When talking about financial health, the most frequent response I get to the question “are you financially healthy” is “what does that mean”? I quickly launch into the definition for emerging markets that defines you as financially healthy if you,
- Balance income and expenses, meaning you live within your means.
- Build and maintain reserves to invest in your future, smooth uneven cashflows, or handle financial emergencies.
- Manage existing debt and access potential resources, which includes ensuring you are not overindebted, using the right products, and can access additional funding should the need arise.
- Plan and prioritise to order your spending by needs and wants while still keeping aside money for savings and investments.
- Manage and recover from financial shocks through multiple financial plans such as savings and investments, diversifying your incomes, generating income from assets, or investing in insurance products that could shelter you from shocks.
- Use an effective range of financial tools. This speaks to your financial literacy and the ability to use various financial tools, and products to track and improve your financial status.
The very next question is usually, “you’re talking about budgets, right?”. Yes and no. A budget will help you achieve some of these: plan and prioritise, and balance income and expenditures. However, you need more financial tools and metrics to help with financial planning and tracking your progress. One of these metrics is your net worth.
What is net worth?
Net worth is the value in cash that you would have left if you sold off everything you own and paid off your debts. As an equation,
Net Worth = Total Assets - Total Liabilities
The result can be positive or negative. Positive net worth means that your assets exceed your liability and if you had to sell everything you would still have some cash in hand once you paid off your debts. If you have a negative net worth, you are indebted and perhaps need to invest more, earn more, clear off debts or reduce spending. If you were to sell all your assets, you would still owe someone some money.
Negative net worth is not necessarily a bad thing as there could be reasons why your liabilities exceed your assets, for instance, you’re just starting your career, and you have a student loan. Or you just bought a house on mortgage. As a snapshot in time, net worth is a good indicator of where you are financially and could help you figure out where to focus your financial efforts.
Net worth should not be confused with cash flow. Cash flow is a summary of incomes and expenses. Cash flow speaks to the now, whereas net worth measures your wealth and tells of your past choices. High net worth has no impact on your cash flow. You may be a millionaire in assets but have no income from your assets unless you sell them. Conversely, a high income does not mean you have a high net worth. You could be spending all your money on expenses or have too much debt, and thus you could have a low or negative net worth.
How do I calculate net worth?
- List all your assets:
These are all the things you own, whether you are paying loans on them or not. Assets have value and can be current or fixed. Current assets are liquid and easily accessible. Cash, loans to people or businesses, balances in bank accounts, mutual funds, and pensions fall in this category.
Fixed assets are not easily liquidated and include property (land, building), shares or equity in a business, expensive jewellery or art, motor vehicles (at the depreciated rate), etc. As you list your assets, consider those that are tangible and the intangible as well. Assets you use like furniture may not be included in your asset list. They depreciate rather quickly and are difficult to resell. If you decide to have them in your list, be very conservative with your valuation, even more conservative than your other fixed assets.
2. List all your liabilities:
These are all the monies you owe, whether formal or informal, including tax liabilities. List the total amount owed, including interest and fees at that point. Loans, credit cards, goods and services on credit, HELB, and overdue bills all form your liabilities.
3. Subtract your liabilities from your assets:
Once you have your amounts in step 1 and 2 above, subtract the total liabilities and total assets to get your net worth.
Why do you need to calculate your net worth?
There’s a lot of controversy about net worth and whether it is an important metric. Some people think that it is a superfluous metric that shows only a snapshot in time. They argue that banks only assess your willingness and ability to pay and not how much you have in assets at the time. This is true. A positive cash flow is more important for you when seeking loans.
However, net worth as a metric helps you accurately measure your wealth, showing what you could have if you had to liquidate your assets. Further, it moves the focus beyond income alone. While cash flow is essential, we know that having a high income doesn’t necessarily mean we’ll save or invest more. Even with promotions and revenue increases, we will more likely spend on lifestyle than savings. Besides, the size of your income doesn’t influence what your net worth will be. We know people with lower incomes have higher net worth due to living below their means and investing more, and people who earn more but fund their lifestyle with debt. Net worth helps you track your progress based on your investments and savings.
Calculating your net worth also avoids overemphasising asset value while ignoring debts. Yes, your car, those plots, and the house are assets, but if you have taken loans to buy them, how much of the asset belongs to you? This metric shines a light on your debt status. If you purchase all your holdings on debt, you may not be doing as great as you think you are. I know debt is an emotional conversation, but before we get into whether you should take loans or not, consider your debt to income ratio (how much you owe vs how much you earn) and debt to asset ratio (how much you owe vs how much you have in assets). Are you overindebted, are you spending on assets that don’t generate income, could you repay your loans if your bank called in their credit note?
Now that you know your net worth, what’s next?
As I said earlier, your net worth is a metric that measures your financial success, capturing all of your efforts in one place. Now that you know your net worth, you can take steps to improve it. Increasing your net worth is primarily about reducing debt and increasing assets.
- Pay off your debt: You now know that liabilities reduce your net worth so pay off your loans as fast you can. Living debt-free is a significant step towards financial freedom.
- Increase your assets: As you decide what to invest in, a word of caution. Keep an eye on the ROI. You may be purchasing assets that are good to have but don’t really advance your quest towards financial freedom. Purchase assets that save you money in the long run (house) or will generate revenue. To be wealthy is not to own assets but to generate a passive income that allows you to maintain your lifestyle, whether you continue to work or not.
- Reduce expenses and direct the savings towards investments: If you reduce your costs, you’re likely to achieve financial freedom faster. Compound that by putting the savings towards achieving your goals. If you budgeted KES 20,000 for car service and spend KES 15,000, put the extra KES 5,000 in your savings or increase your next loan instalment amount. The little savings you make every day add up, use them to increase your net worth.
- Find new sources of income: To help you save more and reduce your need to borrow, get additional income sources. The side hustle, rental income, or interest or dividends from investments can give you more cash in hand. Remember to invest this money rather than spend it. For instance, you could use your primary income for expenses and invest all your other income.
- Maximise retirement contributions: One, you get a tax deduction if you save for retirement. Two, if your employer has a plan that matches your contributions, you’re leaving money on the table if you don’t use the pension plan. Three, your retirement fund can be used as collateral. I believe these are reasons enough to start that retirement plan, don’t you?
Remember that the money you contribute to NSSF will not be enough to retire. You cannot live on KES 2,400 a year. You’ll have to make a more robust plan.
Saving and investment is about delayed gratification not for its sake but rather to put money towards the things that are important to you. These things could be important in 6 weeks, six months, six years or six decades. The idea is to have enough money to support those needs when the time comes. Net worth as a metric gives a snapshot of your current status based on the decisions you have made so far. Net worth as a metric doesn’t consider your income and by itself is not sufficient to determine whether you’re going to achieve your financial goals or not. Instead, this metric shows you how far you’ve come in your journey and highlights areas where you need to do more. If you want to motivate yourself on your financial freedom journey, calculate your net worth every year and see how far you’ve come. A word of caution, this journey takes time and you need to put in the work. It won’t happen overnight.