The average person does not know his or her net worth, nor how to compute it. On top of this, many people and businesses have a negative net worth, meaning that they have more debt than equity.
Assessing equity versus debt is done by way of a balance sheet. Just as an income statement measures one's short-term financial health through the comparison of income and expenses, the balance sheet measures long-term financial health through the comparison of assets versus liabilities.
Determining Assets- Equity in Valuable Property
Unlike income, assets are a bit more complicated and misunderstood. Many believe assets to be anything they own that can be sold. Best-selling author and investor, Robert Kiyosaki, believes that assets are things that "put money into your pocket."
Kiyosaki explains this idea in his book Rich Dad, Poor Dad by explaining that his banker will let him list his titanium driver as an asset worth $500 (until he tees off with it) but Kiyosaki does not believe this piece of property to fall under the definition of an asset. Neither do clothes, electronics, or power tools.
As off putting as it may sound that the assets in one's life just disappeared at an alarming rate, this philosophy makes for very easy record keeping.
Assets tend to run a short list. Some people do not have any assets while many just have a few. The asset category tracks the stated value of investment and retirement accounts, savings, a business, and real estate for personal and investment purposes.
The reason personal real estate is listed, despite not falling under the definition that Robert Kiyosaki endorses, is measurement against the large liability it often accompanies in the form of a mortgage.
Determining Liabilities- Long and Short-Term Debt
Liabilities are money owed for items that have already been purchased, be it a candy bar that is accruing at 20% on a Visa, or a personal home mortgage. They are complemented by the payments made against them listed in the expense column of the income statement.
Just as the list of expenses is often longer than that of incomes, there are usually more liabilities than assets in one's personal ledger. The reason is easy access toward obtaining credit. A college student with a school loan, car loan, and a credit card will often have a savings account, but no home or other investments leaving him with 3 liabilities and 2 assets (1 according to Kiyosaki, unless the car is a taxi or limousine).
Unlike the expenses on an income statement, listed liabilities do not change every month. There will be monthly variations in account balance increases and decreases, but there should not be an influx of new or different accounts, and no account should be unaccounted for as is often the case with expenses in the income statement, leading to the necessity of listing money that is spent miscellaneously.
Assets Versus Liabilities- the Moment of Truth
When equity and debt has been totaled, the final step is to subtract debt from equity. If equity is greater, then net worth is positive. If debts are greater, then net worth is negative.
Maintaining accurate financial records is very important in knowing where one stands. Without them, an unrealistic view can be formed by avoiding the liabilities associated with assets. A BMW and a large home can be very valuable, but the owner may not be if he is upside down on both.
In order to increase net worth, liabilities need to be paid down while equity in assets is increased. This is only possible when cash flow from the income statement is positive as a result of income exceeding expenses.
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