Know Your Net Worth

It might be a fictional movie, but the quote above hits the mark in real life. This doesn’t have to be how the story ends for you. You have the power to choose a different path if you want. You can start three steps today to ensure you are not in that 90% with little to no net worth. I am going to focus on step one in this article. I have already written about steps two and three, which I will touch on briefly at the end.

What is Net Worth

The first thing you need to understand is what precisely net worth is. Net worth is a basic formula:

Assets – Liabilities = Net Worth

Many people don’t know how you calculate their net worth, and they have never figured it out. Some don’t want to. If you fall into the category of people that don’t even know or have never calculated your net worth, let’s start with the worst-case scenario and get it out of the way right now.

Negative Net Worth

For far too many people, that number is negative! That means you have more liabilities than assets; you have a negative net worth. While this is certainly not an enviable position to be in, there are two things you need to understand if you want to turn this scenario around…

It is NOT Permanent

Negative net worth is NOT a permanent situation. You can turn this around. I will not mislead you; it is often a hard road to turn around, but anyone can do it if they want. The first step to fixing this situation is to spend less than you make. I am sorry if you thought I would deliver a divine secret known only to money magicians somewhere in a secret mountain monastery.

If you continue spending more money than you earn, your debt will continue to balloon, and your net worth will ALWAYS be negative and worsen over time. To solve this problem, you need to create a wealth gap.

It is NOT a Reflection of Your Value to the World

I have met doctors that earn well into the six figures with a negative net worth. You have individuals that hold one of the most prestigious professions in the world with the power to heal that have a negative net worth! I have also met business professionals who went to school and learned finance and accounting and should know better but have a negative net worth and carry thousands of dollars in credit card debt. The bottom line is your profession, education, and social background don’t give you an automatic ticket into the positive net worth club.

Conversely, I have met individuals with straightforward businesses, including handyman, with well over a million dollars in net worth. I discussed this person in Why the Faux Rich Will Never Be Wealthy if you want to know more about his back story.

One of the wealthiest and brightest businessmen I have known never went to college. He worked as a millwright at an automotive company. He owned millions of dollars in real estate, a large stock portfolio, and a pool and deck company. If you met him on the street, you would never know. He was plain-spoken, wore blue jeans and flannel shirts around town, and drove a pickup truck. No mansion, sports car, fancy suits, or Rolex watch. What was even more interesting was the fact that he worked in a trade based blue collar profession but had a net worth that was far greater than any manager he reported to.

One of my early mentors also fell into a similar profile. He grew up poor on a rural farm in northwest Ohio at the tail end of the Great Depression. In high school, he started raising farm animals, selling used farm equipment, and growing produce for sale. He thought he should go to college but discovered that he would have to sell all his assets to pay for it. He opted not to do that. When I met him many decades later, he owned a farm, extensive real estate investments, a large stock portfolio, and ran a successful financial consulting business. Over the course of his life, he had bought several dilapidated farms and turned them around. He was a multi-millionaire.

The takeaway from this is that people you would expect to be rich and have a significant net worth may not, and those you would never expect to have a net worth can be some of the wealthiest people in our society. Considerable net worth is not about your profession, the amount of money you make, or your perceived value to society. It comes down to simple choices anyone can make. The question is will you make those choices and grow your net worth, or will you resign yourself to a life that could have been if only…

The Components of Net Worth

Now that you know the formula for figuring it out, let’s look at the two components that make up your net worth. While this should be a very straightforward explanation, it isn’t. There are different opinions about what constitutes an asset and a liability. There are financial gurus, some quite famous, that argue things I would call an asset aren’t.

Assets

The first category is assets. Here is the definition of assets as defined by Investopedia:

An asset is a resource with economic value that an individual, corporation, or country owns or controls with the expectation that it will provide a future benefit.

It further states…

An asset can be thought of as something that, in the future, can generate cash flow, reduce expenses, or improve sales, regardless of whether it’s manufacturing equipment or a patent. 

This is very close to the definition I learned in college while studying accounting, and it is still the definition I stick with today, and that puts me in direct conflict with some of the famous gurus out there. One guru I won’t name, but if you think about it for 3 seconds, you will figure out, says assets are ONLY assets if they throw off cash flow. If it doesn’t generate cash flow, it is not an asset, and since there are only two components of this equation, it must be a liability. I disagree with that concept.

I stick to the definition in Investopedia and the one I learned in college. An asset simply must have value. Most people in the finance world will say that an asset must have one of 3 things to be considered an asset:

• Generates cash flow
• Can be sold to generate cash
• Has a future potential value

For example, using the definition from Investopedia above, manufacturing equipment or a patent are assets. I agree, but what if both of those items are owned by a business that isn’t using them? Instead, what if they generate costs, i.e., you must pay to store and maintain the manufacturing equipment or legal fees to maintain and defend the patent? In that case, the guru I noted above would argue that since it doesn’t generate cash flow and requires you to pay money to keep it, it is NOT an asset, but that is very short-sighted in my book.

If I were the business that owns these items, I could sell them, raise cash, or put them into service and generate cash flow. Both have potential future value, and they are assets. In calculating your net worth, I would advise that you stick to the traditional definition of assets and not the limited version of assets. If they have value, they are assets.

Not all Assets are Created Equal

Having argued that anything of value should be considered an asset, I will concede the point that not all assets are created equal. There are quality assets and poor assets. Here are some examples from best to worse

Rental Property

A house you own and rent out, which generates positive cash flow each month after you service the debt and pay all expenses, would be considered a class A asset in my book. On this point, the financial guru and I agree. This particular asset generates cash flow, and I could sell it to generate cash if I need to raise capital.

Personal Residence

I am a fan of owning your house and not renting. A house that you live in will cost you money to own. You will need to pay a mortgage each month, pay property taxes, and pay for maintenance. Your net worth will increase due to the reduced mortgage, and the house will appreciate. You will not get any cash flow from this asset, but if you need to, you could sell the house to raise capital. If you didn’t want to give it up, you could set up a HELOC on it and borrow against your equity. You can’t do either of those if you rent your residence. The financial guru and I would be in direct conflict on this being an asset. He would specifically say it isn’t because it doesn’t generate cash flow and costs you money each month. However, everyone needs a place to live. Shelter is a basic human need. If I rent, I own nothing. If I buy, I can build equity. I have an asset, but I will concede it isn’t as high quality as the rental property above. It is still an asset, but perhaps not the best one.

A Boat

Let’s go right for the throat on this one. The financial guru would call this a liability. It costs money to purchase and maintain, depreciates in value every month you own it, and doesn’t throw off any cash flow. It is a total liability, correct? Nope, you can still sell it to generate cash. I will concede that it is depreciating every month, and now that it is used, it won’t necessarily generate a lot of cash if sold, but it can still be sold and will likely still generate some cash. That makes it an asset. I could also rent it out, and it would generate cash flow. Is this an ideal asset? Absolutely not! I would personally never own one. I consider it one of the worst examples of an asset, but if you can sell it and raise cash, even if you lose money, it is still an asset.

Think about a stock. Nobody I know would argue that this is not an asset, but what if it drops below what you paid for it and stays there forever? I can still sell it and generate some cash, but less than I paid. Unless it pays a dividend, it will never produce cash flow, so according to the financial guru, shouldn’t this be a liability? How is it different from the boat above? At least with a boat, I can have a little fun, but the devalued stock worth less than I paid just pisses me off. I might not have to shovel cash into it like a boat every month, but it still produces no cash flow and may be worth less than I paid.

So, why did I spend all that space arguing about what is and is not an asset? I did it because there are gurus out there with A LOT bigger megaphones than I have that fill this space, and I believe they mislead people by warping the definition of an asset and liability. If you don’t use a standard definition, you will never be able to calculate an accurate net worth number.

You are free to disagree with my definition, but understand it isn’t MY definition; it is the exact definition used by accountants, business professionals, and investors worldwide. As I did above, I will concede that not all assets are of equal quality. Clearly, there are some far better than others, and some I would personally never own (a boat) that make a piss poor asset and would cost you money every month, and you will lose money when you sell it.

Asset Case Study

Here is why I am arguing against some of the most well-known financial gurus on what is an asset and what is not. When I was first out of college, I rented an apartment with my wife and stayed there for two years before purchasing a house. When we moved, I owned nothing. I couldn’t sell the apartment; I couldn’t borrow against it. All I had was a pile of canceled rent checks.

I bought my first house in a nice suburb with excellent schools, and I still live in that same community today. This house required monthly mortgage payments, and I had to pay property taxes and maintenance. According to the guru, this was a liability.

Fast forward 16 years. The mortgage is paid off (15-year mortgage). Now I only need to pay property taxes and maintenance on this house. When we bought our next home, we didn’t have to sell our current house first. We were able to slowly move our stuff out and fix it up after we moved. Two months later, I rented this house out, and today it generates incredible cash flow and is very easy to rent. The costs are low with no mortgage. I couldn’t have done this if I had rented for those 16 years. When I moved, I would have owned nothing and wouldn’t have an asset to rent.

What if I had a 30-year mortgage and still owed 14 years of payments on this house? So, what. I could still rent it, and while the cash flow wouldn’t be quite as high because I would still have a mortgage on it, my net worth is still better because of the equity I have, and it also generates cash flow every month. In addition, I set up a HELOC line of credit on the house. That line of credit serves as cheap capital to buy flips and put down payments on other real estate investments. I pay no interest on this line of credit; when the balance is zero. Finally, when I pull money off the line to use it, who pays back the loan? My tenant does, with their monthly rent. I am better off owning a house and not renting for those 16 years. A house is an asset, period.

Liabilities

Now that I have trashed the concept of what some gurus call a liability and an asset, let’s look at actual definitions of a liability. I am going back to Investopedia for this one. Here is what they say…

A liability is something a person or company owes, usually a sum of money. Liabilities are settled over time through the transfer of economic benefits, including cash, goods, or services.

This aligns very closely with what I learned in my college accounting and finance classes about what a liability is. Notice it isn’t a house, but the mortgage on that house. It isn’t a boat, but the loan to purchase that boat. You must understand this basic concept. A liability is something you owe money on. That something could have an underlying asset like your personal residence or a boat. It is even possible that the liability is higher than the value of that asset, i.e., the house or boat. I can almost guarantee the boat will be, and at least once in my lifetime, many houses fell into this category. After the housing collapse of 2008 – 2010, many people that had purchased houses just a few years earlier now owed more money on them than they were worth, at least for a while. Eventually, the value for most of them did recover, but it took time.

However, what if you kept both and paid them off over time in the underwater house and money-losing boat? The liability, the loan on both, is now gone, but the asset is still there. You can sell both and generate cash. Will you make money on either? The boat is very unlikely, the house maybe; it depends on how far underwater you were and what the market did after. In both cases, once the liability is gone, you were still left with something you could sell and raise money. That is why it is essential to understand that a liability is a sum of money owed and not necessarily an object.

Calculating Net Worth

Defining a personal residence as a liability vs. the underlying mortgage on that house will lead you astray when calculating your net worth numbers. Separate assets and liabilities. Calculate the amount of both and subtract the liabilities from your assets. That is how you will figure out your actual net worth.

Here is an example:

Assets

Personal Residence: $200,000

Car: $13,000 (as valued by Kelly Blue Book)

Boat: $5,000

Stock in Amazon: $15,000

Rental Property: $100,000

Total Assets: $333,000

Liabilities

Mortgage on Personal Residence: $105,000

Car Loan: $10,000

Boat Loan: $4,500

Rental Property Mortgage: $65,000

Total Liabilities: $184,500

Assets – Liabilities = Net Worth

$333,000 (Total Assets) – $184,500 (Total Liabilities) = $148,500 (Net Worth)

Notice I didn’t define objects as liabilities in this example, i.e., the personal residence, car, or boat. Instead, I counted them as assets for their actual value and subtracted the liabilities owed on them to arrive at my net worth. This is the proper way to calculate your net worth, and this is how actual accountants, business professionals, and investors do it.

Let’s change a couple of those numbers to show you how it affects the number:

Assets

Car: $13,000

Boat: $4,500

Liabilities

Car Loan: $16,300

Boat Loan: $6,200

Assume all other assets and liabilities from above remain the same. In this updated example, notice I now owe more on my car and boat than they are worth. Are they still assets? Yes, because if I sold them for their actual value, I would still offset my liabilities by whatever I could sell them for. Yes, I would lose money on both, but I would cancel out some of the liabilities, which means they have value.

Changing the two numbers above means

Assets = $333,000

Liabilities = $192,500

$333,000 – $192,500 = $140,500

Notice by changing the liabilities to be worth more than the asset is worth for both the car and boat, which is a likely scenario, my net worth decreased from $148,500 to $140,500 because I owe more on the car and boat than I can sell them for.

What happens if I use the financial guru’s definition of assets and liabilities? Well, the house, car, and boat become liabilities by their definition, so presumably they are removed from the asset column, BUT the loans I owe for them are still there…

Guru Asset Calculations

Personal Residence: $0

Car: $0

Boat: $0

Stock in Amazon: $0

Rental Property: $100,000

Total Assets: $100,000

Remember, only assets that generate cash flow are counted. Amazon stock has value but generates no cash flow, so it is not an asset and is worth nothing, according to them. If you think I have gone too far by leaving the Amazon stock off my asset list you can add the value of the stock back in, it doesn’t change the final calculation a lot. The rental property generates cash flow, so it would still have its original value of $100,000

Guru Liabilities Calculations

Mortgage on Personal Residence: $105,000

Car Loan: $10,000

Boat Loan: $4,500

Rental Property Mortgage: $65,000

Total Liabilities: $184,500

$100,000 (Total Assets) – $184,500 (Total Liabilities) = ($84,500) Negative Net Worth

See the problem with the guru’s definition of net worth? Because I defined objects as liabilities instead of assets, thus reducing their value to zero but still having the actual underlying liabilities (debt) on those assets, I created a situation where I had a negative net worth. This is not a realistic way to discuss or evaluate net worth.

In the above example, even the Amazon stock is technically a liability because it doesn’t generate cash flow. If Amazon suddenly started paying a dividend this would instantly change from zero value to $15,000 in value simply because it now generates cash flow. I hope you see how absurd that definition is and why that isn’t useful in determining a proper net worth number and should be dismissed.

You must understand that all assets have value, and liabilities are NOT objects but represent a monetary debt owed, which may or may not have an underlying asset. For example, if I take my credit card and buy dinner out for ten friends, I might have a $500 debt, but there would be no underlying asset to offset even part of this debt unless you value fertilizer. This is how business professionals, accountants, and investors calculate assets and liabilities. It produces an actual number that is both useful and illuminating.

The Balance Sheet

In previous article, where I introduced the topic of personal financial statements, I discussed a balance sheet. As a quick review, the balance sheet lists assets at the top, followed by liabilities, and after subtracting your liabilities from your assets, you get your net worth.

The personal balance sheet is the key financial statement I work off monthly. When I started, I tracked my net worth every month. At the end of the month, I would go through and add up the value of all assets and all liabilities and calculate a new net worth number. This took a considerable amount of time and became a bit tedious. I decided that for where I was in my financial journey and the assets I owned, calculating it quarterly gave me very similar numbers and didn’t require so much work per month. Some people think you should figure it out every week! This is even more extreme in my book.

I suppose I could do it every week if my investment portfolio were large enough and I had a bookkeeper helping me track everything. It might bring some value to my life. However, I am still not convinced that knowing that number every single week would create enough helpful information to alter my investment strategy or give me useful financial information to act on. Knowing it every quarter does.

When I first came across this concept in college while reading the book Beating the Salary Trap by Richard Riffenbark, he would only calculate his net worth once a year. In the book, he said he would figure it out every year on New Year’s Day. While watching the parade on TV, he would pile all his financial records around him and calculate his net worth. I just dated myself with that example, but if I had to gather boxes of paper to figure this out, I would probably only do it once per year. Today, the task is considerably easier and faster with online resources and spreadsheets.

When I calculated my net worth for the first time, it was a profound experience for me and emotional. Without getting too personal here, I will say it was positive but lower than I thought it should be given how many years I had been working and the fact that I had an MBA and thought of myself as a decent investor and an astute businessman. It deflated me a bit to see that number. If it had been negative, I would have been seriously depressed.

Imagine if a doctor that makes $350,000 per year did this and found their net worth was negative! It is possible because a high income doesn’t automatically give you a high net worth. It might help having higher income, but you can easily have an expensive lifestyle and negative net worth no matter what income level you are at. These people are what I call the faux rich.

The Value of a Balance Sheet & Knowing Your Net Worth

The point is no matter your number, simply knowing it will open your eyes and start you on a journey to better financial health. If you don’t calculate your net worth, you don’t know where you are in your financial journey. You are like a ship captain sailing a boat on a stormy night with no instruments to guide you. Are you in the middle of the ocean or 300 feet from rocks that will sink your ship? Does your boat have 200 gallons of gas with the harbor only 3 miles away or do you have 3 gallons left and 300 miles from shore? The point is you simply don’t know. If you don’t know, you can’t improve your situation.

The personal balance sheet is the proverbial instrument that lets you guide your financial ship, showing you precisely what your assets are and how much your liabilities are at any given time. After you update your balance sheet on whatever schedule you decide is most appropriate, ask yourself this key question…

What actions do I need to take to increase my net worth?

Notice I started that question off with “what” and added “actions” to the question; this creates expansive thinking and opens possibilities instead of shutting your mind down. It helps you think clearly and draws on your creative faculties. By adding the word “action” in there, you understand YOU need to DO something to improve the number. You can’t simply sit on your backside and do nothing and hope it gets better. Can you purchase another asset, or does it make sense to sell something and pay off a liability?

With a personal balance sheet, you can calmly evaluate the numbers and ask yourself this fundamental question. You can assess the possibilities and, most importantly, take action! The action allows you to improve the situation and the balance sheet tells you what steps you should take.

When I started this, I didn’t have a model of a personal balance sheet. I knew what a business balance sheet looked like, which was helpful, but a personal balance sheet is different. I want to save you some time. Below is a link to an Excel personal balance sheet template and a video of me walking you through it. I put numbers in and walk you through how I constructed it and how to use it. 

Conclusion

It is essential to understand your net worth. If you don’t know your net worth, you can’t figure out how to improve it. You are essentially in a rudderless boat in the middle of the ocean with no idea where you are or how to improve your situation. The personal balance sheet gives you the clarity to evaluate precisely where you are and is the tool you need to improve your situation.

However, to calculate the personal balance sheet, you need to understand what an actual asset is and what a liability is. Certain financial gurus who might be popular and well-liked are leading people astray with their definitions. If you read their books or attend their seminars, focus on some of the other great things they teach, but don’t follow their definition of assets and liabilities. If you do, you will NOT have accurate numbers and will have a hard time improving your situation. Instead, use the definitions used for decades by accountants, investors, and business professionals.

Once you have all your numbers, plug them into the template and calculate your net worth. No matter what that number is, understand that you CAN make it better. It is not a financial death sentence if the number is negative or far lower than you thought it would be. It simply means you have a bit more work to do. Start by asking yourself the critical question…

What actions do I need to take to increase my net worth?

Once you do that and take action, your numbers will start improving. If you spend less than you earn and choose sound investments that include alternative investments, your numbers will improve. It is mathematically impossible to decrease your net worth if you spend less than you make, increase the wealth gap, and invest wisely.