The last six months have been financially challenging for most of us due to the inconvenience and trouble unleashed by COVID-19. The pandemic and the economic lockdown imposed by the government to contain its spread has resulted in job losses and salary cuts across the board.
This has been a wake-up call for many of us and forced families to reassess their financial position. This is however easier said than done. Unlike companies or the government, most of us seldom maintain a book of accounts. What most of us do is to manage cash flows and try to meet the immediate expenses with our immediate sources of income and cash inflows.
If you want to get a firm handle on your finances, the starting point should be your net worth rather than cash flows and income.
A change in net worth is the best way to gauge your financial health and its progress over time. A sharp decline in net worth will also provide you with a warning signal that your financial planning is not working. Alternatively, a steady rise in net worth is a confirmation that your finances are on track even if you may be facing some immediate hiccups in income and cash flows.
Net worth also comes handy if you want to borrow either for long-term asset purchases such as a house or a short-term loan to fund immediate needs. Everything being equal, banks will be more willing to lend to a person with higher net worth. A higher net worth will also allow you to negotiate for lower interest rate or more lenient repayment terms for the loans.
Lastly, net worth gives you a sense of your spending and leveraging power. Higher the net worth the greater is your ability to borrow against it and spend on big-ticket items or financial emergencies.
Calculate your net worth
In simple language, net worth is the amount by which your assets exceed liabilities or dues. It is calculated by subtracting the current value of all liabilities and loans from your assets.
This includes savings and current current account deposits, savings in provident funds, the surrender value of life insurance policies, cash in hand (if it is substantial), fixed deposits in post offices, corporate deposits, bonds, shares of listed companies, current value of your mutual fund units and gold and silver that your family or spouse may own.
Other assets include house, land and other property at their current market value and vehicles also at their current value. Paintings, work of art and antique furniture also qualify as assets if a monetary value can be assigned to them.
Now start counting all your liabilities. These include the outstanding amount of home loan, vehicle loan, credit card loan, personal loans, education loan or other loans.
Now subtract the sum total of your liabilities from the total monetary value of your assets. This will give your net worth. To put it differently, net worth is whatever is left after selling all your assets and paying off all debt.
Individuals with net worth of Rs 2 crore or more – excluding the house they stay in – are classified as high net worth individuals (HNIs) and get special treatment from bankers, investment advisors and wealth managers. Alternatively, a negative net worth indicates bankruptcy, at least technically. This makes it urgent to reduce your liabilities.
Ideally asset accumulation and price appreciation should happen simultaneously.
It is worrisome if you are accumulating assets but your net worth continues to decline or the rise is not meaningful. In such a scenario, you need to get out of the assets that are not growing in value or showing a declining valuation trend.
Is your net worth working for you?
This means that now you need to calculate your annual returns from the net worth. For this calculate all the income – actual and imputed – that you are earning from the net worth. This will be the total of the interest on your bank account and fixed deposits, annual dividend income from your investment in shares and mutual funds, approximate annual rent that you save by living in the house that you own (net of interest on the home loan), rent from other properties that you may own excluding interest and maintenance charges.
For example, if you calculate your net worth to be at Rs 50 lakh and it yields you an annual income of around Rs 3 lakh, the return of yield on your net worth works out to 6 percent. This is on the lower side and you may want to raise the share of high yielding assets in your portfolio like bank fixed deposits or high dividend-yielding stocks.
Lastly, compare the yield on your net worth with the prevailing interest rate on loans and see if you can leverage the net worth to get low-cost loans to invest in more assets like stocks or gold.
With an eye on your net worth, it will be much easier for you to plan for retirement or your child’s education.
(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).