Our personal balance sheets can tell us a lot about our current financial standing. It’s simple, assets minus liabilities equals net worth. Over time, the goal is to pay down liabilities, increase assets, and in turn increase net worth. If you’re sticking to a strategy that essentially sticks to this basic concept, you’re more likely to find long-term financial success. This article will explore how tracking your net worth is important and how it can help positively influence financial behaviors that ultimately lead to a better financial situation!
Understanding Cash Flow
First, before we jump into analyzing a balance sheet and tracking net worth, it’s important to understand another crucial part of your current financial situation. Our cash flow, or in simpler terms, what’s coming in every month versus what’s going out. Cash flow is an important tool to HELP increase our net worth. If our cash flow is correctly allocated on a month to month basis, it’s positively reflected on our personal balance sheets.
For example, if you’re earning $10,000 each month net of taxes, 401(k) contributions, and other deductions from your pay, figuring out how to maximize this income in correlation with your unique goals is key. Let’s say you spend $2,000 on rent, and another $3,500 on other living expenses, that leaves $4,500 each month to be used towards financial goals. Those goals could be paying down debts (credit cards, student loans, personal loans, etc), which depending on the interest rates associated with them, can oftentimes be one of the first items to tackle. It never makes sense to pay interest in the double digits on any form of debt, typically in the case of credit cards or personal loans.
Let’s assume in this case you’re paying off student loans at 6.5% interest rate and decided to put $1,500 month towards that goal. Next, you’ve realized the need to set up an emergency fund as a buffer against any large unexpected expenses in the future that will allow you to avoid using debt and having to pay interest on that debt. Typically, 3-6 months worth of living expenses is an adequate amount for an emergency fund for someone in this situation. They’ve decided to allocate another $1,500 a month to this goal.
Lastly, with the remaining $1,500 in cash available each month, you’ve determined there aren’t any other short-term goals to work towards, instead, you’d like to invest the remainder in a taxable account for the long-term.
Pro Tip: Automating all these transfers each month makes managing your cash flow even easier!
Having the wherewithal to understand your monthly cash flow helps align it with the goals you’re trying accomplish. It also will positively reflect on your balance sheet, ultimately increasing your net worth. In this case, the act of paying down student loan debt (decreasing liabilities), building an emergency fund (increasing assets), and building a taxable investment account (increasing assets) are all positive reflections in increasing net worth.
While managing our cash flow correctly helps drive positive results in our balance sheet, it’s also important to understand how to correctly manage AND maximize assets and liabilities. First, we’ll analyze the assets side of the balance sheet.
Assets essentially include anything that you actually own. That could be real estate, your 401(k), checking and savings accounts, stocks, or a business. All these items add up to your total assets. It’s safe to say everyone has a long-term goal of financial security and to spend our TIME as we please without having to worry how to support ourselves financially. In order to do so, we have to build assets to support ourselves in achieving financial independence or a more commonly referenced term (although I think the lifestyle it references is greatly changing) retirement.
Ideally, these assets will be working for you. In the case of 401(k)’s, the investments within the account are earning dividends and interest, which are being reinvested over time. The funds are also benefiting from capital gains, or the price increases over time. Ultimately, investment performance and consistent contributions to the account drive up the balance of the account over time. In turn, increasing your net worth. All at nearly zero work for you! This is the beauty of our market system.
Once you’ve reached a level of assets to provide enough security for financial independence, you may consider using the 401(k) assets towards supplementing or providing for your lifestyle. If you’re no longer working, then the assets are drawn from the account, thereby reducing your assets and net worth.
The key point to understand about building and managing assets is to allow them to work for you! Of course, diversifying assets to protect against losing everything in a poor investment is important as well.
Liabilities or debt, if used correctly, can be a great tool in increasing net worth long-term. If used incorrectly, it can set you back years towards achieving financial goals. A simple example is student loan debt. It’s an essential debt to leverage that you potentially used to invest in yourself. In doing so, you greatly increased your future earning potential, which likely outweighs the principal and interest you’ll pay over the life of the student loan.
Debt should ALWAYS be viewed through this lens. The capital you receive as a loan should be deployed in a way that the return on the investment is greater than the interest you’ll pay for the loan. While it’s not always easy to predict from an investment perspective, it does help eliminate any unnecessary forms of debt. In terms of consumer spending and credit cards, if you’re building a balance and paying extremely high interest on the balance, you’re definitely not earning more in return!
If you’re ready to settle down and start a family, buying a home might be a priority. I argue this decision shouldn’t necessarily be made from an investment perspective, however, determining how to BEST leverage a mortgage to achieve home ownership is important. If you have cash available for a greater downpayment that would allow you to lower the interest rate by 1% over a 30-year term, it can make sense to do so. The 30-years worth of interest adds up pretty quickly, especially if there aren’t other available assets outside the home that have the potential to earn a greater return than say 4.5% (the hypothetical mortgage interest rate). This concept refers to opportunity cost. Is my dollar better allocated towards the home downpayment OR can it be leverage better by using a loan to finance the home and using the dollar invested elsewhere?
Managing liabilities or debt correctly can help accelerate growth in assets and in turn your net worth. However, be wary of overleveraging and using consumer debt incorrectly, as it will negatively impact your ability to increase your net worth!
Tracking Net Worth
What ultimately matters in regards to long-term goals is whether our net worth is large enough to support our desired lifestyle. That’s not to say you don’t love your job and want to continue working for a long long time. But, how nice would it be to have that peace of mind knowing you have the flexibility to pursue whatever it is you wanted.
The first step towards achieving this is actually understanding where you currently stand. Technology today makes this relatively easy. Account aggregation software such as the software I use for building financial plans for my clients, make this process simple. You link all your accounts (checking, savings, credit cards, 401(k), equity plans, real estate) and allow the software to aggregate everything in your personal balance sheet. Revealing what your current net worth is!
Visually identifying your current financial situation in itself can be a motivating factor. If you’re not happy where you currently stand or set goals to achieve in terms of your net worth over the next few years, you’re significantly more likely to take the next steps towards achieving those. Coincidentally, that’s through gaining a better understanding of your cash flow and maximizing it towards your goals!
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At a minimum, starting to track net worth can lead to other positive influences in financial behavior. Milestones such as achieving a 6 figure net worth, or 7 figure, are positive reinforcements towards ultimately allowing you to live the life you want on your terms, and using money as a tool to achieve that.
If you’re too busy, a delegator, or need help with any of the topics discussed in this article, schedule a free consultation today to learn how working with a financial planner may benefit you!