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It is always good to know where you are before you consider making any route corrections. This applies as much to your financial journey as it does to any road trip that you may take. The one number that best describes your financial situation after considering your income, expenses, assets and liabilities is your net worth.
Taken in isolation, each of these will just tell you a part of the story. A high income does not translate into a strong financial position if expenses are high and therefore savings and investments are low.
Similarly, a large asset base that is largely funded by debt may be a stress on income rather than providing stability to your financial situation. The net worth will tell you where you stand and what corrective steps you need to take to get your finances back on track.
Calculate Your Net Worth
To calculate your net worth start with your assets. Take the current market value of all the assets you own. Include cash, investments, jewellery, real estate and any other asset that has value. From the total asset value, reduce the sum of all your outstanding debts or liabilities, irrespective of how big or small the number is and who you owe it to. What is left is your net worth, and that is what you currently have to meet your needs and goals.
A positive net worth that grows steadily over time is a sign that you are securing your financial future. It means that you assets are growing in value and you are saving enough after meeting debt repayment obligations to add to the assets.
It gives you the confidence that you are on track to meet your goals. A negative net worth, on the other hand, is a call to immediate action.
If what you owe is more than what you own, you need immediate action to manage your expenses so that more savings are available to pay off your debt.
Look Beyond The Numbers
There is information beyond the numbers that can tell you what you are doing right or what needs to be changed.
A positive net worth and low debt is a good sign because it means your assets are created out of your savings. There are no claims on these and are only for you to enjoy.
Debt that is linked to assets that have the ability to appreciate—say real estate—can still benefit your net worth.
Real estate appreciates over time and adds to your net worth and a home loan is typically a low-cost loan. If you have a long list of assets but your net worth is low, then it indicates a dependence on loans instead of savings to fund purchases. There will be a stress of repayment on the income and the risk of losing the asset if the loans are not repaid in time.
In such situations, repaying debt may take precedence over saving and investing for goals. If this is not corrected soon enough, you may find yourself with not enough accumulated to meet your goals.
If your net worth is low because your liabilities, such as credit card dues and personal loans, are high then it indicates a lack of control on your expenses and the spending habits. This could be the main area that you then need to focus on to get your net worth back on track.
Chart The Course Of Action
Trends in the net worth can provide triggers for actions to protect and improve net worth. A sharp decline in net worth may trigger a review of the performance of the investments.
If the majority of your net worth is drawn from one asset, then a fall in its value will sharply deplete the net worth.
Instead, hold a diversified portfolio of assets, some money in debt, some in gold, some in real estate and some in equity; so that a fall in the value of one type of asset may be cushioned by gains in others and your net worth may see a smaller erosion.
Another reason for a sharp decline in net worth may be additional debt that has been taken on, and you may need a debt reduction plan to pay off debt as quickly as possible.
Volatility in the net worth from one period to the next may trigger a review of the extent of risk in the portfolio.
Stagnation and sluggish growth in net worth may warrant a re-look at the income and expenses of the household and devise ways to generate more savings for investments.
Have an investment plan in place so that savings are invested to work for you and not left idle in the bank.
Track your net worth regularly, say annually, and watch the trend. The growth in net worth should be high at the stage in life when income is growing and the ability to save and take risks is high.
At the stage in life when investments are used to pay for goals, there will be a slowdown in the growth of the net worth.
In the retirement stage where you are drawing down on your previous investments to meet current expenses, your net worth may start coming down.
It is, therefore, important to correlate the trend in the net worth with the age and stage in life before considering action.
Set targets for your net worth so that you can work towards building your investments and reducing debt in a disciplined way.
It will motivate you to make the right choices and bring a long term focus on building wealth.
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