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When evaluating an investment opportunities, investors often look to the financial records of companies to observe trends, opportunities, and signals that tell them whether an investment is wise or should be avoided for alternatives that are more profitable. One of the financial records examined is the balance sheet. The balance sheet is an accounting of the firm’s investment and financing decisions. When subtracted from one another, an investor arrives at an accurate representation of what the company and, consequently, the owners of the company are worth as a result of the managers’ decisions.
The same logic can be used to calculate your own personal net worth. Such a calculation includes considering your assets, debt liabilities, and future earnings. Read on to learn how to calculate your personal net worth and your individual wealth.
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The Accounting Balance Sheet Identity
Assets found on left hand side of an accounting balance sheet represent the investment decisions of a firm’s managers. This side includes cash, machinery, land, plant, equipment and anything else of value owned by the company. The right hand side of the balance sheet includes both liabilities and owner’s equity. Liabilities are anything that the company owes such as long-term debt, short-term debt, notes, and unearned revenue.
Included on the right side of the balance sheet is the owner’s equity or a calculation of what the company is worth. This value also represents the value to the company’s owners, typically the stockholders of a corporation. These two sides of a balance sheet give rise to the balance sheet identity. As its name implies, everything on the left side of balance sheet must equal everything on the right side. The balance sheet identity is given as:
Assets = Liabilities + Owner’s Equity
At first glance, the balance sheet identity does not make intuitive sense. However, doing some simple algebra, we can rearrange the identity to look like this:
Owner’s Equity = Assets – Liabilities
Now the identity makes more sense. It states that what a company is worth (owner’s equity) is its assets minus its liabilities; the company’s worth is determined by removing from its assets what it owes in debt. This basic identity is the foundation for calculating personal net worth.
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How to Calculate Your Net Worth
To calculate your net worth, first you must make a list of all your assets. This includes your house, car, cash, furniture, investments, television, IRA, and anything else of value that would significantly increase your net worth. Then you make a list of everything you owe including mortgage payments, credit card debt, loans and, again, anything that would significantly alter your net worth. By simply subtracting your assets from your liabilities, you will arrive at an estimate of your net worth.
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Several complications come into play when calculating personal net worth. These complication include handling items that represent both an asset and a liability, fluctuating market prices, and the net effects of refinancing debt. However, net worth is a simple matter of applying the balance sheet identity on a small scale. Learn how assets, debt liabilities, and future earnings are used to calculate personal net worth and individual wealth.
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Some Complications in Calculating Your Net Worth
One calculation that gives people trouble is how to handle items that represent both an asset and a liability. For example, suppose a person calculating net worth is ready to consider the value of his/her home. The individual owns the house but the mortgage is not completely paid off. In this case, the owner of the house need include the value of the home on the asset side and the value of the mortgage (debt) on the liability side. In this way, only the portion of the value of the house that is not still owed to the mortgage company contributes to the person’s assets.
Another complication in calculating net worth is fluctuating values in secondary markets. To use the value of a home again, homeowners know that house prices fluctuate according to several factors but most prominently because of general economic conditions. The consequence is a fluctuating net worth as the value of one’s assets fluctuate. This is also true for inflation. Inflation is the constant devaluing of currency due to increases in the volume of currency in a given economy. These two factors alone make net worth fluctuate in real time. Therefore, any net worth calculation is simply a snapshot of a person’s value, not unlike a balance sheet is a snap shot of a company’s value.
One more complication includes changes to net worth without an increase in assets or an elimination of liabilities. One such example occurs when an individual refinances a debt. This refinancing is usually done to reduce interest rates and take advantage of the fact that the book value of debt is higher than the market value of the same debt. When this occurs, the refinancing increases net worth without a change in either assets or the debt’s principal amount.
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Including Future Earnings in Your Net Worth
One aspect of net worth not captured with the balance sheet identity paradigm is future earnings. Companies are worth more than just a subtraction of liabilities from assets. Otherwise, the price of stocks (partial ownership is a company) would simply be assets minus liabilities divided by the number of outstanding shares of stock. Stock prices are typically higher than this number based on speculation about future earnings. In fact, stock prices rise and fall based on this very speculation by investors.
However, future earnings must be “brought back" to today; you need a way to figure all future earnings by arriving at a value of what those earnings are worth today. This can be done by using the present value of an annuity formula. This formula is given as:
PVA = CF * [((1 + r)n – 1) / (r * (1 + r)n]
Where PVA is the present value of the annuity, CF is the cash flow, r is the discount rate, and n is the number of periods.
Suppose that an individual expects to earn $40,000 per year over the next 20 years. What is the value of those cash flows at a 10% interest rate? Using the formula above, we have.
340,542.55 = 40,000 * [((1+0.1)20 – 1) / 0.1 * (1 /+ 0.1)20]
Therefore, the present value of $40,000 a year for 20 years at 10% is approximately $340,500. Forgetting to include future earning s can skew perception of what a person is worth today.
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Why Calculate Your Net Worth?
Calculating net worth is useful for several reasons. First, over time it allows an individual to consider trends in his/her net worth. This is useful because it indicates whether the trend is increasing or decreasing the asset to liability ratio. Second, net worth is a good indicator of whether an individual will qualify for a loan and what interest rate that loan will carry. Offered a high interest rate, an individual can show the potential lender a net worth figure that may shed a more positive light on the ability (or riskiness) of the individual to pay off that loan according to terms. Third, it can be a source of pride to see one’s net worth increasing over time. Such annual calculations can help an individual set and meet goals such as having a certain amount of money at retirement. Whatever the reasons, calculating net worth is simply a matter of considering what one owns and what one owes.
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Net worth involves relatively simply calculations that take into account both assets and liabilities. Like a company, assets represent investment decisions and liabilities represent financing decisions. At the individual level, these calculations are not unlike what large corporations are required to provide to the public concerning its managers’ decisions in running the firm. The benefits of calculating net worth include a measure of both practical and personal accomplishments.