What is value of Net Worth?
In personal finance, Net Worth is referred to as an individual’s financial state at a given point in time. In a very simple form, it is the value of assets minus the value of liabilities.
When we individuals include all the assets in our financial planning, we tend to include value of our house, value of car, and other capital goods items. Here I am talking about assets that we use in our daily lives (not the ones we use as investments). The way I look at it is, instead of tying my financial resources in non-performing assets, what if I used it to generate more cash flow. If I have one million dollar, and I buy a house, then my capital is lost. It is not going to generate more money. Well yes, anticipating value appreciation and expecting to cash in 20+ years down the line is the different issue. Even after 20+ years, one will need a place to live! To buy a house 20 years down the line one will perhaps need more money (time value of money and inflation!), and if one does not down size, perhaps all the capital appreciation will go into a new place.
In addition, net worth is a moving target in a sense that external sources (beyond my control) drive it. I cannot control how to manage it. I cannot control its progress. So how will it help me in my goals?
Among others, I believe increasing cash flow is very significant element of wealth creation. Using available resources to increase one’s cash flow will increase your wealth. If I have a million dollar, I would use it to open MacDonald or Dunkin Donut which will generate continued cash for me, instead just of tying it up in non-performing asset which I use in my daily life.
Suffice to say, I do not use Net Worth as a benchmark, or as measure of progress. In my financial planning, the use of Net Worth is worthless. It does not provide me an effective way of measuring my goals or progress. Therefore, I address these assets as current expenses (house of living, car for diving, etc).
What are your thoughts about Net Worth? How does it help you measure your financials goals?
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I personally do use Networth Values, both Short-Term and Long-Term. However, I refuse to use the cash basis of Accounting for Networth Values as the cash basis doesn’t give you a true picture.
As Dividend Tree pointed out, it is true, things like your house doesn’t have an income producing, but it still has expenses related to it. However, I think Dividend Tree is erroring in that he is thinking from the cash basis of accounting point of view, not from the accrual basis of accounting point of view.
Okay, so you are asking, what is the difference?
Cash basis doesn’t take into account any of the so called paper transactions such as interest earned/incurred, but yet not yet paid in/out, or depreciation on long-term assets. Accrual basis on the other hand does take these things into account so as to give you a more true picture of where you stand.
Now, don’t get me wrong, we all need a safe haven, so as not to end up building a house out of cards, thus we have to factor that into our personal finances. However, a lot of people look at depreciation as it’s bogus and rediculous to take into account. I’m about to explain why it’s NOT bogus and why it needs to be taken into account, but for reasons different from what’s given out there in the business world.
First, let’s get into the meaning of depreciation. As you use such long-term assets like a car or a house (yeah yeah, I know all about the argument a car depreciates the moment you take it off the lot, but I’m also going to dispel that myth too under the assumption you were truly planning the real purpose of purchasing such long-term assets), the value of it is going to decrease as time progress as a result it’s man made and like anything else that’s man made, it has a limited useful life time period (rather if it’s via years or units of usage) Some long-term assets (those items lasting longer than a year) will depreciate at a faster rate in the beginning (such as a car) as a result of needing more repairs down the road than other assets will (such as a house). If you want to continue to use these long-term items over time, you will either have to repair them or replace them, thus there’s a cost to that. That’s where depreciation initially came from. Note, the moment you purchase the long-term asset, you didn’t use very much of it if any right at that point, so why would it lose 50% of it’s value from a usage stand point of view? Yes, true, you can’t sell it back to the dealer for the price you bought it from the dealer, but that price difference is more of a function of finances (note, we also hitting up on economics with such things like sunk funds), not a function of usage.
Of all TANGIBLE items you will ever purchase (Note, things like stocks and bonds are not tangible items in the realm of Accounting), all of them will have some form of depreciation on them. The ONLY EXCEPTION to this rule is the land you purpose. Note, even when you purchase a house, the house and all “LAND IMPROVEMENTS” are depreciable, but the land itself IS NOT depreciable.
Why then do we have so much issue figuring out the real networth value of such businesses? To be quite frank, if you are realistic, it isn’t that hard to do and pretty easy to figure out. However, like most other people, business managers will fudge the real numbers to get the numbers to read what they want them to read, and that’s where the problem lies at.
Okay, so now people are telling me they don’t use depreciation for any such purpose when it comes to repair/replacement of such items. People generally think of 3 main reasons why depreciation is used according to most people:
Business (cause it’s required. However, this requirement came about from the fiasco that took place in the roaring 1920 when business managers lied to the banks and thus the banks failed when the banks couldn’t get their money from the businesses that lied to them.)
Taxation (yes, from a business point of view, we also have taxation, which depreciation of long-term assets lowers our tax bills)
Charity (Even on a personal matter, we have to at times depreciate our long-term assets in order to come up to a remaining cost basis donated to report on our Schedule A.)
Fine and dandy, but none of these 3 reasons apply to me with regards to our household’s personal finances. I however have 3 other reasons for it.
First, what does that long-term asset really cost you over time (TCO or Total Cost of Ownership)? In order to determine this, you have to figure out the depreciation rate on such long-term assets, preferably using US GAAP rules. This means you have to go back to the initial time period you purchased the long-term asset assuming you went through the appropriate steps such as determing it’s total cost to put the item into usage, how long it’s expected to last, and which depreciation method fits the item best relative to what’s expected over the useful life time period in regards to repair/maintenance expenses.
Second, you should use this depreciation schedule to put off to the side of that same amount of money as what the depreciation schedule show, so as you can repair/replace such long term assets.
Third, if you do the things in the first 2 steps, you have just went on your way to avoiding having to take out a long-term debt.
Now there’s my 3 reasons for using a depreciation schedule. This depreciation schedule also impacts our Networth values. If done properly (note, if you lie about this, you are only lying to yourself and only hurting yourself, so be smart about this), you can still base some of your goals off of the networth value. Don’t get me wrong, there are some limitations to it, but it’s not 100% bogus as a lot of people make it out to be. As for which Accounting method to use, I personally will NEVER use the cash basis of accounting. I will ONLY use the accrual basis of accounting. Cash basis doesn’t give you a true picture of where you stand financially.
Note, when you are having to take a debt out on such long-term assets, that cuts into your ability to put money into investments where it really counts. Not only that, but that interest charge is a negative to your daily residual income while the earnings on your investments (assuming it’s a profit, not a loss) is a positive on your daily residual income.
As for financial goals I use:
1 goal set against Short-Term Networth Value (note, all assets except retirement funds minus all liabilities except expected taxation on retirement funds). This goal is for the purpose of looking at the big picture of the here and now as we are not fully to the spot we need to be at. For right now, it’s set at increasing ST Networth Value by a minimal of $12,000 per year.
1 goal against daily residual income improvement (this year, I made an exception to this goal given another major goal I been working on which basically made this goal next to impossible to meet), which is set at $3.65. May seem easy, but that is how much residual income you increase it by for a single day with the money you put into investments or how much do you reduce your daily residual expense by paying down debt.
25% of “ACTUAL GROSS INCOME” must go to countable savings (Net contributions into retirement funds, Net debt reduction, net contributions into emergency fund). Note, amounts taken out of either of the 2 funds counts against this goal and an increase to debt counts against this goal. However, cause there are those bad years, one need to shoot for 40% in the good years.
Can’t state enough how important the sacrifices that go into wealth creation are.
Curious if anyone has caught this book yet? “The Richest Man in Town” by W Randall Jones. I’ve read half of it so far and let me tell you it is well worth it. Would like to hear what everyone else thought of it?
http://www.richestmanintown.com
mei,
I haven’t read it yet. Thanks for the suggestion.
Best Wishes,
the concept of networth is another crap created by wall street. it cannot be validated. it is very subjective. they created it to bump up their own bounty. they bump up the false sense of value, but they take bonuses in cash. they make smart moves, only for themselves.
Personally, I don’t calculate a true net worth. I only calculate my cash, investments, and debts. Having a positive net worth is good so that you’re not over leveraged with debt, but after that it’s just a feel good metric. Like you, I’d prefer to track cash flow or income replacement.
Slinky’s last blog post..Victory is mine!
Slinky: Good to know we have similar approach. Thanks for stopping by!
DGI,
I believe current financial collapse is combination of many things, and not only the individual consumers. If individuals chose to take those mortgages, then the smart (qualified, knowledgeable, six figure salaried wall streeters) financial investing community were more than happy to lend to these crappy consumers. If I fail the exam and still get passing grade, then my teacher and the university who appointed such a teacher is also at fault. Not me alone.
I am certainly for owing a house. There are no two thoughts about it. My viewpoint is about using it for net worth which provides a false sense of richness. Treating the mortgage payments as expense out facilitates the real benefit. Because it is not available now. This false sense of richness results in re-tapping of housing equity. Another way to look at this is, it gives a false impression of net worth which is tied as housing equity, which in turn is worthless for wealth building. As you folks mentioned it is only a very good inflation edge. Above all it is a place to live, not to be cashed or measured in net worth.
Thanks for leaving your comment. I like the discussion.
Best Wishes,
I agree with dividend growth investor. Owing a house is always a better deal. But I also believe net worth is crappy because it gives a false sense of wealth, which is not there. It is just a financial jugglery spread by financial cheats at wall street. And you need two hands to clap, same way, if people screwed up then folks in financial services facilitate the screw up.
Even though income generation is important saving money by investing in a house is important as well.
It’s true that 1 mln opens a mcdonals franchise, which could earn you say $50K. But what if you decide to rent out a house worth $1mln ( since you need a place to liv anyways) whose rent is also $50K/year. Would you be better off owning a home and not renting, or owning a franchise and renting?
I would personally own a home and hedge myself against rent increases and inflation since I need a place to live no matter what. People who think they could use the money they need for living expenses are responsible for the current financial collapse.