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Chapter 2

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Assessing your current wealth

Taking Stock

The first step in assessing your current wealth is determining your net worth. It is the starting point forfinancial planning. It provides an indication of your capacity to achieve your financial goals. Your networth can be ascertained by drawing up a personal balance sheet, as shown in

Worksheet 2. 1. The process consists of three steps:

1. List the items of value that you own. These are your assets.

2. List the amounts that you owe to others. These form your liabilities.

3. Subtract your liabilities from your assets; the difference is your net worth.

This relationship is shown below:

Items of Value - Amounts Owed = Net Worth

Definition:Your assets are the things that you own. You probably own assets that have many different forms,including cash, investments, personal property, real estate etc.

Assets possess value. Value can be of different types. The most basic measure of value is cost i.e. theamount of money you spent in acquiring the asset. However, usually cost is not a very accurate meaureof value. This is because, over time, the market value of an asset changes significantly from its originalcost. For example, your house may have cost Rs. 10 Lakhs ten years back. But today it is likely to sell formuch more. In case of such assets, market value or the amount someone would be reasonably willing topay for it in todays marketplace is a much more accurate estimate of the value. However, collectorsitems like art pieces and antiques have an emotional value which may be significantly different from theirmarket value or cost.

In the Balance Sheet or the Statement of Net Worth, the assets are arranged in order of liquidity. Themost liquid assets are listed at the top of the list and include cash, bank accounts, and money marketmutual funds.

Definition:Liquidity is a measure of the ease with which an asset can be converted into cash or cash equivalents.The easier an asset is to convert into cash, the more liquid it is. Cash is the most liquid asset.

The cash surrender values of your whole life insurance policies and annuities can be determined bycontacting your insurance company.

The value of cars can be obtained from agencies which buy and sell used cars.

Household furniture, clothing, and personal effects should be more conservatively valued so as not tooverstate their value. It should be remembered that in an actual sale of these items, you are likely to getfar less than the estimated values.

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Your home is likely to be your largest asset, so its value should not be over- or under-stated. The figurethat you should use is the current market value; that is, the amount that someone would be willing to payfor your house. Do remember that the cost of the property is not an accurate indicator of its value if youhave owned your house for a long period of time. The most recent selling prices of houses similar toyours in your area are a good indicator of the likely market value of your house. Real estate brokers canalso provide you with an estimate of the value of your house.

Note

There is another school of thought, which proposes that the value of a self-occupied house should not beconsidered in the net worth statement because one cannot really sell the house to raise resources. Thisapproach is also worthy because it is the more conservative of the two.

Liabilities

Definition:Your liabilities are amounts that you currently owe (i.e., your financial obligations). The sum of yourliabilities is what you must pay today to overcome debt.

Begin by listing your most current debts, such as utility bills, telephone bills, and others.

Next, list the balances outstanding on your credit card debts and loans. For most people, a home loan istheir largest single debt outstanding. The amount to include is not the original amount of the loan but thecurrent outstanding balance. The current outstanding balance of the loan can be obtained directly fromthe lender.

Add up all the amounts owed to others and to get the total of your liabilities.

Net Worth

Definition:Your net worth is the difference between the totals of your assets and liabilities. In other words, if yousold all your assets for the values stated and paid off all your debts, the amount left over would beyour net worth. The net worth of a person is a measure of a persons financial position as of the dateof the personal balance sheet.

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Steps:

List all items of value starting with cash, investment assets, the current value of your house, andpossessions.

List and total all liabilities.

Subtract total liabilities from total assets.

Notes:

Assets

Determining the value of your stocks, bonds, and mutual funds is easy. The prices can be found innewspapers or on financial websites.

WORKSHEET 2.1 How to determine your net worth

A. Assets Amount (in Rupees)

Cash

Bank Accounts

Fixed Deposits

Cash surrender value of life insurance

Cash surrender value of annuities

Market value of investments

Mutual funds

Stocks

Bonds

Others

Market value of house/real estate

Investment property

Vehicle(s)

Household furniture/appliances

Jewelry/precious metals

Collectibles

Loan receivables

Others

Total Assets

B. Liabilities

Credit card balances

Bills outstanding

Outstanding loan balances

Taxes due

Others

Total liabilities

Net worth [assets minus liabilities (A-B)]

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Why Is Determining Net Worth Important?

Determining your net worth is the first step in financial planning and assessing your financial wealth. Networth is a tool for comparing the changes in your financial position over a period of time. An increase innet worth over a period of time is a favorable trend, and a decrease in net worth is a reduction in wealth.

There are a number of ways to increase net worth:

Appreciation of assets (for example, a rise in the value of stocks, bonds, mutual funds, and realestate).

Reducing liabilities.

Increasing income, such as through salary and wage increases as well as growth in investmentincome.

Reducing the amount spent on living expenses.

The importance of increasing net worth is obvious. It is important to remember that addition of assetsmay not always increase your net worth. This is especially true for depreciating assets, such as cars,computers, electronic equipments etc.

Investment assets like shares could also lose substantial part of their value.

Creating a personal balance sheet will assist you in tracking your personal wealth over time and enableyou to see relationships among the balance sheet items. The relationship between liquid current assetsand current liabilities indicates the relative ease or difficulty in paying upcoming debts. This evaluationratio is the current ratio and is determined as follows:

Current Ratio = Current Assets Current Liabilities

For example, if a person has Rs. 10 Lakhs in liquid current assets and Rs. 5 Lakhs in current liabilities,the current ratio is 2. This means that for every Rs. 1 in current debts, there is Rs. 2 in liquid assets.Generally, most current debts are repaid from liquid current assets such as cash, savings accounts etc.In the event of unemployment or insufficient liquid current assets to cover current debt, longer-terminvestment assets would need to be liquidated to pay off the debt.

The other significant relationship between balance sheet items is the debt ratio, which is total liabilitiesdivided by net worth:

Debt Ratio = Total Liabilities Net Worth

For example, if a person has Rs. 1 Lakh as total liabilities and a net worth of Rs. 2,00,000, the debt ratiois 0.5.

We need to make the Cashflow statement and the Income and Expenditure Statement, to assess changesin networth.

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Chapter Review

Exercise

1. Mukesh bought a flat for 12 Lakhs, worth 20 Lakhs today. He has no loan repayments i.e. EMIs dueon his flat. He has FDs worth Rs. 2 Lakhs and cash of 30,000 in his account, jointly held with hiswife. He has mutual funds worth 1.5 Lakhs and stocks worth 1.5 Lakhs. Ritesh, an old colleague ofhis, has taken a loan from him for Rs. 50,000, for which he pays him 10,000 every month. His wife,Geeta is fond of diamond jewellery and owns up to 3 Lakhs of diamond jewels.

Mukesh bought a car for 4 Lakhs, 3 years ago. He has a tax liability of Rs. 35k per year. He has noother outstanding bills pending, except for telephone and electricity bills to the tune of Rs. 5,000 .

A] What is his net worth?

B] Can you think of ways of increasing his net worth?

C] What is his current ratio and debt ratio?