By Matt - Monday, July 9th, 2007
What do you do when you want to figure out on what type of financial footing you stand? Do you go to you bank account to see how much money you have? Well this might work if you had no investments and no liabilities; essentially it stops working before you leave high school for most people. So beyond this you either take a wild guess or you rely on one of two statements: a net worth statement or a cash flow statement or both but we’ll get to that. Very often I’ve seen the net worth statement used without anything else (and I did that for a while myself), which often excludes the cash flow statement. They’re very separate and have very distinct uses; you really can’t have one without the other in my opinion.
So what exactly is net worth? Well net worth is defined by the wikipedia (http://en.wikipedia.org/wiki/Net_worth) as
Net worth (sometimes “net assets”) is the total assets minus total liabilities of an individual or a company
Essentially all of the items that you own that have value compared with all of the loans and credit card debt separated from it. For example I’ve got a pension plan that I contributed when I working in my early twenties and now I’ve got about $35,000 in there and to match this I had $10,000 in credit card debt my net worth would be incredibly easy to calculate and I would have a net worth of $25,000. Its rarely that straightforward but it should give you an idea of how it works.
From what I have been able to tell net worth is a snapshot in time from the moment you gather all of the numbers to pull the statement together. Often these numbers change from day to day (especially if you have a lot of money in investments such as stocks or mutual funds). If you’ve been in the PF blogging world for any length of time you’ll notice a lot of people use net worth statements more often than naught in assessing their monthly goals and achievements.
Also banks use a modified version of a net worth statement to determine if you are eligible for a loan or a credit card (modified because they consider other things such as income, credit score and a few other things). Regardless net worth statements are a great way to take a current snapshot of your financial health and have their place.
One thing to keep in mind about net worth is the fact that your assets column/section is often arbitrary and the true value of the items in that list is hard to peg down. For example if you put your car down as an asset and set a wholesale value that you looked up for it you might be ok but if you needed or wanted to sell the car you might not get nearly as much for it as you think or want.
Cash flow on the other hand is defined by Wikipedia (http://en.wikipedia.org/wiki/Cash_flow) as:
Cash flow is an accounting term that refers to the amounts of cash being received and spent by a business during a defined period of time, sometimes tied to a specific project.
A bit of a mouthful but it’s the amount of money that you spend and bring in over a period of time. For example if I made $1000 a month and had to pay rent of $500 without any other expenses my cash flow for the month would be + $500. Again this is a very simple example but it shows that the cash flow needs to be tied to a period of time and since a lot of our regular expenses revolve monthly that’s the best period of time to use.
A cash flow statement is a very useful term since it compares how much money you’re brining in to how much you’re spending. If you happen to be spending more than you’re brining in you’ve got a negative cash flow, which is never a good thing. It gives you an idea how well you stand on a month-to-month basis and if your cash flow for the month is negative it’ll give you an idea where you can trim down and spend less. Also it’s a great tool to help you budget more accurately.
Cash flow statements aren’t nearly as popular in the PF blogging community from what I’ve found because to keep them really accurate takes time and effort and I assume a lot of bloggers keep them behind the scenes and only show net worth. Regardless they’re not as popular from what I’ve seen.
On a personal note one of the traps that you can fall into with cash flow is not setting the right timeframe. I would keep a running cash flow from pay to pay which is great for that two week period but a lot of bills are on a monthly basis. Another thing that can throw off a cash flow statement is the fact that occasionally we have yearly or one time expenses which we forget about when we throw one of these together.
Net Worth vs Cash Flow
Both of these statements have their place and their uses but one without the other doesn’t tell you very much. As part of this comparison I wanted to use myself as a case study until I realized just how off my cash flow was. My net worth is positive and as long as I’m a little careful it’ll continue to grow slowly over time or stay the same. Unfortunately because my cash flow is negative I will pay a credit card down only to need to rely on it before the month is out. So my net worth alone doesn’t paint the whole picture of my financial situation.
That is probably the most deceptive thing about a net worth statement in my opinion is that it can increase slowly over time but you struggle from pay to pay and from month to month without knowing why. I’m sure a lot of PF bloggers will look at this and say well its obvious that if you spend more than you make you’ll struggle. Unfortunately I believe that I’m like a great many people out there where I don’t pay as close attention to the money going in and out of my account as I should and the net result is I know I’m spending more than I should be and than I have so I float along kind of treading water. Budgeting alone doesn’t solve this because of the small-unexpected expenses that come that inevitably get forgotten.
A net worth statement will also tell you where you owe money for things such as credit cards, loans and mortgages which is good and gives you the larger perspective and can help you coordinate where to put any extra left over money you have. Mix into this a cash flow statement and you’ll know what you can and can’t spend in the month. It’ll help you create an accurate budget and reduce unnecessary expenses to bring your finances under control.
Its not a difficult exercise to create both of these but it can be a daunting one which is why when I took a step back to create mine as part of writing the notes for this article I was taken a bit aback. Over the past 6 months I knew where my net worth was (within say $1,000) and I had a rough idea how much I was spending. I had a budget and thought I was floating along ok, I knew I wasn’t bringing in as much as I was spending but I thought they were pretty close. I think this is exactly the type of situation that gets a lot of people into trouble, they have a rough idea of where they are and they seem to be struggling from pay to pay but they can keep going.
In my case I realized that I was spending between $700-800 more than I was bringing in and this is just using rough numbers. When I realized this I was completely floored and it just dawned on me that this is why I had been struggling for the last decade. I would spend more than I made but I wouldn’t really know how much and as long as I could pay my bills or pay for everything somehow I would be ok. A very very bad idea; I would recommend going through the exercise of creating a true cash flow statement for yourself (or if you’re married for your family). Then I would suggest that you run this list by someone who knows you very well its incredibly easy to deceive yourself or miss-estimate when doing this. If you’re living from pay to pay not really understanding why your credit card is never paid down and why you’re struggling your answer might come in that fancy little cash flow statement.
In my next post I’ll go through my cash flow statement and tell you what I’m in the process of doing to fix the problem of hemorrhaging money like its going out of style.
[tags]net worth, net worth statement, cash flow, cash flow statement, financial health, money[/tags]