Generally speaking, wealth is defined as an abundance of something. In the world of finance, this “something” refers to our assets, and we typically use a number known as “net worth” as a proxy for wealth, where net worth is calculated as total assets minus total liabilities. We can use this equation to determine the wealth of any entity that owns assets—individuals, businesses, and even whole countries. Let’s look at how the formula can be used to calculate your personal wealth as an example.
The assets that most individuals own fall into one of three categories: liquid assets, household assets, and investment assets. Liquid assets include the balances in your checking and savings accounts as well as the cash in your pocket (or under your mattress). Household assets are assets that are harder to convert to cash right away with little or no loss in value, such as your home, automobile, furniture, jewelry, and other personal valuables. Investment assets refer to items such as certificates of deposit, stocks, bonds, mutual funds, individual retirement accounts (IRAs), employer-sponsored retirement accounts, precious coins, or other articles you are holding with the expectation that they will increase in value. Even that stamp collection that Uncle Ernie bequeathed you falls into this category. There is also a category called “intangible assets.” A lot of folks consider you to be wealthy if you are in good health. Unfortunately, good health is hard to quantify, so it and other intangible assets are typically left out in the calculation of wealth.
Next, your total liabilities need to be considered. While assets are what an entity owns, liabilities are what that entity owes. If we were to include only total assets in the net worth equation, then the wealth of an individual, business, or other entity that took out a $100,000 loan and deposited it in a checking account would be increased by that $100,000, which would make no sense at all. When calculating of the wealth of an individual, these liabilities include credit card balances, installment loans (e.g., money borrowed to purchase cars, boats, or major appliances), student loans, mortgages, and any other debt the person might have, such as back taxes owed.
As a quick example, let’s assume that your cash on hand is negligible, but your checking and savings account balances total $12,500. The current market value of your home is $350,000, and the blue book value of your automobile is $15,000. Your passion is photography, and you estimate the market value of your equipment to be $25,000. You also own a $5,000 certificate of deposit (CD) with three years to maturity, have an IRA currently worth $40,000, and non-retirement mutual fund account investments totaling $35,000. Your current credit card balance is $2,250, and you still owe the bank $215,000 for your home. You also have $8,000 left to pay off your car loan. Your wealth (net worth) is calculated as total assets minus total liabilities as follows:
Total assets = bank account balances + market value of home + market value of car + market value of photography equipment + face value of CD + value of IRA + value of mutual funds = $12,500 + $350,000 + $15,000 + $25,000 + $5,000 + $40,000 + $35,000 = $482,500
Total liabilities = credit card balance + mortgage balance + car loan balance = $2,250 + $215,000 + $8,000 = $225,250
Your wealth (as measured by your net worth) = $482,500 – $225,250 = $257,250.
There are a couple of things to bear in mind here. First, notice that an entity’s current income doesn’t factor into the equation. A high-income individual who lives beyond his or her means, spending the money on items such as dining out, theatre tickets, and luxurious vacations instead of asset acquisition will not have a high net worth. The same goes for businesses and other entities. Second, having a high net worth, or wealth, does not automatically translate into financial stability. For example, the total market value of the assets of an entity may substantially exceed the amount of its liabilities, but if the value of its liquid assets is not sufficient to pay its current debt obligations, it could experience financial difficulties. This is sometimes why some Hollywood celebrities die impoverished and corporations that are “too big to fail” go bankrupt.