Far too many people don't understand their true financial position. They take a glance at their checking account every once in a while and assume that number tells the whole story.
Most of the time it doesn't. To understand your true, full financial position you have to understand the concepts of net worth and liquidity.
What Is Net Worth?
Net worth is the sum total of what you own and what you owe. This extends well beyond how much money you have in the bank. In financial terms, net worth is the sum of your assets and your liabilities.
What Are Assets?
Your assets are everything you own that has tangible value. Yes, cash counts toward this, but so do all of your major possessions as well. If you own a car or property, these are assets. Any stocks and bonds you have count too. So would a comic book collection, a piece of art or a signed baseball card. Under a particularly thorough accounting you would probably even include your living room furniture.
Essentially, anything you own which could sell for a non-negligible amount of money counts as an asset. Generally accountants tend not to consider various pieces of personal property under assets, so you wouldn't likely include your TV, novels on the shelf or the food in your refrigerator. All of these are technically assets, but would likely have minimal value if you tried to convert them into cash.
What Are Liabilities?
Your liabilities are any defined, enforceable debts or financial obligations. This typically includes categories such as credit cards, student loans, mortgages, car loans and rental payments.
The standard model for liabilities looks only at actual debt. This is money that you have taken out and currently owe or money that you currently owe for rendered services. For example, if you pay your cable bill at the end of each month, that month's bill is considered part of your liabilities because you have received the service (a month of cable) but have not yet paid for it.
The next month's cable bill would not be part of your liabilities, as you have not yet incurred that debt.
As a result, a typical liability calculation does not include the rent that you pay on an apartment lease. Although this does create a contractual obligation, under the standard terms of a residential lease you owe the money in advance of receiving services (that is, you pay the rent for a given month at the beginning of that month). As a result, you have an obligation but not technically a debt.
Nevertheless, people who cannot get out of their lease (for example, if the terms of the contract or local laws prohibit subletting or assignment) should probably include its full value in their calculation of liabilities.
Calculating Net Worth
Calculating net worth is an exercise in tallying up all of your assets then subtracting all of your liabilities.
You will start with all of your cash and cash-like assets. This includes the balance of your bank accounts, the value of your investment portfolios, etc. Only use current values. Don't include any estimates for future growth. Your net worth is what you have at the time of calculation.
Next, take the current market value for all of your major assets. This includes any property that you own (for example if you own your home), your car, if you own any other vehicles like a boat or motorcycle, if you have a stake in any businesses, your retirement accounts, etc. Remember that these assets can appreciate or depreciate over time; vehicles in particular will typically be worth far less than you paid for them. For anything on which you pay property taxes, the government valuation of the asset's value is typically a safe valuation to use.
Finally, take the value of any other assets you own. This will include the cash value of any insurance policies on which you can collect, any debts that someone else owes you or personal property with significant value (such as art, memorabilia or a marketable collection). Once again remember that the price you paid for something is not necessarily the price that it is worth. Just because you bought a TV for $500 doesn't mean it's a $500 asset. The only question is how much you could sell it for.
The sum value is the total collection of your assets.
Next, list your liabilities. You will start with your immediate liabilities. These are any debts due in full within the next year. This typically includes any bills that you currently owe (for example, if you hired a plumber but have not yet paid him), any unpaid taxes and any credit card debt. (Credit card debt is considered a short-term obligation even though you can pay it off over a period of time.)
It is not technically correct to include monthly bills for services and utilities in your list of liabilities because you don't actually owe this money. While you might intend to spend $120 per month on a cell phone, as long as you could cancel this service at any time it is not a liability from an accounting standpoint.
Next, account for all of your long-term debts. This is money that you owe which is due over a period of time longer than a year. It typically includes debts such as student loans, home mortgages and auto loans.
Finally, include any contractual obligations that you might owe. This is an unusual category for the average individual. Here you would account for any money that you owe someone through a binding contract even if it is not actually a debt (that is, you didn't borrow that money). Typically, you would have accounted for this in the first step when you tallied up any unpaid services rendered.
The sum value is your total outstanding liabilities. This is all of the money that you absolutely owe to other people.
Subtract Liabilities From Assets
Subtract your total liabilities from your total assets. This is your net worth. It is the calculation of how much you would own after you paid all of your creditors in full.
For example, let's say Sally has $150,000 in a retirement account. She owns a house assessed at $250,000, and she owes $100,000 on the mortgage, and has no other debt. Her assets - the retirement account and the house - add up to $400,000. Subtract the $100,000 mortgage owed, and you get a net worth of $300,000.
It is quite possible for the number to be negative. This means that you owe more money than you currently have.
What Is Liquid Net Worth?
Liquid net worth is the portion of your total net worth that is held in cash or which you can easily turn into cash. Basically, the calculation of your liquid net worth is "how much cash can you get quickly if you needed it?"
The rule of thumb for liquid net worth is essentially "cash plus anything that you can sell within 24 hours." Technically anything can be sold quickly. If you put up a Craigslist ad offering to sell your three-bedroom home for $28, odds are you could move that property in less than a day.
So there are two ways of calculating liquid net worth.
1. Cash plus all cash-like assets
Under this method, you will first tally up all of your cash holdings. Then you will include the contents of every investment portfolio that you can sell relatively quickly. This includes Treasury securities, but you will calculate them at present value not at their value upon maturity. (Treasury bills and bonds are generally considered highly liquid, since you can almost always find ready buyers for them.)
Don't include investment portfolios that have restrictions on liquidation. Do include your retirement accounts, but reduce their value for the tax penalties you will owe on taking money out early.
This is the quick and dirty method of calculating liquid net worth, and is generally accurate.
2. Cash, all cash-like assets and an estimate of what you could get for your major illiquid assets
To liquidate something is to turn it into cash. This is why stocks and bonds are considered highly liquid assets, because you can quickly and easily sell them for their face value. An illiquid asset is something that you can't easily turn into cash. It includes property like land and vehicles because the process for selling these assets tends to be fairly involved and takes time.
Even the most illiquid asset has a price at which you could move it quickly unless you are blocked from doing so by contract or law.
To calculate liquid net worth under this process, you would first do the calculation above: all cash and cash-like assets. Then you would consider your major illiquid assets and estimate how much you could sell them for in 24 hours or less. Add this to the total and you have an estimated liquid net worth.
The problem with using this process is that it results in a highly speculative figure. You're essentially guessing at what would happen if you tried to launch a fire sale and cannot be certain that your numbers are right.
Remember not to Include Liabilities
One key difference in calculating liquid net worth is that it does not typically involve liabilities.
Again, use the 24-hour rule of thumb with this calculation. If you have money that's due within the next day, assess that in your liquid net worth. This will impact your ability to put cash into your hands quickly. Other than that, liquid net worth is a pure, short-term cash position. You will not include liabilities.
Why Net Worth Matters
Understanding your net worth is critical to understanding your personal finances for several reasons.
It Tells You if You Have a Negative Net Worth
Don't panic if your net worth is negative. This is quite common, especially among young people who owe student loans. (In fact, many graduates will not have a positive net worth again until they are in their 30s or 40s.)
If you have a negative net worth the most important thing to figure out is why. If your net worth is dragged down by long-term obligations, this might not be so bad. If it has been dragged down by value-add obligations, such as an investment property or student debt, you might actually be just fine.
On the other hand, if your net worth is negative due to short term obligations like a credit card balance or unpaid bills, this is a much bigger issue. Which brings us to the second point:
Net Worth Tells You Where Your Money Is Going
Calculating your net worth is a good way to get a picture of how you're spending your money and where you have it invested. It can let you understand if you are spending too much money creating short-term debts or on things that don't create value. It can also give you a good picture of how much of your money is tied up in big, illiquid assets.
There's nothing wrong with having your money invested, in fact it's a very good thing. Just be sure you could also get access to cash in an emergency without having to tap into your 401(k).
It Helps You to Create a Better Financial Plan
Finally, understanding your net worth helps you to plan for your own financial future.
Put simply, you can't make a plan around something you don't understand. Unless you know where your money is, what you owe and how much you actually have, you can't accurately plan for the future. There's a good chance you'll keep getting to the end of each month surprised by how little is left in checking.
Net worth lets you look at who you owe, what you have and where it's going, and from there you can plan your next steps.
Introducing TheStreet Courses: Financial titans Jim Cramer and Robert Powell are bringing their market savvy and investing strategies to you. Learn how to create tax-efficient income, avoid mistakes, reduce risk and more. With our courses, you will have the tools and knowledge needed to achieve your financial goals. Learn more about TheStreet Courses on investing and personal finance here.
It's never too late - or too early - to plan and invest for the retirement you deserve. Get more information and a free trial subscription to TheStreet's Retirement Daily to learn more about saving for and living in retirement. Got questions about money, retirement and/or investments? We've got answers.