Why the net worth calculation trumps how much you make

Why the net worth calculation trumps how much you makeOne of my favourite calculations is the net worth calculation. It is not only meant for those who appear in rich lists of magazines, but is an important calculation for anyone who is working towards financial freedom.

Effectively, the net worth calculation lets you know whether you are getting richer or poorer! Your net worth is calculated by adding up all of your assets, then subtracting all of your liabilities; it is simply the difference between what you own and what you owe.

If your assets exceed your liabilities, you are well on your way to financial freedom. If, on the other hand, your liabilities are more than your assets, it means that you are living beyond your means.

Listen to Maya and Mapalo discussing this and other topics on the My Money, My Lifestyle podcast

A lot of the time, people concentrate solely on their salary. They concentrate on how much they make, which does make sense. But it should not end there. You should ask yourself: what am I doing with what I earn? How much of my salary am I keeping (to invest)? In a recent talk I gave, I asked the over 300 women attendees how many years they had been working and how much of their salaries over their working lives they had kept to go towards their investments. The buzzing room became slightly somber.

One of the most contested discussions around the net worth calculation is whether or not your primary residence is an asset to be included in the calculation. Understandably, your house has a lot of equity and for most people; it is their most expensive purchase. The argument however is that you always need somewhere to live, and that your house will only bring in money once you sell it. Even then, you will always need a place to stay.

How do you calculate net worth?

List all your assets:
Primary residence…………….R 1 500 000
Rental Property…………………….R 700 000
Pension/Provident Fund……..R 400 000
Tax-Free savings account……..R 80 000
Total Assets……………………R 2 680 000

List all your liabilities:
Bond on primary residence….R 1 150 000
Bond on rental property……………R 500 000
Credit card………………………………….R 120 000
Overdraft……………………………………….R 30 000
Store accounts…………………………….R 25 000
Total Liabilities………………….R 1 825 000

Net worth = assets (R2 680 000) minus liabilities (R1 825 000) = R855 000

In the example above, net worth is positive, but for many South Africans, the reality looks very different. The net worth for most individuals and households is negative, with people driving around in cars they can’t afford, purchasing homes that are too expensive for them to live in, and racking up debt to fund their lifestyle. It’s no wonder that a lot of people don’t focus on the net worth calculation!

Your net worth number tells you whether you are progressing financially or going backwards. It doesn’t matter how big your salary is. What matters is what you do with it.

You can either use your salary to get more credit, thereby incurring more liabilities  and decreasing your net worth, or you can use it to accumulate assets.

There is no ideal net worth number. Every financial situation is unique. What is a goal for one person will not be so for the next. It all lies in what you set as the goal for yourself as an individual or for your family.

I often get asked by couples about how to manage money as a family. My answer is to set financial goals as a family. For example, you could say: we want our net worth to positively increase by 10% by the end of the year. This helps you focus on the bigger goal, which ultimately helps you make better financial decisions every day. But this is also applies to individuals.

Thinking about your net worth is taking a much broader view of your finances ‒ a bit like a balance sheet versus an income statement. If you want a positive balance sheet, it affects the choices you make in the income statement.

Improve your net worth

Calculating your net worth at least once or twice a year provides a good indication of where you stand financially. And these are some of the ways in which you can improve your net worth:

Squash debt

Debt is expensive; it costs money. The interest that is charged on your debt eats away at your disposable income that you could potentially invest. Before you think of saving or investing, you should work at paying off your debt first. This will decrease your liabilities, moving you closer to a more positive net worth.

Live below your means – and invest the difference

Living below your means is a simple money principle and yet it eludes many. Living below your means affords you the freedom to save and invest. Don’t get trapped in the lifestyle creep circle, where the more you earn the more you spend.

Invest, don’t just save

The market can be an intimidating place and the financial services industry doesn’t make it easy. With acronyms like RA, ETFs, TFSA, etc, one can easily get overwhelmed with all the jargon. This is one of the many reasons why a lot of people just save and don’t invest. The purpose of investing is to earn inflation-beating returns so that your money can still have purchasing power when you need it.

Don’t get overwhelmed by choosing which share/company to invest in. Just get your foot in the market by starting out with a general exchange-traded fund.

This article first appeared in City Press.

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