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Money Management
May 8, 2024
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Knowing your financial well-being plays a vital role in helping you understand the current state of your finances and plan for your future. So, how do you measure your financial well-being?
Your financial well-being is closely tied to your net worth. This is because you can improve your finances and build wealth by growing your net worth. If you can maintain a positive net worth and stay financially stable, your can improve your financial health.
Your assets and liabilities define your net worth. Once you understand these concepts, you can kick-start your journey of improving your financial health and building wealth. This article will explore everything you need to know about assets, liabilities, and net worth.
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An asset is anything you own that has monetary value and can be converted to cash when needed. They range from investments and properties with financial value to the money in your savings account and pension fund.
Assets are things you own and can use to build wealth, generate income, or both. You can also use them to get out of a financial fix. For instance, if you find yourself in unplanned debt, e.g., medical debt, you will use your assets to settle it.
An asset should be able to give you financial benefit. It should be something that you can sell and pocket into cash. Therefore, when calculating your assets, you don't count items you own but can't convert to money.
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You can categorise your asset into four groups depending on different factors. When calculating the total value of your assets, you will sum them.
Here are the four categories:
Liquid Assets: These are cash and cash equivalents. They include money in your bank account, Saccos, money market accounts, etc. Liquid assets can be exchanged for cash quickly, and you rarely incur losses. Short-term investments like treasury bills or fixed deposits with short maturity periods can also be considered liquid assets.
Illiquid Assets: These are things that can take longer to be converted to cash. They include your investments (e.g., a business you own), jewelry, real estate properties like land and houses, antiques, art, etc. Illiquid assets can also include your investments, such as a stock portfolio, cryptocurrencies, pension funds, and whole life insurance.
Tangible Assets: Tangible assets are things you own but don't generate income or appreciate. However, you can give them a value, sell them and convert them to cash. They include personal properties like your car, furniture, equipment, appliances, and electronics.
Intangible Assets: These are non-physical items that have financial value. They might be income-generating or not, but when you put them on the market, they can be sold. Intangible assets include things such as copyrights, intellectual properties, and patents.
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You might have noticed that ''skills'' as an asset is missing from the list above. There is no doubt that your skills are your greatest asset. After all, they have the main characteristic of an asset; they help you generate money.
However, skills can't be given a monetary value when determining the total value of your assets. You can't quantify them. Therefore, you can’t add them to your assets.
So, what steps can you take to determine the value of your assets?
When determining the value of your asset, it is crucial to take the right approach, as each is valued differently. Liquid assets, pension funds, stocks, and crypto are straightforward as they are often denoted in their cash value.
However, you will need to get an appraisal when determining the value of your illiquid, tangible, and intangible assets. Consider hiring an appraiser, as they would help you know the market value of your assets if you were to sell them.
Once you determine the value of each asset, you can create a balance sheet to help you sum them up and keep track. This will come in handy when calculating your net worth.
Finally, you can count your equity if you have a debt-financed asset. For instance, if you have a Ksh10m mortgage but have only paid 30% to the lender, you own 30% of the real estate. Therefore, you can only factor in 30% home equity when calculating your assets.
And if you have an auto loan, your vehicle can only be an asset if your outstanding loan balance doesn't exceed the car's value. For example, if your vehicle has a market value of Ksh900,000, but your lender owes you Ksh1m, you are "underwater" on the loan and have no equity in the car. The same can also apply to your house if it depreciates in value because of a fire or natural disaster before you pay off a mortgage.
Assets are used to determine your financial well-being, and acquiring them helps you increase your net worth.
To show the importance of assets, Robert Kiyosaki, the author of "Rich Dad, Poor Dad," says, "The rich get richer by continually reinvesting asset profits back into assets."
Assets can provide you with multiple benefits.
First, they can help you generate passive income. Unlike your job, where you have to spend time and energy to make money, your assets can help you generate cash while you sleep. This can be vital in protecting you from loss of income and guaranteeing you financial security in retirement.
Second, assets can be used to protect yourself and your money from inflation. Investing in appreciating assets like real estate and gold can help you preserve your purchasing power. Additionally, you can sell an appreciating asset later for a profit.
Thirdly, you can use your asset to get loans. Leveraging your assets as collateral can help you get better loan terms, e.g., lower interest. However, keep in mind that defaulting on such a loan could lead to the repossession of your asset.
Fourth, assets help you build generational wealth. You can pass it on to family members or other heirs to ensure your legacy lives on after your death.
Finally, assets can come in handy when dealing with financial hardship. You can sell or liquidate an investment to get yourself out of a fix.
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Liabilities are debts and obligations that you owe other people or institutions. They're the accounting opposite of assets and consist of all accounts payable. Liabilities can also include items with the monetary value you borrow.
Liabilities are used to gauge your financial health. When creating your financial statement, liabilities are listed on one side and assets on the other. You are financially healthy if your liabilities' total value doesn't exceed your assets' value.
To settle a liability, you must sell or hand over an economic benefit. The benefit can include cash, transferring assets, or fulfilling a service.
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Personal liabilities can be categorised into two groups:
Current Liabilities: These are financial obligations and debts you must settle within a year. They include digital loans, credit card balances, and other short-term loans. Current liabilities also include unpaid taxes, wages, and rent due that year.
Non-Current Liabilities: These financial obligations are not due for settlement within one year. They include long-term loans like HELB, car loans, mortgages, business loans, long-term leases on a property, deferred taxes, accrued expenses, bills due, the money you owe others, etc.
When calculating your liabilities, you simply sum up everything you owe to lenders and institutions. You will only factor in what's left on the loan for mortgages or student loans, not your starting balance.
For example, if you are calculating your liabilities in January, you should include amounts payable within that year. They consist of any taxes the government owes you, rent, and other bills due, and if you have domestic workers, you should factor in the wages they owe you.
Additionally, any money you prepaid is a liability as you owe an economic benefit. If your employer has already paid you your salary for the next three months, you should count that as a liability until after you have rendered the service and earned it.
While you should control your liabilities and ensure they’re always less than your assets, you should remember that not all liabilities are bad. Context is important. Taking an expensive car loan that doesn’t increase your productivity or generate income is wrong. However, taking a student loan to advance your education and earn more money in the future can increase your net worth.
Other liabilities like mortgages will help you build wealth as you acquire equity.
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Liability management encompasses many strategies and objectives, including avoiding too much debt, paying off excessive debt, and making certain investments to help build financial security. Managing liabilities is a crucial part of maintaining your financial well-being. To do so and to ensure that your liabilities are being handled responsibly, you should follow the following steps:
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Your net worth is the snapshot of your overall financial well-being. It is the primary metric to measure how you progress financially over time.
Your net worth is the difference between your assets and liabilities.
Therefore, to calculate your net worth, you must create a balance sheet that sums your assets and liabilities on different sides. You will then subtract your total liabilities from your total assets.
A simplified example is if the value of your house, car, and investments add up to Ksh6m and you have an outstanding debt of Ksh4m, your net worth is Ksh2m.
When calculating your net worth, you will only factor in assets that can be converted to cash quickly and have a financial value. Your car and piece of land contribute to your overall net worth; your home appliances are assets, but they don't. Therefore, don't include them in your calculations.
The same goes for liabilities. You should factor in everything you owe to ensure you get the correct results. If your liability is a loan or unpaid money that incurs interest, you should count the interest, too, as it is in your payable account.
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To learn how to calculate your net worth, let's look at a more detailed example of John, a 33-year-old banker.
John's Assets Include
Total Assets: Ksh2,180,000
John's liabilities include the following:
Total Liabilities: Ksh1,370,400
To calculate his net worth, John will minus his liabilities from his assets.
Therefore,
Ksh2,180,000 - Ksh1,370,400 = Ksh809,600.
John's net worth is Ksh809,600
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Your net worth can be positive or negative. In the case above, John has a positive one. But if he could take a Ksh1,000,000 loan tomorrow to buy a piece of land, his net worth could drop to negative Ksh190,400.
So how much should your net worth be?
There's no one main answer, as different variables are at play. If you are a young person starting your career, you will likely have a low net worth. If you start life with a HELB loan, no assets, and no savings, you will have a negative net worth.
When calculating your net worth, income isn't considered. A person can be doing well and financially stable but has negative net worth. Meanwhile, another person would be a homeowner with a positive net worth but struggling to meet their daily needs. Therefore, net worth can't be used to measure financial success.
Net worth should only be a reference point for measuring financial progress over time. Ideally, your net worth should be increasing. If you take out a mortgage, your net worth might go into the negatives. But as you get more equity, you will notice an upward trend.
You should measure your net worth at uniform intervals, such as quarterly or annually. You can also recalculate after making a big purchase (e.g., a car) or after taking out a big loan.
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Whether you have a negative net worth or looking to maintain a positive net worth and build more wealth, you should consider the following strategies:
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Building your net worth takes time and effort. You should ensure that you are always thinking long-term and doing enough research. But by following the right approach, you can get there.
Always ensure you are accumulating the right asset, reducing your liabilities, and measuring your progress regularly. This all can be a daunting process. Therefore, consider talking to experts whenever you hit a roadblock.
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