One of the challenges in personal finance is understanding which numbers matter and what they mean. Over the next two posts, we’re going to cover the two key numbers you need to understand where your money is going and where it’s taking you: net worth and cash flow. The concepts are way less intimidating than they may sound and at the end of this article, you’ll be able to calculate both net worth and cash flows and have some intuition for what they mean.
Net Worth: Where You Are and Where You Want to Go
If you were to reduce a person’s finances to a single number, net worth would be it. Net worth is calculated by adding up all your assets (i.e., any bank account with a positive amount of money in it and anything you own that’s worth money) and subtracting off any debts. If you were to sell everything you own, liquidate your bank accounts, and pay off your creditors, the pile of cash you’d be left with is your net worth.
Net worth is a useful starting point for a number of reasons. First, net worth functions similarly to the “you are here” mark on a map, providing you with a datapoint for your financial situation that can be compared against the path you’d like to follow. Looking at your net worth today and asking yourself where you’d like it to go is the first step to creating a plan for your financial future.
Second, you can’t hide anything in your net worth. Net worth takes into consideration every account you have and all the money that goes into and comes out of them. One of the exercises I’d recommend (and the subject of an upcoming article) is to look at the change in your net worth over the course of a year. This change is precisely how much you were able to save after all your expenses and can often be a surprisingly small number. By comparing the change in your net worth to your income, you can get a high-level view of your spending and savings, providing a foundation for budgeting and building a savings plan. Net worth treats your debts and assets equally in the sense that saving $1000 in a checking account has exactly the same impact on net worth as paying off $1000 on a loan. This equivalency can be helpful in making decisions, because by looking at net worth you’ll always get “credit” for both paying down debts and building up savings.
Third, and perhaps most importantly, net worth gives you a sense of what you can do with your money. If you want to retire with $40,000 of annual income from your investments, one rule of thumb says you’ll want a net worth of roughly ~25x that or $1,000,000. You could argue that you’d actually need investments worth $1,000,000 to collect this return and, for example, owning a house worth $1,000,000 and having $0 in savings or investments wouldn’t work. Even in this case, net worth still gives you a good read of your options, as you could always sell your house and invest that money to achieve the same result. Net worth tells you that you have that money somewhere and where you choose to put it is a different question.
For these reasons, net worth is the best place to start when forecasting your finances and evaluating the impact of one decision as compared to another. Findi is designed to make this process easy, handling the math for you and quantifying the impact of decisions on your net worth.
However, net worth is also subject to a number of limitations. As hinted at in our investment income example, it doesn’t tell you anything about where you have your money parked and how easy it is to access. In our example, you could sell your house to unlock your $1,000,000, but that process is much more cumbersome than say transfering $1,000,000 out of your checking account and net worth doesn’t give any indication of this. Net worth also doesn’t give any sense of where money is coming from or going to. To get a sense of where your money goes, which determines a lot about how your finances feel on a month-to-month basis, we need to look at cash flows.
Have questions, comments, or suggestions for future posts? Leave me a note below and I’ll do my best to reply.