Relationship among Human Capital, Financial Capital and Economic Networth

$$ \text{Net wealth} = \text{Total Wealth} – \text{Liabilities.} $$

This can be thought of as similar to the fundamental accounting equation, in that:

$$ \text{Equity} = \text{Assets} – \text{Liabilities} $$

Only in this case, the fundamental accounting equation pertains to an individual rather than a corporation. The liabilities represent payments owed, whether in the form of a mortgage or the result of a lawsuit, these are funds that are legally owed in the future (not the same as a desired purchase). Also note that net worth, net wealth, and economic worth are all similar ways to say the same thing.

$$ \text{Total Wealth} = \text{Financial Capital} + \text{Human Capital} $$

The total wealth portion of the equation above is the result of adding together HC and FC. As the typical individual ages and progresses in their career, HC will usually comprise a smaller portion of total wealth. This is because aging means fewer and fewer working years ahead of the individual. In contrast, FC will increase as the individual works, earns, and saves. The goal is to realize the inflows of human capital and turn them into financial capital over time.

Question

Which of the following best represents a liability to an individual investor:

1. Goal of sending two children to college.
2. A planned purchase of a large Recreational Vehicle.
3. $200 of credit card debt.

Solution

The correct answer is C.

This debt is for a purchase that was already made, and is legally owed to the lender. While the two previous answer choices likely represent a much larger burden, these are not liabilities but desired future purchases. Their course could be reversed with no legal ramifications.

A is incorrect. It is not a liability. It represents a financial goal or aspiration, but it’s not a current financial obligation or debt. It’s more of a future financial objective.

B is incorrect. It is also not a liability. It represents a future planned expense or goal, but it’s not a current financial obligation.

Reading 9: Risk Management for Individuals

Los 9 (b) Discuss the relationships among human capital, financial capital, and economic net worth