What is Net Worth?
Net worth is the value of a person or company and can be computed by deducting the total liabilities from the total assets that are owned by the individual/company.
Net worth can be computed using the following formula:
Net Worth = Assets – Liabilities
If a person or company owns assets that are greater than liabilities, it is said to show a positive net worth. If the liabilities are greater than assets, it implies a negative net worth. A positive net worth is associated with good financial health, whereas negative net worth can be perceived as a negative signal and shows the inability to settle liabilities.
The concept of net worth can be applied to multiple levels. It can be used for an individual, a group, an organization, a government, or even an entire city or country. For the purpose of simplicity, we will limit our discussion to the net worth of either individuals or organizations.
- Net worth is the value of a person or company and can be computed by deducting the total liabilities from the total assets that are owned by the individual/company.
- If an individual or company owns assets that are greater than liabilities, it is said to show a positive net worth. If the liabilities are greater than assets, it implies a negative net worth.
- The concept of net worth can be applied to an individual, a group, an organization, a government, or even an entire city or country.
Calculation of Net Worth
The calculation of net worth seems rather simple, but the most important part is how assets and liabilities are computed and what falls under the buckets of assets and liabilities. Below, we will go over the steps to compute the net worth of an individual.
Assets include everything that can be given a tangible value. For an individual, it can include their possessions such as house, car, or a piece of art, and also includes their bank accounts, insurance policies, and investments. Personal belongings, such as clothes and furniture, are typically not included as assets, as they are not sold in case of bankruptcy or liquidation.
Liabilities include any financial obligations that need to be repaid. It can include loans, mortgages, rent, or bills. When calculating liabilities, take the repayments that are currently outstanding – not something that will be due in the near future.
For example, if we are computing the net worth of an individual at the end of the year, and they pay their utility bill each month, we will only take the amount due for that month (say December) and not include subsequent amounts for January or February of next year.
However, in some cases, house rent may be treated differently, as most lease payments are for a year so that an entire year’s payment may be treated as an obligation. Most people would exclude rent from net worth calculations.
Calculating Net Worth
After making a list of the total assets and liabilities, you can simply deduct the liabilities from the assets and arrive at the net worth. It can be repeated once or multiple times a year and can be used to assess the financial health of an individual. The same process applies to organizations.
The Net Worth Method
The net worth method refers to an indirect balance sheet approach to estimate income. It essentially uses an individual’s net worth on two different dates to detect if there is any income derived from unreported or unknown sources. The method is typically used by accountants, especially if there is any litigation related to fraud on concealing reported income and net worth.
The use of the net worth method is demonstrated in the figure below. The first step is to calculate the net worth of the individual at the start and end of the period. In the example, we’ve denoted them as current net worth (NWc) and past net worth (NWp).
It is important to find the opening and closing net worth using the same asset value method (cost, fair market value, etc.). The difference between the net worth is referred to as the net worth increase (NWI). Any non-deductible living expenses are added to the NWI to derive the income value.
After arriving at the income figure, the income or funds that are declared or evident are deducted from the amount. The difference will show you how much income is coming from unknown or undeclared sources.
Another important point to note is that during the process, any part of income that is derived from sources such as gifts or loans should be declared to ensure accurateness and thoroughness of the exercise.
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