Personal-Finance

Why the net worth sum trumps how much you make (or your salary)

2019-11-08 10:37

One of my favourite calculations is that of net worth. It is not only meant for those who appear on rich lists, it is an important calculation for anyone working towards financial freedom. Effectively, the net worth calculation informs you if you are getting richer or poorer.

Your net worth is calculated by adding all your assets and subtracting all your liabilities. It is simply the difference between what you own and what you owe.

If your assets exceed your liabilities you are well on your way to financial freedom, but if your liabilities are more than your assets it means that you are living beyond your means.

A lot of the time people concentrate solely on their salary; they concentrate on how much they make, which does make sense, but you should ask yourself: “What am I doing with what I earn? How much of my salary am I keeping or investing?”

In a talk I gave, I asked more than 300 women how many years they had been working and how much of their salaries over their working lives they had kept to go towards their investments. The buzzing room became slightly sombre.

One of the most contested discussions around the net worth calculation is whether or not your primary residence is an asset to be included in the calculation. Understandably, your house has a lot of equity and for most people it is their most expensive purchase. The argument, however, is that you will always need a house to live in and that your house will only bring in money once you sell it. Even then, you will still need a place to stay.

So how do you calculate net worth?

LIST ALL YOUR ASSETS

Primary residence..................R1 500 000

Rental property......................R700 000

Pension/Provident fund...........R400 000

Tax-free savings account.........R80 000

TOTAL ASSETS.......................R2 680 000

LIST ALL YOUR LIABILITIES

Bond on primary residence......R1 150 000

Bond on rental property..........R500 000

Credit card............................R120 000

Overdraft..............................R30 000

Store accounts.......................R25 000

TOTAL LIABILITIES..................R1 825 000

ASSETS – LIABILITIES = NET WORTH

R2 680 000 – R1 825 000 = R855 000

From the example above, the individual’s net worth is positive, but the reality is that for many South Africans the picture looks very different. The net worth for most individuals and households is in the negative.

With people driving in cars they cannot afford, purchasing homes that are too expensive for them to live in and racking up debt to fund their lifestyle, no wonder many do not focus on net worth as a measure of wealth.

Net worth tells you whether you are progressing financially or going backwards. It does not matter how decent a salary you earn, what really matters is what you do with it. You can either use your salary to get more credit, thereby incurring more liabilities, or you can use it to accumulate assets.

There is no ideal net worth number. Every financial situation is unique. What is a financial goal for one individual will not be so for the next person; it all lies in what you set for yourself or as a family.

One of the questions I often get asked by couples is: “How do we manage our money as a family?”

My advice is that you set financial goals as a family, for example, you could want your collective net worth to positively increase by 10% at the end of next year. This helps you focus on the bigger goal, which ultimately helps you make better financial decisions every day. But this is also applies to individuals.

This kind of thinking about your net worth is a much broader view of your finances. Like a balance sheet versus an income statement, if you want a positive balance sheet, it affects the choices you make in the income statement.

Calculating your net worth at least once or twice a year provides a good indication of where you stand financially. These are some of the ways in which you can improve your net worth:

1. Squash debt

Debt is expensive, it costs money. The interest rate charged on most debt is quite high and it eats away at disposable income that you could potentially invest. Before you think of saving or investing, you should work at paying off your debt first. This will decrease your liabilities and move you closer to a positive net worth.

2. Live below your means and invest the difference

Living below your means is a simple money principle, and yet it eludes many. It affords you the freedom to save and invest. Do not get trapped in lifestyle creep, whereby the more you earn is the more you spend.

3. Invest, don’t just save

The market can be an intimidating place and the financial services industry doesn’t make it easy. With abbreviations such as RAs (retirement annuities), ETFs (exchange-traded funds), TFSAs, among others, one can easily get overwhelmed by all the jargon. This is one of the many reasons some people just save and don’t invest. The purpose of investing is to earn inflation-beating returns so that your money will have purchasing power when you need it. Don’t get overwhelmed by choosing which share/company to invest in, just get your foot in the market.


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December 8 2019