This is the final installment of the Personal Finance 101 series here at www.planyourescape.ca. Today I'll be discussing cash flow and net worth. After learning about income, expenses, assets and liabilities, an overview of cash flow and net worth will be a nice conclusion to this series. By understanding our cash flow situation and our overall net worth, we can quickly evaluate our personal financial health. These basic measures can be useful tools for tracking our progress towards financial freedom.
The concepts of cash flow and net worth are not that complicated but they can be extremely useful to you when you are trying to get a handle on your personal finances. Let's take a look at a quick diagram that illustrates cash flow and net worth.
Cash flow is a measurement of the difference between what we spend and what we earn. Or to use the terms that we've learned about in earlier articles in this series, cash flow is the difference between our expenses and our income. Cash flow can have either a negative or a positive value. If our cash flow is positive it means that we are spending less than we are earning over time. If our cash flow is negative it means we are spending more than we are earning over time. For example, if you find yourself $100 short at the end of the month, it means you've got a negative cash flow. If you've got an extra $100 at the end of the month then you've got a positive cash flow.
When speaking about professional athletes, Patrick Ewing once said, "They make a lot of money, but they also spend a lot of money." The reason I like to look at cash flow is that it measures both our income and our expenses relative to each other. You can have someone who earns $100,000 with $99,000 in expenses leaving them with a $1000 annual cash flow. You can also have someone earning $30,000 with $20,000 in expenses - leaving them with 10 times more money than the $100,000 earner each year. By measuring cash flow, you get the overall picture; while looking at income or expenses alone you only get one side of the story.
The other useful personal finance measurement is net worth - also called net wealth. While cash flow dealt with income and expenses, net worth deals with assets and liabilities. So your overall net worth is the difference between your total assets and your total liabilities. It is the difference between what you own and what you owe. Like cash flow, your net worth can have either a positive or a negative value. If you have more assets than liabilities your net worth will be positive. Your net worth will be negative if your liabilities out weigh your assets.
In much the same way that someone can earn a lot of money but still have a poor cash flow, it is possible for someone with a lot of assets to have a low net worth. As we learned before, often assets will have a corresponding liability: such as a house and its mortgage. For example, if someone owns a $1,000,000 house but has a $950,000 mortgage to go with it, then the house is only adding $50,000 to their overall net worth. That's nowhere near the $1,000,000 price tag on the house. So it is important to look beyond the assets you've got and take into account your debts and other liabilities as well.
If we maintain a positive cash flow, over time we will be left with excess cash. This money can be used to pay back our liabilities (debts) or to purchase assets. By paying down our liabilities and building up our assets, we are gradually increasing our net worth. If our cash flow is negative then the opposite will happen: over time we will need to sell our assets and take on more debt to meet our expense requirements each month. This process will decrease our net worth and leave us in poor financial shape.
So, the key to building net worth is to keep our cash flow in positive territory. We can do this by decreasing our expenses and increasing our income. Then we can use the cash from our cash flow to purchase good quality assets that will appreciate in value over time and to pay back our debts and liabilities. By reducing our liabilities and stocking up on high quality assets we can build a strong net worth.
Cash flow and net worth are good things for us to track on a monthly basis. They are basic measurements of our personal financial health and they allow us to track our progress towards financial freedom. They can be a useful benchmark of our current situation and can be the target of specific financial goals. For example, once we know our present situation we can aim to improve our monthly cash flow by $100. We can strive to increase our net worth by $2000 over the span of one year. Once we have set these goals we can easily track our progress and see the results of our efforts. This can be a very rewarding process: both psychologically and financially!
So now we have a basic understanding of the main concepts related to personal finance: income, taxes, expenses, savings, assets, liabilities, cash flow and net worth. Armed with these terms and an understanding of what they mean, you will be able to discuss, examine and evaluate different financial ideas to find out what is the best for your particular situation. Your financial foundation is set and you're ready to start building on it. Good luck!
This article is part of the Personal Finance 101 series.