Category: Finance 101

How do you calculate your Net Worth? What does it mean? These are all questions we should be able to answer.

Net Worth is as simple as the equation: Assets – Liabilities = Net Worth

For many Net Worth is an expression of vanity, to others it is a symbol of progress. Personally, Net Worth to me provides a report card that I can track annually, and by summarizing my Net Worth in a Balance Sheet type manner also can help give a qualitative understanding.

Monthly Income	Monthly Liabilities
Active Income	Budget Expenses
Passive Income
Personal Assets	Personal Liabilities
Savings	Outstanding Debt
Investments
Property
	Net Worth

As you can see in the above “personal balance sheet,” I separate out current from long-term assets and liabilities. Where this differs from a corporate balance sheet is that instead of “Current” assets or liabilities, which would be within a 12-month period, I substituted it for monthly.

My reasoning for this is that it makes it much easier to perform in a quick manner. Could you do an entire year? Sure, but this exercise is to give a quick and reliable indicator of your personal financial management. The easier to perform, the more likely you are to continue doing it.

Let’s dive into each category required to calculate Net Worth?

Personal Assets

Assets can include anything that you may purchase, gain, make or have. Really anything of value can be an asset. For Net Worth purposes, I would classify an asset as something that has value and that you are or would be willing to part with. In terms of value, something that has a “liquid market” is preferred. For my assets, I do not include my couch, my socks, or many other possessions.

Things I include are savings, investments, rentals, cars, houses, etc. Whether to include your primary residence and/or daily driver cars are up to you; there isn’t a wrong way to do it. If you have taken out a loan for it, it might make sense to have it in there, or if you own it outright and may not be willing to part with either of them, you may not want to put it in there. The goal is to be consistent with how you measure so that you can track your progress with some degree of accuracy.

Monthly Income

Another class of an asset would be income. Overall there are two types considered, Active income and Passive income. Active income is what you get from your work at a job, from a business, or from an activity. Passive Income is what you get returned from previous business, activities, or investments in which you are not currently tied. When your Passive Income Exceeds your Monthly Liabilities, then you effectively could retire.

Personal Liabilities

The next category would be Liabilities. Personal Liabilities are mainly any outstanding debts that are owed. As discussed in other posts, there are several different thought processes on debt. Rather than politicize a “which is best” approach, I will only say, the more debt or higher degree of leverage, the riskier your financial situation is.

Monthly Expenses

Other than Personal Liabilities on the “personal balance sheet,” there is also Monthly Expenses. Typically, you should have a plan for any normal expenses and these should be a part of your budget. Other things within a given year that are larger purchases or events can be saved for separately. An example would be to set aside monthly installments to pay for special occasions such as Birthdays, Anniversaries, or Holidays.

Here is an example of the categories within my personal balance sheet:

Monthly Income	Monthly Liabilities
Active Income (Business Income)	Personal Budget Expenses
Passive Income (Rental Income)	Rental Expenses
Personal Assets	Personal Liabilities
Savings/Checking Accounts	Personal Mortgage
Investments	Rental Mortgages
Retirement Accounts
Vehicles
Personal Homes
Rental Properties
	Net Worth

Over time the goal is to build passive income, savings, investments, and rental properties; In parallel, also to reduce personal liabilities. By reviewing this annually, or more often as needed, can assure you that you are being a good financial manager of your money.

100/0, 80/20, 60/40….and eventually better. What do these numbers describe? These are a spending-to-savings ratio that we currently have or want to get to. If you have a 100/0 then you spend 100% of what you make and save 0% of what you make. 

First Goal: Spend Everything! (Within your income)

That’s Right! Spend everything you make but only what you make. This is probably the silliest advice for someone that is past this, but hey, why give successful people advice? This of course is directed at people you may know or maybe even yourself. If you currently spend more than you make, if your budget requires you to pull from your savings every month…. well, then this is for you.

So, if I am over 100/0, with 105/-5, how do I get it to 100/0. This of course is going to be similar advice to use throughout all of your personal finance endeavors. By using a mixture of increasing earnings, reducing expenses, and reducing debt you can achieve any percentage you want.

I know because I figured out how to grow my income by over 500% in the last 15 years, and 300% of that was in the past 8 years. I am not doing this to brag and I use percentages for people to relate to each other. While raising my income, I also lowered my expenses, cutting out extras that we weren’t using to reduce the overall. Did I cut my cable, do I live a bare-bones lifestyle…oh gosh no…but keep it as an option if you are in serious financial trouble and want out. Lastly, some of the expenses were monthly payments that came from debt. So, I systematically took out those as well, but the trick is not just to pay off debt, it is to limit the debt you have to a little or nothing.

Income

How to do this? Use the potential that you already have. The quickest and easiest way to increase your income is to ask for a raise (discussed here), get a second job, or a higher paying job. Some people recommend selling stuff, however in my experience if you haven’t done it before, or don’t have the time, your return for the time you spent isn’t as justified.

If you have a big ticket item that you are willing to part with such as an extra car, fancy jewelry or more liquid items like those, that might be an idea to obtain some quick results. Regardless of the method, raising income, accelerates your results. Looking at it from a business perspective, which would you rather be a business making $100 earnings per share or $1000 earning per share? So, be confident stand up tall and earn to your potential.

Expenses

Another step is reducing expenses. Starting out you may have to cut all non-critical expenses to make ends meet. What is non-critical? Easy, what would you be concerned about with kids…food, shelter (including clothing), and heat (A/C where it is hot). These are just examples, but as you can see, critical is what keeps you alive. In this phase, minimum payments on debt may be necessary, worse yet, not paying unsecured loans may be necessary; more on this in a minute. Other ideas, such as roads are free, you don’t need a gym membership run out side, or come take care of my kids, they will where you out. Expenses that you keep is what you decide is important to you, but the goal is to get to 100/0 or better.

Debt

Here we go, the subject that I have seen so much hate posts on the internet for. If you are a “no debt-er” you chastise anyone that would ever think of taking on debt. If you want to use debt for certain purposes, you advocate that there is “good debt.” And lastly, if you have no idea, or realized too late that you weren’t initially responsible enough for debt you have “bad debt.” As I mentioned before, do I like debt? No. Do I have credit cards?

Yes, paid off every month. Will I take out a loan? Depends, on the purpose, the amount and the type of debt. For many, I recommend a no debt strategy. For the responsible and accountable, I recommend good debt as long as it fits into your 80/20 or 60/40 mix, has no interest or very low interest, and is used on an something that you can liquidate to pay off the loan.

Another aspect as discussed before is settling some of your debts. If you can’t afford to pay everything to feed your family, then don’t pay unsecured debt (i.e. credit cards) versus your home loan or to put beans and rice in your stomach. Do call the creditor and discuss your situation, and try to stop interest accrual, arrange a payment plan, or see if they will settle on the amount. If they do any of these, keep all records…this is important as it can come up years later on your credit report as something you owe. If you can afford to actually pay down all your debts, then do so.

Let me make this clear, your NAME, your SIGNATURE, are tied to your WORD; if you signed a contract, I always recommend you fulfill your obligation. I have never walked away from any debt, I have never been foreclosed on (another story). I have had to shut down credit cards and then arrange a payment plan, however I paid what I owed. Here are some debt payoff methods:

Debt Avalanche

With current debt there are different ways to pay it off, here are some of the most common ones. Financial planners often recommend “debt avalanche”. With this you write out all of your debts and pay down the largest interest rates first. Then take that amount and put it into the next one. This “saves the most on interest.” The downside is that large loans take a while to pay off and someone could get distracted.

Debt Snowball

Another version is the “debt snowball”. Effectively take everything again and write it out smallest to largest amount and then again take what you paid before and put it into the next one. Upside on this is that it can emotionally help you get excited about paying off debt to give you the “small wins.” (If you set percentage or amount remaining goals with the “debt avalanche” you could get this similar emotional win.)

Debt Snowman

Why when talking about debt is everything related to snow? Not sure, probably because it feels could if you are on the wrong side of it. Here is another method, lets call it the “debt snowman.” This is the way I used to pay off my debts and the way I recommend. First, categorize your debts into unsecured, secured, and important secured (important secured is usually something you intend to keep and may or may not pay off in this process [i.e. house or car with 0% interest rate]).

Next, pay what you can on all minimums and extra to the secured with the highest interest rate or lowest payment. Yep, use either of the “debt avalanche” or “debt snowball” thought processes. Again, after it is paid off then move on to the next applying everything extra to the debt. After secured is unsecured, and of course lastly is the important secured. If you want no debt, pay it all off. If you don’t care about having “good debt” then just make sure the debt you keep is on exceptional terms, such as 0% interest. The important thing is when making these choices, they are yours, not someone else’s. You have more invested if you agree with the process.

Getting past the 100/0

Getting past the 100/0 keep everything above in mind and continuing your path. The next step is to ensure to mitigate your risk, increase your savings and investments, and diversify into additional sources of active and passive income.

Insurance. This subject doesn’t get anymore fun the more you talk about it. BUT…IT IS IMPORTANT.

On the road to building your wealth, there are times where you want to pay to protect yourself from unexpected large losses. In the finance industry, many of these are called “hedges.” Hedging is a popular strategy many professional investors use to mitigate downside risk.

So How do we hedge our personal finances?

Well, for starters, we use insurance. Insurance comes in many forms and many of these products are all equal. Some products are not in favor of the consumer. Not one product will protect you in all instances. Some examples of insurance products are: Auto insurance, Home Insurance, Life Insurance, and also Liability (Umbrella policy) insurance.

The point of these types of insurance is to pay out a small premium to a company that is willing to provide you “adequate” coverage for that premium.

Auto Insurance

If you own a car, or lease one, you have heard about getting auto coverage. There are many types within this such as liability only or collision coverage. Generally, if you have a loan on the vehicle, your banker will usually have you provide proof of collision coverage for the vehicle. This is more expensive than liability, however it will cover more in the event of an actual collision.

Do you always need collision? Depends. If you have a really old car in which you have the money to replace if you got in an accident, then you may only need liability. However, you are driving the nicest fanciest thing off the lot, even if you owned it outright, you may still want full coverage on it just in case. If you are in the middle though, there are more factors that play into it.

Home Insurance/Renter’s Policy

If you own a home, typically you want to protect yourself in the event of natural disasters. For most American’s, their home is their single largest investment towards the contribution of their net worth. This being said, having a home policy can provide the cost to rebuild in an unplanned natural disaster.

For renter’s, you may still want to have the protection of your possessions. This is a good policy that you can get to help protect you against the cost in case something happens to the place you live.

Life Insurance

Here is a debate that will not go away. Whole or Term Life…This conversation has turned more philosophical than anything. If you believe in whole life, and you have reasons to have it, and it makes sense to you, just understand it is a VERY expensive policy. If you save and invest your money, you may only need a term policy while you work toward your goals. Eventually, with enough money, why would you still need life insurance?

Many policies now come with riders for children or to turn term policies into whole. Riders are a feature which can turn a policy into a better policy in case your situation changes. For instance, if you had a term policy with a whole life rider. You pay a term premium, and then if something happens and you decide you want whole, you can exercise the rider, pay the additional fees and have your converted policy. Again, get what works for your situation.

Liability Insurance

If you are a high net worth individual. Congratulations. You may need more coverage than any of your existing policies will allow. In that case, an umbrella policy may work for you. Many people that I know that has these types of properties are typically real estate investors, public figures, and business owners. If for any reason there is a claim to go after a person’s personal investments, liability insurance can cover those situations. Anyone can get them; however, they are typically not needed until you are trying to protect a lot of wealth.

Though this is just a few of the different types of insurance, I will try and cover them in more detailed in a later post. If you feel you need a policy, that you don’t have, please contact a licensed insurance agent.

If you were a business your goal would be to generate a profit utilizing the resources you had while solving a need. As an individual, you must also take your resources to earn a profit for yourself. Of course, your lifestyle and location determine how much that would be. When respect to income, there are two main categories active and passive income. Many internet sources will site many different forms of income, but they all fall into one of these two categories.

Active Income

Active income as it sounds is any activity that you have to “actively” participate to produce income. Typical forms of this would be to be an employee, own a services business or own a retail business.

EMPLOYEE

As an Employee you trade your time for income. Short and simple. Increase your skill level, and your time is more valuable. Get a second job or third, you can capitalize on otherwise idle time. Therefore, as an employee, your main ways of increasing income from this source is become more valuable or spend more time doing it. Most people start this way and eventually work towards entrepreneurship or retirement.

ENTREPRENEUR

As an Entrepreneur you also trade your time and capital for income. By taking on more risk, you are able to produce higher returns of income. As discussed, you can have a services business, a retail business, or both. In a services business, you trade your time performing a service or teaching others how to do it for you to generate income for yourself and them. In a retail business, you offer products to sell. You set up the supply system, the inventory system, and all aspects of the retail business. If it is profitable enough, you can trade some of your profit for hiring a manager, which in turn can turn it into a passive income stream. If you invest anytime into it at all it is still more likely an active income source.

INVESTOR

Another type of Entrepreneur is an Investor. This is categorized separately to show a distinction between the different amounts of energy invested. An Entrepreneur generally invests more time then capital to produce income. An investor generally invests more capital to produce income. Though most of the activities of an investor generate passive income, someone who is an active investor, also known as a “venture capitalist” or “angel investor,” is constantly investing time and capital to generate returns.

Passive Income

This leads us into passive income sources. Passive income is income generated through a previous activity that without your continued time and energy (or with minimal oversight), generates income. Examples of this could include real estate rentals, dividends, capital gains, etc.

DIVIDEND INCOME AND CAPITAL GAINS

Dividend Income and capital gains are many ways that businesses can reward their investors. From the Investor standpoint, this is a good stream of earning money off of the money that has already been saved.

RENTAL INCOME

Another type of income from invested funds is rental income. Typically this form of income comes from the rent or lease of property, house, storage, or anything the like. By buying a property and then leasing or renting, you are able to generate annual income in addition to the possible capital gains associated.

Making the switch

Early on, most all people start off with active income of some sorts. Though you can grow your active income by becoming more skilled or by spending more time working, you are still trading hours for dollars. By saving some of that income to invest into passive income sources, you can start to add to your income and eventually replace your active with passive income. At that point, choosing to work is your choice, not someone else’s.