Your Liquid Net Worth – Explaining the Concept

The concept of “liquid net worth” merely combines two financial concepts: liquidity and net worth.  It defines the amount of your net asset worth that you can convert to cash easily. The first step to determining your liquid net worth (L.N.W.) is to calculate your net worth and then determine how much of your net asset worth is liquid. You do this by subtracting the total liabilities from the total assets and then determining how much of that amount the individual is willing and able to convert to cash.

Strictly speaking, you may be able to convert most of your assets to cash. However, when calculating your L.N.W., you need to ensure that the assets that you define as liquid are:

a) Available for conversion: you must be willing to convert the asset and it should not be held in lieu of a loan or other form of debt.

b) Readily convertible- the asset should be convertible within a reasonably short period. This could vary depending on whether you are calculating immediate cash needs or are using a less demanding period (weeks or months).

c) Convertible without incurring significant losses- you can convert most of your assets to cash at some point or another. However, you can purchase a collectible for a million dollars and be forced to sell it for one hundred thousand dollars when you need cash. You converted the asset to cash but the prohibitive loss incurred indicates that the asset should not be included (unless you are using the actual cash value of all your assets in anticipating a worst-case scenario).

These criteria readily eliminate certain assets such as real estate (under certain circumstances) and even collectibles. However, the determination of your net worth and, by extension, your liquid net worth is not hard and fast. Instead it is a process with multiple likely outcomes.

Your liquid net worth may incorporate assets like stocks or annuities- financial products that are typically less-liquid than cash accounts or Money Market Funds. Whatever assets you include should be liquid in the context of your financial circumstances and the reason for which you are undertaking the calculation of your L.N.W.

Even if your asset composition does not change, your liquid net worth can be affected by asset valuation, changes in circumstances or even your decisions on which assets you are unwilling to convert to cash. For example, whether you include an extra property or car that you own depends on where that asset resides in terms of your financial goals. You should consider an asset, which you want to retain, illiquid.

However, if circumstances force you to sell that asset and you do a valuation, you need to consider the value of the asset in terms of a current price that it can easily fetch. The accounting principle of prudence is necessary when determining your liquid net worth.

Like many other aspects of accounting, your liquid net worth is a fluid concept. However, it is useful to know your liquid net worth and maintain it at a healthy level. Being forced to sell assets is a recipe for loss- especially if potential buyers know that you are desperate and must sell the asset.

Darrell Victor is a freelance writer and former insurance advisor. For more Personal Finance articles, click http://www.helium.com/users/338815/show_articles?channel=6