Everyone wants to be *rich*, right? (duh). Almost everyone who wants to be rich would be tracking his/her net worth very closely through some kind of a balance sheet. But sometimes, I wonder if most of us really understand what *rich* (or wealthy) means in terms of our assets, liabilities, and net worth. Here are a few example questions that can quickly cause confusion in this respect:
- If you compare your net worth now to your net worth 5 years ago, how would you know if you are wealthier now than in the past?
- Are two people with the same net worth equally rich?
- Between two people, is the one with greater net worth wealthier than the other?
- Are people with more income wealthier than people with less income?
The questions look trivial don’t they? Instinctively, most of us (including me) would start looking at the net worth numbers on a balance sheet to and attempt some kind of a comparison. The problem with this approach is that raw net worth numbers can totally throw you off the track.
Some bloggers (like Flexo and Ben) have discussed the importance of ratios (as opposed to raw net worth) in evaluating your financial situation, but may be, even these are not enough to determine whether you are wealthy (for reasons that will be clear with the examples). I will consider two popular ratios for this post:
- The debt/income ratio: Lower is better; lowest possible value is zero.
- The assets/debt ratio: Higher is better; highest possible value is infinity.
Here is another method (rule of thumb) proposed in “The Millionaire Next Door” by Stanley and Danko to find out whether you are wealthy or not (let’s call this Stanley and Danko rule):
Multiply your age times your realized pretax annual household income from all sources except inheritances. Divide by ten. This, less any inherited wealth, is what your net worth should be.
Now, lets assume that there are 5 friends (say V, W, X, Y, and Z) all 30 years old. Your task is to compare their balance sheets and determine the richest of them all. Their income, debt, net worth, and assets are shown graphically below. For each of them, the two popular ratios mentioned above and their classification according to Stanley and Danko are given along with the graph (if you apply the Stanley and Danko rule to them, at their present age, they would be categorized as “wealthy” if their net worth is equal to or more than three times their income). Your job is simple, just look at them and help me locate the *richest*. I will make it even simpler for you by making their net worths the same (all of them have a net worth of $60,000).
Mr. V’s info: Debt/Income ratio = 0; Asset/Debt ratio = infinity. Stanley and Danko rule says - wealthy
Mr. W’s info: Debt/Income ratio = 1.5; Asset/Debt ratio = 3. Stanley and Danko rule says - wealthy
Mr. X’s info: Debt/Income ratio = 0.6; Asset/Debt ratio = 3. Stanley and Danko rule says - not wealthy
Mr. Y’s info: Debt/Income ratio = 1.2; Asset/Debt ratio = 2. Stanley and Danko rule says - not wealthy
Mr. Z’s info: Debt/Income ratio = 1.33; Asset/Debt ratio = 1.75. Stanley and Danko rule says - not wealthy
So go crazy with all the ratios you want and drop a line with your answer as to who is the wealthiest among the 5 guys.
I have deliberately not specified the purpose of this post; by the time you work out on who is rich, you will figure that out yourself. I think this might be a learning moment for some of us and the assumptions that we make about our and other people’s net worth.
If you extend your results to future years, who, do you think, will be the richest in the long run?
Also, if you were to ignore the ratios completely and just go with a gut feeling…who one would you point out as the richest?