- 1. Your net worth statement will show you a comprehensive picture of your assets and liabilities.
Your net worth is the difference between what you own and what you owe. Consider the equity value of your home, which is the difference between what you could sell your home for today minus the mortgage that you owe. Your net worth is calculated similarly, but using all your assets and all your liabilities.
Your net worth statement is a balance sheet showing your current financial situation. It lists your assets and your debts at their fair market value and reports the difference as your net worth (or equity). Another way to look at your net worth is to say how much money you would have if you sold all your assets and paid off all your debts today.
Knowing your net worth is an important step toward achieving your financial goals.
- 2. You will be able to compare your wealth over time to see if you are on track with your financial goals.
Your net worth statement is a picture of your financial situation on a certain date. By updating your net worth statement periodically, you will be able to compare how your net worth changes over time. I recommend that you prepare your net worth statement at least once per year and compare it with the previous year’s statement.
If one of your financial goals is to be debt free in 10 years, then you can easily see how much your debts have decreased from the prior year. You may find that your debts are not decreasing fast enough for you to meet your 10 years goal. So, you can reflect on the past year to determine what you need to change in the coming year to get you back on track for your goal.
Comparing your net worth statements over time is an important feedback tool.
- 3.You will discover how your financial decisions affect your wealth which will help you determine what you need to do if your net worth is not growing.
Comparing your net worth statements will reveal how your financial decisions affect your net worth. Some assets appreciate in value while others do not. If you spend your income primarily on things that do not appreciate in value, you will find that your net worth is stagnant or decreases over time.
This will become readily apparent by comparing your net worth statements. For instance, if you purchase a new car, you will see that your net worth decreases. After you drive the car off the sales lot, you will not be able to resell it for what you just paid for it. Therefore, it decreased in value, along with your net worth. If you financed the purchase, then your debt did not decrease while the value of the car did. If you paid cash, then you traded a non-depreciating asset for a depreciating asset. However, the new car may have lower operating expenses, than the vehicle you replaced, which may result in higher net income that you can add use to pay down debt and thus replenish your net worth.
Seeing how your financial decisions affect your net worth will help you make better decisions in the future.
- 4.You will be able to evaluate your financial needs regarding savings, investments, and insurance.
Your net worth statement can help you plan for the future. Life is uncertain. The best way to handle this uncertainty is to set aside cash for unforeseen events. In some cases, you can purchase insurance to help with uncertainty. In others, you may be able to rely on short term debt, such as credit cards, to help with the uncertainty. Adding debt should be your last resort, since it lowers your net worth. Purchasing insurance lowers your income, but is necessary to cover catastrophic losses to your assets and net worth.
Your financial plan should include a certain percentage of income going into long-term investments, a certain amount of income set aside for cash reserves and short-term expenses, and a certain amount of income for debt reduction. My recommendation is that 10% of income should go to long-term investments, 30% to cash reserves and debt reduction, and 60% to all other expenses. Reviewing your net worth statement, along with your annual household budget, will help you determine how to allocate your income to meet your plan.
Planning for the future is easier using the information contained in a net worth statement
- 5.You will be prepared when your banker requests your personal financial statement for new or existing business loans.
Whenever you apply for a long-term loan, the lender calculates your net worth. They may ask you for a net worth statement, or simply hand you a form to complete, that lists your income, expenses and assets. They already know what you owe by running your credit report. The lender wants to find out how they will be able to recover their money if you default on your loan. If you have a business loan or a commercial real estate loan, the lender will want this information from you each year.
If the lender prepares this statement for you or if you quickly fill in their form each year, then this statement may leave off some of your assets, which may affect whether you get a new loan or get an existing loan renewed. By preparing your financial statement regularly and comprehensively, you will be able to offer your banker a statement that you know includes all your assets and liabilities. You will also be able to explain changes in your net worth with the lender.
Being prepared when applying for a loan or a renewal keeps your banker happy.
© 2016 Bob Norton Consulting APC. Bob Norton is a licensed CPA and real estate broker in Louisiana. The opinions and ideas expressed in this article are informational only and are not meant as tax advice. Consult with your tax advisor to determine how these ideas apply to your situation.