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Understanding...My Net Worth

April 21, 2024
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Finsesh
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Finsesh

Your value as an entity and a guideline for where your net worth should be.

One of the most well-known measures for wealth. Knowing your net worth will provide you with insight into your money behaviors. We will delve into what net worth is, how it's calculated, a guideline for where your net worth should be, and some examples.


 

What is net worth?  

Net worth is the value for you as an entity. It's calculated by adding all your assets minus all your liabilities. Net worth is used to measure wealth, and having a high income does not translate into high net worth. You can have a high income but a low net worth if your lifestyle expenses are high compared to your income level. Your income needs to either buy more assets or reduce your liabilities to increase your net worth.


 

What is an asset?

An asset is something of value that you own. Assets can be income or non-income generating and they can be tangible or intangible. 

Income generating assets: These are assets that you owe that provide you with income such as investment property or dividends that you receive from a stock portfolio.

Non-income generating assets: These are assets of value but you have to sell these assets to realise their worth. Your primary home, furniture and cars are examples of these assets.

For financial independence purposes, assets that generate an income are preferred above non-income generating assets as the money spent on these assets will provide you with an income, hence reducing your time to financial independence. Examples of income-generating assets are money in your bank account, share accounts, retirement savings, investment properties, and equity in a business. Non-income generating assets are your primary residence(home), your holiday home, education plans, your vehicle, and your furniture. 


 

What is a liability?

Liability is the amount that you owe creditors. Liabilities detract from your net worth. Examples of these are consumer debt, personal loans, mortgages, student loans, vehicle finance, or other obligations.


 

Liabilities can also be broken into two:

Bad debt: Bad debt is debt that does not generate an income for you. That means you have to repay all the debt plus interest from your pocket. These loans fund our lifestyles like car loans, personal loans, retail debt, or any line of credit. At Finsesh we love debt that other people repay for us, not bad debt.

Good debt: There is no advantage to bad debt, but good debt can be a tool to leverage and create enormous wealth if correctly used. Leverage is the use of debt to purchase income-generating assets that produce more income in the future, and that appreciates in capital value, while other people repay your debt. This form of debt is the only debt we like at Finsesh, like mortgages on rental properties or sound business ventures. You need to be careful, though, because if leverage is used recklessly, it can become a massive burden and turn into bad debt quickly. 

* Heed of caution: If you're not comfortable with the intricacies of finances and the concept of leverage yet, avoid it until a later stage. 

Education and business debt can also be seen as good debt if the education comes with a high earning salary and the business venture is successful. If you are stuck in education loans for years or your business fails, it will also become bad debt.


 

Benefits of understanding your net worth

Understanding your net worth,  finding out where you currently are with your financial situation, and assessing the areas that you can improve will give you the knowledge and motivation to reach your financial independence goals. It will give you an idea of the type of debt you owe, if you are investing in assets or just spending frivolously. Your net worth provides you with a high-level overview of your financial situation.

Example: Mr. and Mrs. X have a primary home, rental property, and a Toyota Jazz all listed under fixed assets. The primary home and Toyota are non-income generating assets. They have a car wash listed under business financial assets and an EasyEquities account under Investment financial assets. Their liabilities are their house bond, rental property bond, and a small loan amount on their Toyota.

Family X has a theoretical net worth of R2,260,000 but an actual net worth of R685 000. 

In the Net Worth tool provided free with this blog, you will see an actual net worth figure and a theoretical one. Removing your non-income-generating assets such as a car and home from your net worth calculation reflects a more accurate net worth number as these assets are not generating income. It's added to give you an indication of which assets you predominantly own. 


 

Guideline for where your net worth should be

A metric used as a guideline for where your net worth should be, given your age and income, to show how good of an accumulator of wealth you are, is the following:  

Warning: If your number is not even remotely close, have faith that you will get there. 

Here it is: It's called the Millionaire next door formula. You start by multiplying your age by your gross income or realised pre-tax household income from all sources except, inheritances and divide this number by 10. This number minus inherited wealth is what your net worth should be. 

Continuing our example: Mr. and Mrs. X, both 30, earn 500 000 pre-tax income per year, from all income-generating assets. Their net worth should be R1,5 million using the millionaire next door formula. (30 x R500 000 = R15m divide by 10 = R1,5m)

Considering the millionaire next door formula, and that we want to be top quartile net worthers here at Finsesh, take your net worth number and multiply it by two to ensure you are in the top quartile. The top quartile is the number that we are going to strive for.  Dividing your net worth number by two will determine the net worth of the bottom quartile accumulators of wealth. The net worth tool will provide you with your quartile ranking based on your net worth and the Millionaire next door formula as you will see in the below example. 

Let's work further on our previous example:

Mr. and Mrs. X want to calculate if they are successful given their wealth and age relation. They work out that their net worth is R2,26 million.  Based on this, it shows that Mr. and Mrs. X are average to top quartile given the guideline. Given their age and income level, the top quartile's net worth should have a net worth of R3 million, while the bottom quartile is at R0,75 million. 

This quick net worth formula calculation gives you a range of where your net worth should be.  This formula is not a golden rule but a solid guideline. 


 

Summary

Understanding the sources that create your net worth will guide you towards financial independence. Over time you can adjust your assets, invest more in income-generating assets and reduce unwanted liabilities all to provide you with financial freedom. 

Onward to Financial Independence 

If you found this blog post helpful please follow us on Facebook and Twitter @finsesh for more tips on Financial independence.


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