How do you know if you're reaching your financial goals or if you're making financial progress? And what can you do to get to where you want to be at a faster rate? These questions get to the heart of one simple matter: you need to keep track of your finances by calculating two simple measures on a regular basis.
These two measures are net worth and cash flow. Knowing them will tell you how you are doing financially. They will also give suggestions on actions you can take to improve your financial situation. With these two key metrics alone, you can measure and track your success in growing your net wealth.
What is net worth?
Net worth is simply the total amount of assets that you own less the value of the debts you owe. Another way to think of it is it's what you would have left over if you sold everything and paid off all your debts.
Written as a formula it looks like this:
Total assets - Total liabilities = Net worth
For example, if you had a $200,000 home, $50,000 in a Roth IRA, $20,000 in credit card debt, and a $100,000 mortgage, you would have a net worth of $130,000 ($250,000 - $120,000).
Net worth reveals your true wealth. In today's media we often hear "wealth" described in terms of income (how much someone makes annually.) But it's not what you EARN that makes you wealthy, it's what you KEEP. This is what net worth measures.
Taken at a point in time, net worth tells you little. Sure, it can let you know if you are in positive territory (own more than you owe) and give you a relative comparison to how others are doing, but those uses are rather limited. Net worth is most useful when it's tracked over time. In this way you can see if you're making financial progress -- if your wealth is increasing. This is why Free Money Finance's tagline is "grow your net worth." Because if you're growing your net worth, you're making financial progress and becoming more wealthy.
As such, it's vital that you measure your net worth on a regular basis. Personally, I update mine once a month (which is pretty easy to do using Quicken) and this is probably the most frequent you'd want to monitor your net worth (any more frequently doesn't really give you enough time to see progress.) Others measure their net worth quarterly or twice a year. I recommend that you check it every three months at the very least.
What is cash flow?
Cash flow measures the amount of income you make less the expenses you pay. It's what you have left over each month after you pay all your bills.
Written as a formula it looks like this:
Total income - Total expenses = Cash flow
For example, if you earn $2,000 a month after taxes and have expenses of $400 for food, $300 for a car payment, $500 for rent, and $500 for all other costs, your monthly cash flow is $300 ($2,000 - $1,700.)
Cash flow is a bit more complicated to track than net worth because it involves so many different moving parts. For instance, income can be made up of several sources such as salaries, dividends, interest, side jobs, hobbies, and any other payments that you receive. Expenses involve everything from taxes and mortgage/rent payments (generally among the largest costs most people have) to small purchases like a daily coffee, a magazine subscription, a sandwich, and everything in between -- anything you spend money on.
People track their cash flow over different periods of time depending on their stage in life, financial constraints (such as when income is made, when expenses are due, etc.), personal preferences, and the like. I recommend younger folks (people in their 20's and early 30's) and those who are close to having a cash flow at break-even (where income equals expenses) or, heaven-forbid, a negative cash flow (where expenses surpass income) track and record their cash flow once a week. Those who have a bit more space between income and expenses and those who have proven to be able to manage and control their finances with less tracking mechanisms can measure their cash flow less frequently like monthly or once a quarter.
I measure my cash flow once a month. Again, it's quite easy to do using Quicken. I suggest people look over their cash flow status at least once a month at the very minimum.
How net worth and cash flow work together
Tracking both net worth and cash flow is important because of how they work together to improve your financial standing. Your cash flow drives the assets you can purchase and debts you can pay off. Through careful planning of your cash flows every month, you are able to grow your net worth -- your true wealth. Here's how the cycle works:
- Each month, you make income from various sources.
- Each month, you have expenses from various commitments.
- The difference between income and expenses is what you have left over -- your cash flow.
- This cash flow is an asset -- which then adds to the "good" side of your net worth.
- In addition, you may have made debt payments from your cash flow that month that lowers the "bad" side of your net worth.
- If you create a surplus in this way month after month, you will grow your net worth over time and thus become wealthier over time.
In the examples above you have $300 every month left over in cash flow. In addition, let's say of the $1,700 in monthly expenses you had, $400 went to debts and decreased liabilities you had. As such, your net worth increased by $700 that month ($300 + $400). If you did this for a year, your net worth would increase by $$8,400 a year ($700 per month * 12 months).
Tips for growing your wealth
If you've followed along so far, you've probably realized that the formulas are pretty simple. If you want to become wealthier (which means increasing your net worth), there are only a few steps you can take to do so. They are:
- Earn more income. This has the result of increasing your cash flow and thus allows you to add more money to your assets and/or pay off more debt every month -- both of which increase your net worth. For ideas on how to make more money, see 11 Great Ways to Earn More Money.
- Decrease/limit your expenses. This has the result of increasing your cash flow and thus allows you to add more money to your assets and/or pay off more debt every month -- both of which increase your net worth. For ideas on how to lower your expenses, see my various "saving money" categories in the FMF archives (at the bottom).
- Do both. You can significantly improve your finances if you do both of the above -- grow your income AND decrease your expenses. This super-charges your cash flow and allows you to grow your net worth at an even faster rate.
- Increase the value of your assets. This involves managing your assets so they grow in value at a faster rate than they might if left on their own. For instance, $100k left in a CD might earn you 1% a year, contributing an extra $1,000 to your net worth annually. But the same $100k invested in an index fund could earn you 8% a year or $8,000 total. See how the actions you take can grow your net worth? Of course this is a very simplistic example and there are many other factors to consider. But for the purposes of this post it illustrates nicely the benefits to your net worth when you work to grow your assets.
Putting it all together
For the more experienced FMF readers, this post has probably provided few new insights. But for others, this information may be overwhelming. If that's the case, let me simplify the entire process for you. Here's a list of what you should do with the information above:
- Calculate your net worth. Do it soon so you know where you stand. Then set in place a regular update (like monthly) so you can monitor your progress.
- Calculate your cash flow. Do it soon and also plan to update it at least once a month if you fit the circumstances I've noted above.
- Look over your cash flow to identify ways you can grow your income and decrease expenses. Make a list of next steps to take and start knocking them off one-by-one.
- Look over your net worth and see if there are any assets you can grow. While it's difficult to increase the value of some assets (like your home), others (like investments in stocks and bonds) can often be sources for additional growth. Start to educate yourself on the potential options for making what you own work as hard as possible for you.
In the end, by tracking these two simple measures on a regular basis, you can take steps to significantly grow your net worth over time and ultimately meet almost any realistic financial objective you set for yourself.