Net Worth / The Engine
This is an excerpt from my e-book “Principles of Prosperity,” available now for free download. In chapter three, I introduce the idea of Net Worth; the engine of your financial life. We’re picking up just after the formation of value-centric goals. Then I begin discussing the best way to achieve those goals. Here you’ll read why creating a balance sheet and determining your net worth is the best place to start.
Stripping naked in front of your adviser.
OK, you have your values and goals and are ready to move on. Now, about those financial statements I mentioned…
Some financial planners call this part of the process “stripping naked in front of your advisor.” Yikes. As terrifying and triggering as that might sound, I honestly can’t think of a better analogy. Bearing your entire financial condition and related details can leave you feeling very vulnerable. But remember, this is an important part of the planning process. You are where you are. If bearing your financial soul seems like an embarrassing task, remember a few things:
Your financial planner has seen it all.
They have likely seen much worse.
Your financial planner isn’t judging you (or they shouldn’t).
Your financial planner is on your side (at least they should be).
The more information you provide, the more comprehensive your plan can be.
If your planner does find any issues or deficiencies, they should view it as an opportunity to help you and demonstrate their value.
Your personal balance sheet.
Now that your financial planner knows more about you than you ever hoped, it’s time to take a closer look at your overall financial health. Usually it’s a good idea to start big to get a broad sense of your financial situation. To do this, we use two main financial barometers to gauge your health. They are your net worth and cash flow. (More on cash flow later)
Your net worth is found on your personal balance sheet. The balance sheet is a document that provides a cross-section of your financial health and wellness. It combines all your assets (things you own that have value) and liabilities (debts and other financial obligations) into one clear financial picture. These items are then added together to provide a tidy number, known as your net worth. Think of your net worth as a crude estimation of how much cash you would have if you sold everything you own and paid off all your debts. Your financial planner can create a balance sheet for you, but you can make a simple one yourself. All you need is a piece of paper and a calculator. It should look something like this:
* Many financial experts refer to “assets” as only those things that increase in value or create income. For your balance sheet, include anything that could be sold for value. This applies regardless of whether its value is increasing or decreasing. There are many online resources to use to find values for your home, car, and other common items. If you feel the need to hire an appraiser, feel free, but your financial adviser should be able to help.
If you’re going alone, be more conservative when estimating values of assets. Of course, include all debts in your liabilities column.
Once you or your planner has combined all your assets and debts together, finding your net worth is as easy as:
Extra credit: After finding your net worth, try figuring out your debt to asset ratio. This is done by dividing your debts by your assets. This number tells you how much of your assets are offset by debt. If you have a debt/asset ratio of 50%, this means that 50% of your assets are offset by debt. Most lenders favor this ratio between 35-40%, but obviously the lower the better.
So now that you know your net worth, what does it tell us besides what you would have if you decided to become homeless? Most practically, it gives us a handful of insights into your financial health. First, we can see how much debt you have relative to your assets (see “extra credit” above). This number is hopefully less than 1.0 and should get smaller as you grow older. Second, the balance sheet helps us understand what types of assets and debts you hold. For instance, a mortgage balance of $200,000 is much different than a credit card balance of the same amount! Also, $200,000 equity in your home is much different than $200,000 idling in a savings account.
By examining your debts and assets, we can form a clear picture of how your financial life is balanced. Each category impacts your net worth differently, and some can impact your financial health more than others. I think of each asset and debt as a separate lever in a machine. Each lever a different size and affecting the overall machine differently. This analogy is why I like to call your net worth the engine of your financial health.
Once you have an accurate balance sheet, you and your planner can determine a few important things:
First, by looking at the various levers in your engine, changes and adjustments can be made to optimize future growth.
Second, different “levers” are uniquely helpful or harmful to different goals. Your planner will help clarify how these levers can be maximized in order to meet your value-centric goals.
OK, so you have your personal balance sheet and net worth. Now what? Time to take a look at those goals again. Now that you know your net worth, do your goals seem more or less reasonable? Don’t make any drastic changes yet; again, a planner can help bring that picture into focus.
Regardless of how far away you might be, you’re about to start heading in that direction. Now it’s on to making that engine grow, or finding a better way to fuel it.
