What is net worth?

If you have not realised it earlier, by doing these exercises, you are treating your personal finances just like a business treats its own. Net worth is something that a company tracks. It is given by the simple formula, Assets - Liabilities.

In the personal finance context, assets would be the sum of all investments that you have, the jewellery that can be sold, your auctionable art collection, real-estate that can fetch a potential buyer, etc. Liabilities would be the debts and loans that you might have taken. They may also include objects that might need additional investment to dispose off. As an example of the later scenario, think of a car that is not in its best shape. You might need to spend some 40,000 rupees to repair it before it becomes second-hand market-ready.

There is a possibility that your liabilities might exceed assets. In that case your net worth would be negative. What you must strive for is for a positive net worth that increases with time. This indicates good financial health.

Understanding liquidation

Liquidation is the process of ending a company. During the liquidation process, all asset classes are converted to liquid assets (eg., cash, savings bank balance, etc.) and the liabilities are paid off. If there is any money left, the shareholder or the owner receives it. In real-life scenario, the exercise is often carried out when a company is knee-deep in debt and the debtors see no hope that the business would be able to pay them back. You might have seen in may 70s and 80s Hindi movies, where an industrialist's properties are auctioned following a court-order; thus signalling the fall from grace of a protagonist and the rise of a hero.

This is not the only scenario where liquidation might be carried out. It may so happen that the proprietor of a firm is no longer in a position to run the business. If I draw parallels to personal finance, such situation might be triggered by ill-health or even death. Rarely you might come across someone who would want to do this because they want to donate everything to charity and retire in the Himalayas as an ascetic.

Why do I bring this up? Net worth is practically uncomputable until liquidation is done. For example, you do not know how much you would get for the jewellery your family had been accumulating through the the last couple of generations; you would not know how much you would get for the house that your father had built. How long would it take to find a buyer for that house—would you be able to sell your house in a week, a month, six months, one year?

I would suggest that you choose a time-scale and compute your net worth with respect to that. Include only those assets that you can reasonably liquidate within that time scale. If you choose your time-scale as 1 month, you should not include real-estate. The question still remains—what would be a reasonable choice of this time-scale? To that I would say that if you are a salaried employee or a small businessman, 1 month is a good time-scale. If you are primarily into real-estate or have multiple properties, you should choose a time-scale of at least 6 months.

If you are committed to exploring, you might want to keep a track of your net-worth computed for different time-scales. Also, all assets included in net worth for a lower time-scale will automatically be a part of the net worth for a larger time-scale. In other words, anything that can be liquidated in 1 month can definitely be liquidated in 6 months.

There is also another factor. How much loss would you encounter in the liquidation process with respect to the market value of an asset? Here is a simple example. If you have to liquidate a fixed-deposit prematurely, you would need to pay a penalty of anywhere between 0.5% to 1.5%. This value depends on the penalty rate imposed by the bank, the original duration of the FD, the evolved duration, etc. A slightly more complicated one would be dissolving government pension and provident fund schemes—you might not be able to liquidate all of it by law. You might also hold assets against which you might have to pay taxes during liquidation. For example, long term capital gains tax for liquidating a stock that you had held for quite some time.

The liquidation loss factor is also a function of the time-scale. Often the losses are larger if you have to liquidate some asset within a short period of time. For example, if you have a land in a village whose market value is 20,00,000 rupees, you might be able to fetch that value if you keep a time-scale of 1 year. But if you include that asset in your 6 month time-scale net worth, you might have to account for a liquidation loss factor of 30%. This is merely a theoretical consideration that indicates if you have to sell this land in 6 months, you might have to settle for a value that is 30% lower than what it would fetch otherwise.

Up until so far, all we have talked about are concepts and some examples to illustrate these concepts. To summarise, the following needs to be tracked with time—

1. Your liabilities
2. Your assets that fit the chosen time-scale
3. Liquidation loss factor associated with that asset for a liquidation in that time-scale

We will dive into the design of the first tracker for your net worth in the next section.