Elon Musk has entered the Guinness Book of records. Yet again. But not for sending reusable rockets to space or providing satellite internet to the remotest locations of the world. Tesla’s chief has broken a record for the largest net worth lost by one person. He lost $180B to $200B since November 2021. But then, we don’t see him all that devasted. In fact, he cashed out $3.6Bn worth of Tesla shares in December 2022. What’s happening? Is he rich, or is he poor? What is net worth? And is it different from the cash in hand?
Well, that is exactly what we are going to talk about today. And while we are at it, we would also try to figure out our individual net worth.
What Is Net Worth?
Simply put, net worth is defined as your assets minus liabilities. Jargon much? Okay. How about everything you own minus everything you owe? Calculating net worth can be really helpful in evaluating the overall financial health of an individual or a company.
Oh, for the example I just talked about above; Elon Musk’s biggest asset is his shares in his company, Tesla. So when he lost $200B, that’s because the share price of Tesla tanked about 70% during that year. In fact, his worth fluctuates every moment as $TSLA is traded in the market. But then, as you can imagine, this is very different from the cash in his hand.
Positive net worth is a sign of good financial health and vice-versa.
Net Worth Calculation Explained
The calculation of net worth is fairly simple. All you need is the variables involved in the equation, like assets and liabilities. However, it is often tricky to bucket your possessions into these categories. For example, how would you treat your car? Is it an asset, or is it a liability as it is not generating any income for you? So it is worthwhile that we dive deeper into understanding these nuances.
Assets include everything that has a quantifiable and tangible value attached to it. Let us start with the car example above. Your car, although depreciating in value, still has a quantifiable number attached to it. On the other hand, possessions like a piece of art, the house might appreciate over a period. Regardless of the future value, anything that can be liquidated is considered an asset. This would also include your bank balance, insurance policies, stocks, and other investments.
Would your clothes and furniture be an asset? Most likely not. Because you can’t put a price on them and sell them in a standardized open market if need be.
Liabilities are financial obligations. This includes loans, rent, bills, or mortgages. Once again, while calculating the net worth at a given point, one needs to consider the current obligations, not the ones that are due in the future. This means even something as rent can be treated differently depending on the use case.
If the rent is paid monthly, you need to count it only once. If it is a fixed lease with a lock-in period, you might want to take the entire period as a liability. Traditionally, you simply divide your dues for the period you are calculating the worth. For example, for the month of January, your existing investments would be an asset, and the rent due for the month will be a liability.
3. Net worth
Once you have the aforementioned data, it is simply a matter of subtracting liabilities from assets. Please note that this activity will yield different results at different periods. Hopefully, your investments would grow, and loan EMIs would be coming down over a period, impacting your net worth positively. One can do this activity quarterly to assess their financial health.
So now that we have learned to calculate the net worth of an individual, let us try to put it to some use and find out how auditors use it to calculate the income of an individual.
Net Worth Method
This is an indirect balance sheet method to estimate the income of an individual. It is usually put to practice by accountants, especially when there is litigation involved regarding the concealing of income sources for evading taxes. This method involves calculating the net worth of the individual on two different dates to find out if there is any unreported income.
Let us try to formulate this process. The current net worth is denoted as NWc, and the past net worth is denoted as NWp. Please note that the exact same methodology needs to be used to arrive at these individual figures. The difference between these figures is denoted as NWI or net worth increase.
Any non-deductible living expenses (something you cannot write off for tax benefits) are added to NWI to arrive at the income value.
After arriving at this value, the declared income is compared with it, and one can easily identify the undeclared income.
A key factor to consider here is that income from legitimate sources like gifts/loans should be declared beforehand to ensure that the assessment is accurate.
NW (Net Worth) = Assets – Liabilities
NWI (Net worth increase) = NWc – NWp
Income = NWI + Living expenses
Income from undeclared sources = Income – Funds from declared sources
What Is the Average Net Worth?
As discussed above, net worth is a dynamic value. Therefore, a smart choice would be to compare individuals/companies with the average net worth. This will give you a fair picture of their financial health.
For example, the current net worth of someone who is in their 50s would be much better than someone who has just started earning. This is usually because the latter may have a lot of debts and low levels of income. Therefore, a good move would be to find out the overall average of your net worth(s) calculated over a period. This would allow you to get a realistic picture of your net worth. Since it would account for the net worth of older individuals over a period, it would be much more comparable to someone who has just started.
However, some statisticians disapprove of average as the reliable metric for comparing anything. This is because it is highly skewed due to outliers. For example, if at any point someone had taken a loan with lesser levels of income, their net worth figure would be brought down tremendously.
Therefore a better metric to evaluate is the median. The median is calculated by picking the middle value of the data set when the entire values are arranged in ascending order.
How to Increase Your Net Worth – Quick Tips to Follow
Now that you know how to evaluate your financial health, it is time to explore ways to improve it. Regardless of your current situation, good financial behavior will allow you to preserve the existing riches and create new avenues for your future self.
We strongly believe that it is impossible to improve something that you cannot track. Therefore, if you plan to improve your net worth, you need to boost your savings, and a precursor to that is to cut down on your expenses. Maintaining a budget will help you find out some avenues through which you can optimize your spending. Once identified, you can work towards fixing them.
2. Early payment
In India, the stock market index generally gives a return of 12% annually. Barring the stock-specific action, this is less than a lot of debts you will carry. For example, a credit card debt can charge you anywhere between 24 to 36 percent of interest. Therefore, it is prudent to deploy all your additional funds into repaying your debts rather than saving it or, even worse, spending it elsewhere.
The best of financial planning is often boring. If you do not have significant debts looming over your head, it is advisable to save your money. This involves dividing your money across different asset classes like crypto, stocks, mutual funds, etc.
However, one of the key missions before you embark on your financial planning journey is to maintain an emergency fund worth 6-12 times your monthly expenses. This will ensure that you do not cater to emergencies using your portfolio that is meant for compounding.
4. Start early
This is very important. Even starting early by just five years can yield a crore’s worth of difference over 25 years.
Many people try to innovate with their investments in a bid to outrun the market. However, if you simply let compounding work, it should be good enough to sustain you in the long run.
The net worth of an individual is also impacted by the network of people they surround themselves with. But then, we will stick to a more quantifiable version of net worth that simply puts your assets and liabilities in perspective. A good way to boost your net worth is by diversifying in different asset classes.
1. What does net worth depend on?
The net worth of an individual depends on two factors. The assets they own and the liabilities they carry. The difference between their assets and liabilities is their net worth. The more assets you accumulate, the higher your chances of increasing your net worth. The more debt you accumulate, the likelihood of hampering your net worth increases.
2. Does net worth increase with age?
Usually, when you are starting out in your career, you are carrying a student loan which evolves into a home loan at times. But as you grow older, your loans are repaid while your income has increased steadily. This is, however, a general perception. Usually, net worth has no direct linkage with age.
3. Does net worth include home?
Yes. A home is an asset that can be sold in case of liquidation. Therefore, your home adds to the asset side of your net worth, which, when subtracted from liabilities, yields your net worth. Please note that this is the owned house and not the rented apartment.