of the loan, in essence, exceeds the value of the vehicle. When this occurs, the rate of interest is typically much, much higher than that extended to a Prime borrower. After all, the lender requires adequate compensation for taking on an elevated level of risk.
Valuing Assets and Liabilities
A loan document typically discloses the terms and conditions thus making it easy to determine the value of the liability. Some assets, such as a portfolio of high-quality and highly-liquid common shares is also reasonably easy to value.
The value of some assets, however, is somewhat subjective and difficult to determine. Given this, it is important to conservatively estimate the value of certain assets. Failure to do so could otherwise result in an unrealistic view of wealth and could lead to imprudent decisions.
The value of property in a highly desirable location can, for example, be reasonably approximated. Determining a reasonably accurate value is achievable by comparing a property to similar recently sold properties nearby. Alternatively, consultation with qualified real estate professionals can help determine a reasonable property value.
A dilemma arises, however, when the property is in a region:
- where the population is declining;
- where major employers have left the area;
- that is remote;
- where good recent comparable sales are unavailable.
In such cases, the value of the property might be far less than the perceived value.
It is also important to consider the sale of properties includes various costs (eg. real estate commission, legal fees, property tax arrears, pro-rated utilities, the repayment of encumbrances, etc.). 'Net sale proceeds' are after backing out these costs. It is, therefore, important to account for these when trying to reasonably determine the value of a property.
Tax implications may arise depending on the nature of the property being sold. In Canada, the sale of a principal residence attracts no capital gains tax. The same, however, is not the case when the property is not the principal residence.
Neglecting to consider the tax aspect of the asset sale places people in a predicament of owing money to the tax authorities.
Principal Residence And Net Worth Determination
The treatment of a principal residence in Net Worth determination is a subject of debate.
A principal residence is certainly an asset. Furthermore, if encumbrances are registered we certainly can not just include the liabilities and exclude the value of the home on a Net Worth statement. That just flies in the face of the most basic accounting principle.
I, however, have never really considered the value of our principal residence as a component of our Net Worth. I just keep the value of our principal residence in the 'back of my mind'. To achieve the ability to exclude the value of our principal residence in our Net Worth calculation, we made a concerted effort to be mortgage-free. This way we would have no asset and no liability from a Net Worth calculation perspective.
We could certainly sell our home and raise cash if needed. If we ever HAD to sell our home, however, we would likely apply the net sale proceeds toward the purchase of another home. If we sell our home for a value greater than that of the new residence or we move into a rental property, we would consider the difference between the net sale proceeds and the cash outlay to be an asset.
This is just my conservative nature and I do not expect everyone to have a similar opinion on the treatment of the principal residence.
Asset Accumulation or Liabilities Reduction
Accumulate Assets or reduce Liabilities to grow Net Worth.
Everyone's circumstances are unique. It is important to consider what is best based on information currently available and also based on a personal goal and objectives. A specific course of action for one family may be totally inappropriate for another.
My wife and I chose to prioritize the reduction of liabilities when we were young. We planned to be mortgage-free as early as reasonably possible. We did invest in common shares of high-quality companies. The elimination of non-tax-deductible debt to improve our monthly cash flow certainly restricted our ability to invest.
Our decision to prioritize the elimination of our mortgage was based on the premise that debt elimination provided us with a 100% degree of certainty that our Net Worth would increase. Investing in high-quality companies did not provide such a guarantee. Furthermore, the mortgage rate was 14.25% when we purchased our home in 1990!
Did we make the right decision to fully repay our mortgage in 8 years versus 25 years? I don't know but things worked out pretty well.
How Does Your Net Worth Stack Up?
For those who are fixated on comparing their Net Worth to that of others, the December 22, 2020 release of Statistics Canada's 2019 Survey of Financial Security indicates the median Net Worth of Canadian families was $329,900 in 2019.
Comparable statistics for the US released by the Board of Governors of the Federal Reserve System indicate the median Net Worth in 2019 was $121,760.
I think it is far more important to compare your/your family's Net Worth over a period of time than it is to try and compare yourself to people you don't even know!
Impact Of Inflation On Net Worth
It is important to consider the impact of inflation on your Net Worth calculations. Failure to account for this could lead to an incorrect conclusion on whether your Net Worth situation is improving or deteriorating.
The Bank of Canada's inflation calculator and the US Bureau of Labor Statistics Consumer Price Index inflation calculator are tools available to determine your inflation-adjusted progress.
Factors to Consider When Analyzing Your Net Worth - Final Thoughts
In my opinion, tracking Net Worth over time is superior to comparing your Net Worth to that of others. It is best to focus on progress relative to personal goal and objectives than it is to compare ourselves to people:
- we do not know; and
- whose life circumstances may be very different.
I hope the factors to consider when analyzing your Net Worth are of help.
Stay safe. Stay focused.
I wish you much success on your journey to financial freedom!
Note: Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I do not know your circumstances and am not providing individualized advice or recommendations. You should not make any investment decision without conducting your research and due diligence.
I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with the company mentioned in this article.
