One of the three elephant concepts in this blog and essential element of the personal finance (or any other finance) is to increase your Net Worth. Lets straight jump to what is the net worth, describing it in the following equation:
Net Worth = Assets – Liabilities
Essentially, increasing your assets and decreasing your liabilities, makes you richer. Assets are all the things you accumulate throughout the life and have at the moment: cash, household good (furniture, electronics), vehicles (cars, bikes), real estate, investments, retirement funds, receivables (someone borrowed money from you or owes you a rent), insurances, businesses, etc. Liabilities on the other end are loans (mortgage, student loans), credit cards (if you are in minus on your card), taxes owed (if you have to pay for your real estate or being self employed) and other payable (unpaid bills, child support).
The equation is quite simple, but to increase your net worth is not that easy. For instance, if you buy a car (increase one element of assets) by spending your cash or take a loan with the same amount, your net worth stays the same! If you try to decrease the liabilities by paying back the student loan with cash or taking another loan, your net worth stays again intact! The magic question is thus, how to increase the assets by not increasing (or increasing less) liabilities or how to decrease liabilities by not lowering (or lowering less) assets. We can answer the question by expanding the equation with the time concept and new elements, the Income and Expenses:
Net Worth of today = Assets of yesterday + Income earned since yesterday – Liabilities of yesterday – Expenses incurred since yesterday
Now it starts to become clear that if your period income is higher than the expenses, all the surplus goes in to Assets and thus results in higher Net Worth! In the opposite scenario (if your expenses are higher than income), the liabilities raise faster than assets and your net worth decreases. Liabilities and Assets also appreciate or depreciate in time. Income is your salary, dividends from business, increases in the value of investments, rent payments, interest payments to you. While the income list tends to be short (better to enlarge!), expense list is often very long (counting 15 categories for myself): rent payments, food, entertainment, transportation, investment expenses, it, clothes, communication, presents, household, alcohol, health, sports, education, business.
Now we can formulate several ways to increase your net worth: (1) Increase income in all possible ways and to the maximum potential, (2) Decrease the expenses, (3) Enhance the quality of your assets, so that assets would generate income or appreciate in value, (4) Optimize your liabilities, so that to pay as little interest as possible and borrow only for income generating purposes.
Just before analyzing each way into more detail, it is important to emphasize that it is often not enough to just have a feeling of your net worth, it is (5) important to calculate and track your net worth in time. Only by writing the number down could change your imaginable net worth and actions substantially. More importantly, tracking several months could give you a perspective what can happen in the future, given the present tendency, thus what potential problems you need to solve right now, before it is too late. Tracking your net worth is inevitable for setting efficiently your financial (and even non-financial) goals and making financial decisions to apply for loans, particularly mortgage.
The necessity and importance to calculate the personal net worth could be seen from the corporate world, where companies not only see clear benefits from knowing financial status, but also are required by law to provide their balance, profit and loss accounts, and calculate shareholder’s equity (or net worth).