One of the most powerful concepts in your personal financial success is net worth. Simply put, your net worth is the difference between the value of what you own and the value of what you owe. By tracking it regularly and taking actions to increase it, you will have an exceptional foundation for your personal financial future. There are three simple steps for calculating your net worth in a way that will make it highly useful for your financial planning.
Step 1 – Calculate Liquid Net Worth
The meaning behind ‘liquid net worth’ is the amount of capital you can deploy in a short amount of time to address opportunities or emergencies. The way to calculate your liquid net worth is to add up all of your deposit accounts and investment accounts that can be liquidated immediately. Practically speaking, this will likely be your checking account, savings accounts, and stock or brokerage accounts that are not part of an IRA or 401k. From here, you subtract out any unsecured debt such as credit cards.
The result will be a comprehensive view of your short-term financial resources. This is important to know since it shows how much you can invest in an opportunity. It also shows how much you can spend to mitigate a financial emergency such as a hospital bill or job loss without going into debt. Growing your liquid net worth through savings is the method that most people use to improve their personal financial situation.
Step 2 – Calculate Encumbered Net Worth
After calculating your liquid net worth, it’s time to move on to less liquid assets. The encumbered net worth shows how much you own and owe against assets that cannot be liquidated easily. Generally speaking, the things you will see in this category are your home, any investment properties, and IRA’s/401k’s. The importance of your encumbered net worth is that it represents long-term investments you don’t expect to turn into cash anytime soon. This is the place where you should be most long-term focused.
An important thing to consider is the balance of your net worth. Illiquid investments tend to produce the best returns, but can be a trap. If too much of your net worth is encumbered, you will be unable to capitalize on opportunities or address emergencies. Keeping your net worth in balance is the method that most people use to preserve their financial stability.
Step 3 – Calculate Your Net Worth Monthly
The final key step is to regularly calculate your net worth. The reason for this is because it forces you to keep an eye on your finances. Further, it will shine a bright light on whether you are getting ahead or falling behind. When you are purchasing a new car, maintaining a net worth focus will compel you to pursue a purchase price that is on-par with the salvage value so that you do not take a hit to your net worth.
Generally speaking, the best strategy for growing your net worth is to purchase items with a mind to their long-term value. If you buy a car that you know will be worth near-zero in 10 years, it makes sense to buy one that has already depreciated. If you buy an investment property that is likely to appreciate in value and generate cash flow, it makes sense to invest sooner vs. later so that time works in your favor.
Goal: Seek to grow your net worth every month that it is measured. Accomplish this through aggressive spending, conservative spending, and with cash producing investments.