Quite often we tend to confuse our net worth with the value of our total assets. That is only partially correct. To be precise, your net worth statement is the value of your assets adjusted for your outstanding loans and other liabilities. The result is the net worth. Why is a statement of net worth important? You need this to understand where you stand in terms of your wealth in net terms. When you apply for loans from banks, a certified net worth statement can go a long way in strengthening your case. In case you are looking at securing a visa to the US, UK or any of the European country then again your statement of net worth is a critical document.
So, let us understand what is net worth of a person and hot to determine your personal net worth. How do you calculate your personal net worth and what are the adjustments that you need to make to the same to give a clearer picture. Let us look at the illustration below of a personal net worth statement and how it is broken up..
The idea of the above classification is to ensure that your liquid assets are sufficient to manage your short term liabilities. In case of other assets the market value of investment assets matters more and the statement of personal property is normally only of theoretical value. Let us now look at the key steps to calculating and documenting your personal net worth..
1. List down your assets based on appreciating and depreciating assets
Make a detailed documentation of all your assets. Classify them between assets that can be easily liquidated and those that cannot be easily liquidated. For example, personal belongings like furniture, two wheelers, cars, appliances, computers etc start depreciating on purchase and their market value is always lower than their purchase price. On the other hand in case of investments like equity, mutual funds and bonds, the value of these assets is normally higher than the purchase price. Within this category we need to further classify into highly liquid assets like savings, liquid funds and other long term assets.
2. Value these assets on the appropriate benchmarks
Imputing value is always a simple job for assets that have a ready secondary value. We can directly consider the market price of equities, mutual fund NAVs and bond prices in the statement. Remember to make a provision of 15-20% for volatility in the prices of these assets or use average price of the last 6 months. Valuation becomes a lot more complicated in case of unlisted shares, art and artefacts, vehicles etc. Here you will have to use the closest benchmarks. The idea is to be as conservative as possible when valuing assets so that your net worth statement is not overstated. Also make a small provision for bad debts when you have given loans to others.
3. Make a list of your short term and long term liabilities
There are all kinds of payables. They include your mortgage loans, your car loans, your personal loans, your credit card outstanding etc. The short-term payables maturing in the next 3 months must have sufficient liquidity cover to avoid a payment mismatch. Also make a distinction between static liabilities and reducing liabilities. Typically, when you pay EMI on your home loan or car loan, the principal outstanding also reduces each month. That needs to be factored in to get a clear picture of your long term liabilities outstanding.
4. Put a value to your liabilities
Valuing liabilities is a lot simpler, unlike assets where there is a valuation question. There are a few additional adjustments you may have to make. To be more realistic your outstanding liabilities should be valued based on how much will have to pay to close the loan today. Normally, when you close the loan you don’t just pay the principal outstanding but also an exit charge or a prepayment charge. Factor that and 1 month’s interest also into calculations to make them more realistic and reflective.
5. Calculate your net worth statement and analyst maturity mismatches
Once your assets and liabilities are completely enumerated and valued then you can calculate the net worth as the excess of your assets over your outstanding liabilities. Here your net worth statement is reflective as on that date. You need to however mentally adjust this number for two items. Firstly, make a provision for maturity mismatches if your short term liabilities are greater than your liquid assets. Distress sale of long term assets has a cost and that needs to be factored. Secondly, some of your asset values may be highly volatile, especially if you are exposed to risky equities or risky mutual funds. Try to provide a 10-15% market risk provision depending on volatility to make your net worth statement more realistic.
6. Make a provision for your contingent liabilities
What do we understand by contingent liabilities? These are not actual liabilities in the strict sense of the term but have the potential to become future liabilities in the event of certain conditions. For example, if you have guaranteed a loan for a friend or a relative then it becomes your liability if that friend of yours defaults. There is another case when some property of yours is under dispute and while you may still show the asset, you will have to ideally provide for the contingent liability too.
Your net worth statement is something your bank will issue or an auditor can certify. That is a valid document for a variety of purposes from asset purchase to loans to visas. Above all, it gives you a clear picture of whether your personal equity is positive or negative!