Finance is a multifaceted subject. It cuts across various aspects of our life and at certain times knocks the wind right out of us. For instance, today as I met with a client, we considered how to calculate liquid net worth. Yeah, I know liquid net worth doesn’t garner the attention that net worth alone does. However, both calculations have their place in your finances. So I’m going to share a little about why liquid net worth matters and how you can figure yours out.
If you’ve never heard the term liquid net worth, then perhaps you are wondering what the difference between the two is anyway. The difference is probably simpler than you think. Liquid net worth is more in-depth than just net worth. With so many of us struggling to keep up with money as it is, let me explain in a little more detail.
Imagine you walk into a bank, and the teller asks, “What is your liquid net worth?”
Perhaps you look lost because you never took the time to figure it all up. (In case you don’t know what net worth is—it’s basically, all of your assets minus all your liabilities.) Or maybe you quickly spout out a number. Either way, if the teller asked about liquid net worth, could you answer?
Today, I posed that very question to my client, “What is your liquid net worth?”
He looked dumbfounded; I don’t even know what that is much less how to calculate it. Is it all the cash I have?”
The funny thing is, most people actually subscribe to that notion that liquid net worth is essentially the amount of money in your savings account. Yet, it’s more than just cash on hand.
Liquid net worth works like this. If you had to sell everything you own today, how much cash would readily be available?Click to tweet
Liquid net worth works like this… if you had to sell everything you own today, how much cash would readily be available?
Let’s say you had $10,000 in the bank. Then that cash is worth $10,000. Simple enough on that right? Now factor in taxable investment accounts. Those are worth whatever market value is as of today.
Now, here’s where it gets murky. Let say I have a retirement account with $50,000 sitting in it and I am under the age of 59 1/2. If I cash in the account, I’m forced to pay income taxes. We’ll say our tax rate is 2o-30%. If you have a state income tax as well, factor in another 5-10%. Remember I’m under age 59 1/2, so cashing that it means I owe a pre-payment penalty too. While that $50k factors into my net worth, if I need to make it liquid (cash I have on hand), I’ll roughly cut that amount in half to about $25k. WOW! That’s a major difference!
Another type of investment to consider is direct investments. These are usually illiquid investments. In other words, these investments are very hard to sell. Here’s an example, interest in my business. We’ll say a company is valuated (how much someone would pay for it) at $5,000 and the owner needs to sell it quickly. If they are lucky, they’ll get about $2,000 for it.
Additionally, let’s look at real estate. Take, for instance, if you sell a piece of property in most markets—outside the bubble of L.A—you’re looking at needing to discount it by about 20-25% if you want to sell quickly. That will quickly attract an investor. If your house appraises at a $100,000, a smart investor will snatch it up quickly at $75,0000. So basically, you’ll need to discount direct investments, illiquid investments and hard assets to about 50 -60% of their actual value.
Other hard assets you may want to consider: cars, boats, four wheelers or maybe even a tractor. (Oh yeah! That would be a tough one for me because I REALLY LOVE my tractor!!!) Say I paid $20,000 for my tractor, but today, it’s only worth $18,000. I might not be able even to get $18k. It may be more in the range of about $14k. So again that’s another 20% discount; leaving me getting back only 60-70% of the total purchase value out of my tractor.
So basically, when you calculate all these discounts and series of “afters” you’re left with your total liquid net worth, which is likely 70% of our actual net worth, or our assets minus liabilities. So we are probably losing 25-30% of something’s value if we need to liquidate our lives quickly.
Liquid net worth is pertinent because it allows us to plan for the “what ifs” of life. The importance of this knowledge comes into play if an emergency situation pops up. You’ll want to make sure your liquid assets will cover you. So if your house decides to go up in flames, you suffered a major accident, or you suddenly develop a debilitating illness urgently requiring money, you’ll have an idea of how much you can get, quickly.
While we hope you never need to our liquid net worth, at least you’ll have the knowledge to power through if you do.