I'm sure you would never know this due to my fantastic good looks and charismatic personality, but I majored in accounting.
Accounting has been called the language of business, and throughout my education at the great University of Arizona, we were taught what seemed like thousands of equations to help analysts and accountants understand if a business is in a strong financial position or not.
The most commonly used equation is the net worth equation. Luckily, this is one of the rare exceptions when something you learned in school is actually applicable to your individual life.
I use the net worth equation more now than I ever did in college, and you can use it to help understand where you are and where you want to be.
Your total net worth is the dollar amount found by subtracting your total liabilities from your total assets (Net Worth = Assets - Liabilities).
Knowing your net worth, and how to increase it, is the first step towards financial success. For a typical recent college graduate, net worth is zero or negative. Most graduates have student loan debt and do not own any homes or investments.
By the time they have a family or enter their 40s, most people have a small, but positive, net worth. By the time retirement comes around, people have to start living off of their net worth, so they do their best to build it large enough to sustain them for a few decades.
The way to grow your net worth is two-fold:
1. Pay off liabilities
2. Purchase assets
This brings us to the next logical question: What the hell is an asset and liability?
- Assets are anything that you own.
- Financially speaking, the most common asset is cash.
- A checking account, saving account, or investment account all classify as assets.
- Lines of debt or credit cards are not assets, because you don’t own those.
- Common large assets are homes, businesses and collections (art, jewelry, cars, boats, etc.).
You want to purchase assets that gain value over the long run. Examples of these are stocks, bonds, land, homes, buildings and businesses -- anything you can sell for a profit in the future.
The best assets are assets that grow without you having to do work (i.e. mutual funds or royalties). The worst assets are assets that decline in value over time; cash, cars and technology are prime examples of these assets.
- Liabilities are anything you are liable for. That means anything you are responsible to pay back.
- If your parents give you money for your birthday, they don’t expect that to be paid back. If your parents give you a loan to go to school, they probably expect that be paid back. The latter is a liability.
- Credit cards, loans, mortgages and any other kind of debt is a liability.
Liabilities are important because they negatively affect your net worth, so by shrinking your liabilities, aka paying off debt, you grow your net worth. Unfortunately, almost everyone needs to utilize liabilities in one form or another.
Which brings us to the next logical question: Which liabilities are acceptable?
It's never a good idea to use liabilities to purchase things you can't afford. Buying a house that is above your means or buying a sports car when you can't make a payment on your '02 Ford Focus doesn't make sense.
Do use liabilities to purchase or start a business. In the same train of thought, use a loan to finish your degree, but be sure the degree will be able to pay off its own loan.
You wouldn't take out a loan to start an unprofitable business, so why would you take out a loan to finish an unprofitable degree?
To bring everything back together, let's run through a quick example of how assets and liabilities play into your net worth.
Hypothetically speaking, Bob has a $25,000 student loan and a checking account with $5,000 in it. Bob has a -$20,000 net worth. (See how Bob's salary doesn't matter at all in this equation?)
Let’s say over the course of a year, Bob pays off his student loan. Bob now has a +$5,000 net worth (because of his checking account). If Bob starts investing the next year and ends the year with $10,000 in his IRA, Bob’s new net worth is +$15,000 (IRA + Checking Account).
If Bob buys a house worth $200,000 but only has a mortgage of $150,000, Bob’s new net worth is +$65,000 ($200,000+$5,000+$10,000-$150,000).
This is a fantastic example of how paying off liabilities, investing and purchasing an asset at a discount can increase your net worth.
A quick way to ensure you are always working at increasing your net worth is to create a reminder in your calendar every year on a certain date (birthdays or New Year's Eve work well) to recalculate your net worth.
Your net worth number is the ultimate judge of whether or not your finances are in order. It is not your income, and it is not the value of your IRA or 401(k). Your net worth has the ultimate say on whether or not you are where you should be, so where are you?
Where do you want to be?