Not all Net Worth is created Equal

By, Bob Peters || Sept 28, 2021

In my 36 years as a Commercial Banker I have seen thousands of personal and business balance sheets and what is on the surface is not what it seems.  Wealth is Equal to Net Worth but not all Net Worth is Equal. Even though we know Net Worth is the numerical result of simple arithmetic (all that you own which are called Assets, less all that you owe like borrowed money called Liabilities.  The type of assets and the amount and type of liabilities makes a really big difference to your ultimate Financial Security.

Net Worth equals Assets minus Liabilities 

Wealth is created by growing your Net Worth but not all Net Worth is the same.  Net Worth equals your Assets minus your Liabilities.

We will make up two fictious people, Jane and Marie.  They both have the same Net Worth of $25,000, both have monthly rent of $1,250 and have jobs that pay them $50,000/year but this is where the similarities end.

Jane’s assets consist of $1,500 of cash in her bank account and a brand new car she bought for $61,000 (including tax and license fees).  To make it simple, we will ignore the value of Jane and Maries’ personal assets such as clothes, TV’s, computers, cookware, etc.

Because Jane had good credit and proven job history, she was able to borrow $37,500 or 61.4% of the cost of the car.  The 5 year car loan has an interest rate of 5% which equates to principle and interest payments of $708/month.  So Jane’s rent and car payments combined equals $1,958 or 47% of her Gross Monthly Income.  Jane’s $1,500 in her bank account amounted to less than 1 month of rent and car payments.

While Marie had the same $1,250/mo rent she owned an older (but well maintained) car with a current value of $5,000 and no loan payments.  Marie had $10,000 of cash in her bank account and $10,000 invested wisely in low cost exchange traded funds towards building her Financial Security.  Her $10,000 in her bank account equaled 8 months of rent.  Marie’s sole monthly rent obligation of $1,250 represented only 30% of her gross Income vs. Jane’s total monthly obligations that totaled 47%.

Some Assets increase in value and some decrease 

There are three things that are different about Jane and Marie.  Although Jane and Marie seem to have the same $25,000 Net Worth we know that not all Net Worth is the same.  Jane’s Net Worth is centered in the “equity” of her car (an Illiquid Asset) while Marie’s Net Worth is centered in cash and wisely invested investments (Liquid Assets).

Some assets increase in value and some decrease.  A car is an asset but, generally speaking, a car declines in value (or depreciates) the day you drive it home from the car dealer lot.  You will buy assets that decline in value such as a car, clothes, furniture, backpack, kayak, bike, skies, snowboard, etc.  It’s OK to buy assets that decline in value because much of life is about living. These assets fall into the Want bucket.  You purchase Wants after you cover your Basic Needs and Invest Wisely for Financial Security. 

On the other hand, Financial Security is achieved by building assets that increase in value.  A wisely invested diversified exchange traded fund is an Asset and may fluctuate during short periods but, over time, is likely to increase (or appreciate) in value.  A cars’ value declines about 20% after the first year and further depreciates 10% each year thereafter.  That’s why, generally speaking, buying a car that is approximately 2-3 years old can be a better financial decision vs. buying a new car.  A Diversified Exchange Traded Fund investing in the top 500 US companies, if held for a long period of time, may increase by about 8% each year.

Liquid vs. Illiquid Assets 

It is important to think about every asset in terms of how easy (or difficult) it would be to turn it into cash.  The easier it is to turn an asset into cash the more liquid the asset is.  We care about cash because cash (also checks written on our checking account and electronic transfers) is what we use to cover our Basic Needs.  Cash in the bank is the most liquid of all assets.  As mentioned in the previous section, it’s ok to have assets that depreciate in value and that may offer you very little cash if you tried to sell them.  When you look at these assets, just mentally set them aside because you are not likely to try to turn them into cash.  It is wise to avoid ever being in a position that you need to sell your furniture, clothes, backpack, skies or other illiquid personal assets in order to pay for your Basic Needs.

Shares of an exchange traded fund can be sold and converted to cash in a couple of days.  The price that you can sell your exchange traded fund is readily discovered throughout the day and changes by the minute.  A used car may take weeks to sell.  You may pay for advertising.  The number of potential buyers are often limited based on geography. The condition of the car and the number of used cars on the market also impacts the sales price. Consequently, an exchange traded fund is generally considered highly liquid and a car is less liquid or illiquid.

Liquidity matters (Cash or cash equivalents). Cash allows you to cover your Basic Needs and pay for your debt obligations (credit card balance, loan payments).  While Financial Security requires you to Invest Wisely it also requires you to have cash to provide a cushion for unexpected expenses (medical/dental costs, car repairs, etc.) or loss of a job.  You may want a bigger cash cushion if you have a job that is likely to be difficult to replace because the type of work is hard to come by.  Having a bigger cash cushion would be a good idea if you drove an older car that would likely need higher repairs in the next year or two.  Having a larger emergency fund of cash would make sense if your financial obligations were a higher percentage of your income, like Jane.  

Depending on the factors mentioned above I would suggest not less than 3 months of Basic Needs (including debt payments) but it could be easily 6 months. The highly liquid cash cushion gives you peace of mind and lowers your stress that comes with uncertainties.  A cash cushion is a part of being financially secure. A cash cushion is necessary for peace of mind but it is not part of the Investing Wisely bucket.

Cash Flow and Debt Obligations 

Let’s revisit Jane and Marie.  Jane’s rent and loan payments represents 47% of her gross monthly income ($50,000 annual salary/12 months=$4,167/monthly wages). On the other hand, Marie has a $1,500 rent payment which represents only 30% of the same monthly Gross Monthly Income.  

When it comes to cash flow and debt obligations, Jane has two things going against her: 

1) a much higher amount of her gross monthly income going to pay debt obligations which we include rent because it is a contractual obligation (47% vs. 30% for Marie), and

2) liquid assets in the form of cash ($1,500) in her bank account which represents less than one months’ debt obligations vs. Marie’s $10,000 which represents 8 months’ of debt obligations.

Cash Flow and Debt Obligations do matter!

You have probably concluded that Marie is in a better spot relative to her achieving Financial Security even though she and Jane have the same Net Worth.  Jane’s Net Worth is centered in the equity of her car that declines in value over time (a depreciating asset) while Marie’s Net Worth is centered in wise investments that increase in value over time (appreciating assets).

Further, Jane has very little liquid assets (i.e. cash in the bank) to help protect her if she loses her job or has unexpected expenses and she has a higher percentage of her gross income needing to support her debt obligations.

Financial Security is achieved by growing your Wealth.  Wealth equals Net Worth but not all Net Worth is Equal.  A Net Worth with appreciating assets (vs. depreciating assets) will lead to Financial Security.  Having three to six months of a cash cushion for an unexpected loss of income or unforeseen expenses brings piece of mind and reduces stress.

Keep this in mind:  You may very well “qualify” to borrow money.  Just because you qualify does not mean you should borrow.  Borrowing can make sense if you are secure in your current and future employment. Your current and future earnings are sufficient enough to cover your Basic Needs and loan payments while allowing you to Invest Wisely.  Obtaining a loan may make sense when you have a cash cushion to support debt obligations if you should have a temporary loss of employment.  Obtaining a mortgage to purchase a home may make sense if you believe you are going to stay in the home for at least 5 years (preferably longer) and have confidence in your ability to earn sufficient income to support your Basic Needs, Invest Wisely and pay the monthly mortgage payment.  Borrowing to fund education that could lead to increasing your income could also make sense.  Borrowing to pay for your Wants like vacations, clothes, entertainment is always a bad idea.

One last note.  A Dad’s Advice:  Always, always….pay your credit card balance each month.  A credit card is a tool of convenience.  While you can avoid paying the entire monthly balance, you should pay the entire balance to avoid a very high interest rate.  Even though the credit card issuers will gladly accept your minimum payment (and charge you a very high rate of interest) does not mean you should.