Cover image credit: Balance Scale by Sepehr Ehsani is licensed under CC BY-NC-ND 2.0.
One of the most important quantities in personal finance is what’s known as your “net worth” (NW).
So what is your NW?
Quite simply, your NW what you own minus what you owe.
A digression – LCU
Before we express NW quantitatively, let’s digress a bit to talk about the units of currency. Since different countries in the world use different currencies, in order to keep our writings accessible to everyone around the globe, we’ll use the invented term “local currency units” (LCU) to denote monetary quantities. When reading our posts, you should translate LCU to the local currency of your home country, e.g., in India, LCU stands for INR, in US, it stands for USD, in Europe, it stands for EUR, in Canada for CAD, etc.
Back to NW
Let’s take a very simple numerical example to understand how to compute your NW. Suppose that the only thing you own in the world is a house worth 100,000 LCU, but owe a loan on it for 80,000 LCU1. Then your NW (in LCU) is:
$$ \begin{equation} 100000 - 80000 = 20000. \end{equation} $$
Before we go any further, it’s important to emphasize that this technical definition of NW has nothing to do with its literal meaning. In other words, your worth as an individual, e.g., to your family or society, has nothing to do with what’s defined as NW in the financial sense. There are plenty of people in the world who don’t have a high NW, but yet mean the world to their families, as well as those who may have a high NW, who don’t mean much to their families.
The importance of NW in personal Finance
The reason why NW is so important is that it allows you to cut through all superfluous details to really get an accurate picture of your financial situation. For example, if you drive a fancy car, and live in a fancy house in a fancy part of town, you may be able to give off the appearance of being very wealthy to others2. However, if you had to take out a loan to buy your fancy car and house, and have barely enough money to support your fancy lifestyle along with paying down your loan, then in reality your NW is very low. That is, you’re actually not as wealthy as you might think or lead others to believe!
Thus, NW can serve as the mirror that faithfully reflects your financial picture.
Keep in mind that NW is a snapshot-in-time picture of your financial situation. If your NW today is higher than it was a year ago, it means you’re richer today than you were a year ago. Similarly, if your NW today is lower than it was a year ago, you’re actually poorer today than you were a year ago3.
Assets and Liabilities
The two quantities that define NW, viz., what you own and what you owe, are called “assets” and “liabilities” respectively. To grasp the concept of NW more intuitively, it’s helpful to visualize your NW as a balance with assets on one side and liabilities on the other.
When your assets exceed in value to your liabilities, you can, if you wish, pay off all your debts, and still have some money left over. On the other hand, if your liabilities exceed your assets in value, you cannot nullify all your liabilities with your assets. As the NW visualization above shows, the value of your NW can be gleaned from the dial above the NW scale.
The inability to satisfy all your liabilities is one of the leading causes of financial stress. Financial success basically boils down to keeping this single number, viz., NW, consistently increasing – or at the very least, not decreasing – over the long run 4.