In my previous article Learn the First Important Steps to Achieve Financial Freedom, i wrote about financial stability, financial security and financial freedom. Most of the calculation formula is base on cash flow and income, it did not present the technique for one to measure how success are you or the financial position you are in for a particular time. Calculating net worth on the other hand, provide you a snap shot of how well (or bad), you have been doing, in financial statement counterpart, it’s like the balance sheet of our financial except net worth is more like a score.
So how do we find out our net worth, actually there are various ways to do the calculation, but the fundamental is the summation of all asset (long and short term) minus liability (long and short term). When calculating asset value most people like to use the current market value of asset, meaning whatever the value of the asset in the market that will potentially be part of your net worth, liability is probably the amount you still owe the bank out of the asset or any other debts. For example Colin’s house might worth $300k in current market, after servicing installment for 2 years he still own $250k, taking the equity value into Colin’s net worth calculation it is $50k only.
Example of assets:
1. House/Apartment/land
2. Stock/bond/unit trust
3. Fixed deposit/saving/cash
4. Automobiles
Example of liabilities:
1. Loan (Principle + Interest) still owe to the bank for house/apartment
2. Loan (Principle + Interest) amount owe to the bank for automobile
3. Retail/credit card debt
4. Study loan (Principle + Interest)
Beside an equity value of $50k from owing his house, Colin had purchased some unit trust since the first year he started working which currently worth $10k plus return, he has around $20k in fixed deposit and $5k in saving account. He also own a car that he completed the full payment which is now worth around $40k in the market after depreciated for 5 years. In total, the asset he owns stand at valuation of $50k + $10k + $20k + $5k + $40k = $125k.
On liability side, beside $250k he still owe for his house, he has credit card debt of $1k and study loan of $30k.
Net worth = ( Long term asset + Short term asset ) – ( Long term liability + Short term liability )
So colin’s net worth = ( $300k + 10k + 20k + 5k + 40k ) – ( 250k + 1k + 30k )
= $375k – $281k
= $94k
However, if we just look at this number – $94k, there is no meaning to it. Is this good or should Colin be doing better? In The Millionaire Next Door, the author formulated a way to calculate the net worth one should be achieving by considering the age and income. Multiply the income with age, divide the subtotal by 10, and calculation result is the net worth score band you should be achieving at your age and income level. If the calculated net worth is lower than the score band, one is known as Under Accumulator of Wealth, otherwise one is known as Prodigious Accumulator of wealth (UAW and PAW is also introduced in The Millionaire Next Door).
In our example, Colin 30 years old is currently earning $5k per month, and an annual income of $60k. Multiply $60k with 30 and divide by 10 we get $180k. So at age of 30 with an annual income of $60k, Colin should already have a net worth of $180k. Even though Colin is seem to be doing fine with his net worth but he is only UAW.
One might argue that it is unrealistic to consider person’s age instead of year of working or ones income will only increase over age (Sorry i don’t even know why the author wants to divide the subtotal by 10) but treat this score band as a objective because i know many people doing very well are scoring only as well as Colin, and that’s also why we are still struggling, because we are not outstanding. So what is your net worth tells you about your ability to accumulate wealth?