Many of our finance decisions tend to be by default rather than by design. We make investments and buy insurance policies based on tax planning advice from various sources. We acquire a house with the help of a home loan. We make purchases and spend on lifestyle needs using credit cards and loans. The assets we build and the liabilities we assume over a period of time require a holistic view, sooner rather than later. We need to know our personal net worth, a crucial indicator of our financial wellbeing.
If we want to take better financial decisions and improve our saving and spending habits, we must first draw up a personal balance sheet. This is like any enterprise balance sheet with assets and liabilities which we acquire by rightly managing our household incomes and expenses. Incomes are primarily used to fund expenses. . Any surplus of income after meeting expenses can be used to create assets such as house, car, fixed deposits, jewellery, and other investments. When our income fails to meet our expenses, we are forced to take loans or use a credit card, giving rise to liabilities. Liabilities on the balance sheet indicate our obligations to repay other parties. Incomes and expenses create our assets and liabilities, which are the key facets of a personal balance sheet.
Assets can be considered at the value that they will realise if sold in the market. Liabilities should be considered at the value to be paid back to the lender. Outstanding loan value, in terms of principal remaining to be paid back, can be read off annual statements from lenders.
Personal net worth is simply the excess of assets over liabilities. Positive net worth means the individual has the ability to meet all obligations, using the assets whose value is higher than that of the liabilities. Negative net worth means the individual’s obligations are not backed by adequate assets, which can translate into a personal financial crisis. The strategic objective in managing a personal balance sheet should be to maximise the personal net worth. Higher your net worth, greater the flexibility and ability to meet your financial goals.
The review of a personal balance helps identify assets that are not yielding adequate returns, thus slowly eroding net worth. If assets are earning a rate of return that’s lower than the rate of interest on our loans, it might make better financial sense to liquidate the asset to repay the loan and then use the savings in EMIs to rebuild the asset. Personal net worth is also an indicator of the risk-taking ability of an individual. Investors with a positive net worth will be able to take more risks than an individual with a negative or low net worth.
There are ways in which a low or negative net worth can be managed. We can seek alternative sources of income, such as giving an unoccupied house on rent. We can also consider transferring an existing loan to an institution that charges a lower rate of interest. When we build assets, we should also manage them with the net worth in mind. That is a good starting point in financial planning.
Taruna Changulani is a chartered accountant; is Director and co-founder of the Centre for Investment Education and Learning, Mumbai. Email: firstname.lastname@example.org