If I were to ask you to write down your current salary, you would probably be able to jot down your income to the penny, right? If I asked you to write down your net worth, though, would you know an exact amount, a ballpark range, or even whether this figure is positive or negative?
An individual’s net worth — or personal wealth — is a slightly more complex calculation than income. Even the concept of wealth can be difficult to grasp without knowing all of the factors that go into it.
Last summer I worked for a government contractor, counseling federal employees on their finances. Over several weeks, I spoke with a few hundred employees, and very quickly realized that there was quite a lot of confusion over what “wealth” really means. Depending on the person, one’s wealth was defined by such qualifications as making a good salary, driving an expensive car, or living in a large home.
To help these employees better understand wealth, I illustrated two separate but related ideas for them: a cash flow statement and a net worth statement.
A cash flow statement is a fancy term for this concept: You add everything that comes in (income) and subtract everything that goes out (expenses and taxes). The remaining number, whether positive or negative, is crucial. A positive cash flow means you have money left over to save, whereas a negative cash flow means you are dipping into savings or accruing debt. You can easily calculate your own cash flow using this same formula.
The second item I sketched for them was a net worth statement. This is another big term for a simple concept: Subtract everything you owe (which includes your mortgage, student loans, credit card debt, and any personal loans) from everything you own (which includes bank accounts, investment accounts, your house, and your car) The net result equals your net worth, or wealth. Just like cash flow, your net worth can be positive or negative, depending on how your assets and liabilities literally add up.
Are you still with me? This is the interesting part: how your cash flow is connected to your net worth.
There are two ways you can actively increase your net worth, and they can both be happening at the same time! The first is to reduce your liabilities, which should happen over time as you pay off debts — as long as you’re not simultaneously accruing more debt. The second is to increase your assets. This will happen if you are contributing to a retirement or savings account. Net worth continues to grow as your assets appreciate over time.
Here is where cash flow comes into play. If you are consistently saving some of your income, and aggressively paying down debt, then you are increasing your wealth. Conversely, if everything that comes in is being spent and nothing is being saved, you are not increasing your wealth, but rather living paycheck to paycheck. This is true no matter your income. I’ve seen people making a moderate five-figure salary who save, and I’ve seen people making a high six-figure salary who spend everything that comes in.
Saving, which will increase your wealth over time, is also known as living below your means. This is a simple concept that is easy to implement immediately. Just start an automatic savings program with your next paycheck — even if you allocate $10 to savings, as long as you are not funding your lifestyle with a credit card, you will immediately be living below your means!
Managing your cash flow is the powerful foundation of financial planning work. Most of us have little or no control when it comes to the economy, taxes, costs of fixed expenses, or our earnings. However, we do have control over what we do with our money, and this is why understanding these concepts is exciting. When you focus on things you can control, and take small action steps, amazing things can happen. By taking control of your cash flow, you take meaningful steps toward financial empowerment.
Take your own steps toward a better financial future today. Assess your cash flow and write out your net worth statement. Then ask yourself how you can start increasing your savings and increasing your wealth. For motivation, check your net worth every six months to a year to watch it grow. And be in touch if you’d like some professional help.
Addie McHale is a member of the DailyWorth Connect Program. Read more about the program here.