The first step in the journey towards financial independence and wealth building is understanding your starting point. Let’s call this the baseline. I know it’s scary, but trust me, you can’t begin to measure your progress until you really understand your own numbers.
There are four key components of financial health:
- Income (Post-Tax Earnings)
- Expenses (Spending)
- Net Worth (Assets – Liabilities)
- Real Net Worth (Adjusted Net Worth)
Let’s tackle these one by one.
Income is pretty straight forward, this is the money you are bringing home. There are many sources of income, but the most common would be your salary, any returns on your investments, rental property income, etc. Get the gross number (typically the stated amount you are being paid) and make sure to apply the applicable tax rate (check your pay stub).
The next important number is your Expenses. A quick way to figure this out would be to simply look at your monthly bank statements and see what the total money coming out of your account looks like. We will talk about how to optimize this in subsequent posts.
Next, let’s calculate your Net Worth. This is a bit more work, but essentially you need to find just two numbers. First, determine your Assets. Traditionally an asset is defined as a resource with economic value. Examples of assets are the cash in your savings account, brokerage account, or retirement accounts, equity in homes or rental properties, etc. Then we will look at your Liabilities, there are any debts you may have. Common examples would be student loans, credit card debt, mortgage on a home, etc. Then you simply subtract the two! A positive net worth means that you have more assets than liabilities and a negative net worth mean just the opposite!
So what do you mean by Real Net Worth? Unfortunately it isn’t as straight forward as the Net Worth calculation, but here’s how I think about it.
In Rich Dad, Poor Dad, Robert Kiyosaki encourages readers to think about assets as resources that generate cash. Under this definition, some of the items we described above no longer qualify as assets. The best examples would be equity in your primary residence or in your car. Robert believes that one of the biggest mistakes people make is buying houses and cars and considering them assets when in fact they are not (these ‘false assets’ actually cost you money for maintenance, etc.). However, he would consider equity in a rental property to be an asset because it generates returns in the form of monthly rents. As such, we would exclude these ‘false assets’ from the asset portion of your net worth.
Taking this one step further, in the Financial Independent – Retire Early movement, Real Net Worth not only excludes assets that do not generate cash, but also assets that are illiquid (meaning that they are not easily converted to cash). For instance, although equity in a rental property generates cash, that equity cannot be easily or quickly converted to cash. This is because as an owner of a home, you need to find a buyer and close on a deal before you can get the full equity out of the home. Similarly, Retirement Accounts would also be excluded from this calculation. This is because they are not readily accessible and you are be penalized if you wanted to access that money before retirement age. Thus we would also exclude illiquid assets from our net worth calculation to arrive at our Real Net Worth.
Both Net Worth number are important to know and understand. However, I have found the Real Net Worth number to be a more important indicator of my success on the journey to financial freedom and wealth accumulation. This is because it allows me to see how much money I have available to make work for me.
There are a number of pretty sophisticated online tools to help you determine you net worth and real net worth. I’ve collected a few of them below in case you’re interested. I started off with just a simple excel file and have attached a template below, in case that’s more your speed.
Further details on the FIRE movement and Real Net Worth can be found in the book Set for Life.
Figure out your numbers and keep on moving through these posts!