The Two Financial Measures that Determine the Health of Your Finances (AKA Two Financial Measures to Track Your Finances)

The following is a re-post of a piece I originally wrote for Dumb Little Man.

I wasn't really sure what to title this post (as you can tell from the double title I did choose), but here's the gist of what I was trying to get at: there are two basic measures that I believe people need to track when it comes to their finances. These measures will both guide your money-related decisions as well as monitor your progress (for better or worse) as you try and grow your personal wealth. They are:

• Net Worth
• Cash Flow

Net Worth

Net worth in its simplest sense is assets less liabilities. IMO, it is the single-most important financial measure for us all to track (it gets the edge over cash flow since cash flow could be viewed as a subset and/or feeding into net worth). Net worth tells you whether or not your wealth is increasing and by how much. It's an accurate and (unfortunately in bad times) ruthless measure of how you're doing in growing your wealth.

There are different ways to track your net worth, but which you choose doesn't really matter. As long as you're consistent, you'll be able to determine if what you're doing is helping to grow your wealth or not. As such, tracking your net worth on some sort of regular schedule is a must for any serious money manager.

Personally, I track mine monthly. Each month in Quicken I update the performance of my investments, put in my income and spending, and run a net worth report. I then record it in a spreadsheet and compare it to the other months of the year as well as my status for the same month the prior year. Doing this gives me a quick report card on how I'm doing managing my money as well as highlights where I might need to make changes. In addition, I record my final net worth at the end of each year (and have done so since the early 90's.) That's how I know that my net worth has grown at a compounded annual rate of roughly 16% since then.

I used to update my net worth weekly, but that was simply too obsessive even for me. In addition, there were too many wild swings (up big one week, down big another) as the market went up and down, big bills were paid, etc. Looking at it only once a month seems to level the swings a bit. As such, this time frame works best for me.

Now I'm not saying that monthly is how often you should review your net worth -- simply that you need to review it regularly. Whether it's monthly, quarterly, semi-annually or whatever, you simply need to check it on a regular basis and make adjustments based on what you find.

Cash Flow

Cash flow is simply income minus expenses. It's the amount you have left over after you earn all you can and then spend all you need/want to spend. The difference is then what you can save and/or invest. This is the amount that fuels the growth of your net worth. It's this difference that buys the homes, investments, and the like that drives net worth higher and higher.

This is why I talk about the two parts of creating a strong cash flow -- maximizing your income and limiting your expenses -- so often. If you can grow the former and keep the latter in check, your cash flow will skyrocket, fueling your net worth to new and glorious heights.

The budget is the method most used for tracking/setting/managing cash flow. My belief is that in the early years of managing your own money, a budget is invaluable. It will help you see where your finances are going and how they are spent. It will help you catch things that otherwise might not be noticeable. It will help you make good financial decisions. I highly recommend having a budget for people just starting out handling their money.

After you become a bit more proficient in managing your money, I think you can go to a less detailed and less frequently updated budget. If you've proven that you can manage your money (and especially control your spending) a budget isn't needed nearly as much to ensure your cash flow remains strong.

For the first decade or so of our marriage we operated on a detailed budget that was frequently revised. We created it at the beginning of the year, tracked it through each month, and updated it at the end of each month based on the previous month's results. It took a good amount of time and effort to this, but as I detailed above, doing this had some great benefits and was well worth the effort.

But as time went on, our budget became less detailed and was updated less frequently. It started by being revised quarterly, then twice a year, then once a year. Now we're at the point where we don't have an "official" budget. Our 15+ years of spending put into Quicken is our budget. Other than unique spending each year (like buying a new couch or taking a big vacation), we pretty much spend what we spent the prior year. We've demonstrated that we can manage our spending so tracking it so closely is not needed to make sure our cash flow keeps pumping out the money.

Those are the two financial measures that I think are most important for all of us to track and manage. If you can create an ever-growing distance between what you make and what you spend and if you can convert that difference into savings, investments, and other assets, your net worth will grow like crazy. It really is that simple.

Investment Return

The one other measure that I considered adding to this list is the return on your investments. After all, once you've spent years socking away money into investments like index funds, the growth or decline of those investments will be the single-biggest factor determining the direction of your net worth. That said, I didn't include it for two reasons:

1. I view the return on your investments as a subset of "managing your net worth." If you're tracking your net worth and analyzing it on a regular basis, you will come up with some steps you'll want to take to growing your net worth and making the most of your investments will be one of those. In other words, it's tracked and/or looked at simply by reviewing your net worth regularly.

2. The return on your investments is not the biggest determinant of how well your investments will perform -- the amount of time you invest is much more important. As such, the sooner you can get your cash flow to the point where it allows you to invest a good chunk of money, the better off you'll be. Sure, return can make that performance much better, but TIME is the key factor that will make your investments grow the most.

How about you -- what measures do you track? Do you agree or disagree with how I do it?

Comments

[LiveCheap]

Good post. I think that cashflow is the first thing that younger people need to focus on. They should have it ingrained that monthly positive cashflow is what leads to true wealth. And as you say in the investment return part, the sooner, the better.

The only issue I have with tracking net worth so often is that it can lead you to stop thinking about your cashflow! I've had months were my net worth went up by $25,000 because of some stock that I held that tripled. If you start looking at those numbers too much, you get the wealth effect. Same thing for the illiquid assets, there's nothing more damaging to your cashflow then some financial guy telling you that you are a millionaire. Net worth of things that aren't marked to market daily can be very problematic. A lot of people thought they were real estate millionaires long after they weren't. So liquid Net Worth is really what the important figure is.

So I think the primary focus is on cashflow and except for going back to school, unemployment and retirement, your entire working life should be spent in a positive cashflow state.

Rate of Return: I think that this is actually more important than the net worth. Spend some time at Motley Food or other good investing sites and put your money to work in low cost index funds and good individual stocks. Over a long period of time, a 3 to 4 percent difference in return creates a wholly different retirement. But diversification is just as important. You can get great returns for 10 years by investing in a single sector and lose 70% of it the next year.

[Crystal]

We concentrate on cash flow and specific investments...our net worth seems to take care of itself that way. I might care about our net worth more in the future, which is why I started tracking it monthly last year, but right now I put more importance on paying off our house and keeping our expenses below 50% of our income.

[A Girl and A Boy who love each other.]

Crystal, we have followed a similar plan. We focused on cash flow and kept our expense below 60% of our income and our net worth has grown from 14,000 in Feb 03 to 172,281 today.

[Jackie]

I track my net worth and expenditures similarly, but don't do as much analysis of the results as you do. It sounds like that might be the missing step for me.

[Investor Junkie]

@Crystal: I agree with you. It's funny I wrote a blog post a few months stating that cash flow is more important. Net Worth will take care of itself in the process.

[Old Limey]

If you concentrate on Cash Flow and ALWAYS save, no matter how little, your net worth will take care of itself. When we were young parents we used to get a lot of satisfaction every month when we sat down at the kitchen table after putting the kids to bed and took care of our bills by writing the first check as a deposit into our savings.

We have been compounding our money since 1956 when we emigrated from England.
Here's what 54 years of compounding can produce without adding to the principal. If you add to the principal every month and avoid taking a loss the results are incredible.
At 5% ===> 1,394%
At 8% ===> 6,381%
At 10% => 17,187%

Unfortunately we are in a low interest rate environment today that doesn't help either young savers or old retirees on a fixed income but nothing lasts forever.

[Betty Kincaid]

Tracking cash flow is the 1st step but it's what you do with the leftover cash in your flow that creates wealth. Positive cash flow used to buy assets and increase your net worth is good, cash used to buy goods and services (what some call disposable income)not so good.

It's easy to get complacent with your investments and your spending habits.

Because of all this, tracking net worth remains the gold standard of determining financial health.

[MasterPo]

While cash flow is important, net worth is what is the foundation of a young person's future.

Youth is the best (and only!) time to start investing because time for returns is on your side.

[Terry]

My net worth is negative and my cash flow is zero. (Income is 98 percent of poverty level.)

Pretty much eliminates the need to make financial decisions.

But I'm shooting for a $50 food spending target this month. I've got my daily food spending below $2 (this requires taking advantage of limited extreme supermarket specials which change weekly and might not persist if the economy improves) and have four free church meals planned this month.

[Ken]

Great points. A good reminder for me to calculate my net worth. It's been about a year since I did so.