Every year Forbes magazine puts out a list of the world’s richest people. These people are ranked by their net worth. Net worth must be the most important monetary measurement, then, right? Well, not necessarily. A high net worth is only possible because of cash flow. The richest people in the world obviously have A LOT of money coming in and it would be nearly impossible for them to spend everything they make. Therefore, they are able to build an enormous net worth because what else can they do with all their money besides save some of it?
The average person, however, is not making so much money they simply cannot figure out what to do with it. The average income for a full-time worker in the U.S. is just below $50,000. The average net worth in the U.S. is $692,100. But how can the average net worth be so much more than the average income? Because while cash flow impacts net worth, net worth does not necessarily impact cash flow. But before I go any further, let me delve into net worth and cash flow individually.
Suffice it to say everyone has an opinion on net worth. Some people live for net worth calculations, while others find them pointless. Some people also feel strongly about what should or shouldn’t be included in a net worth calculation. I say, net worth is a personal thing and you should calculate it how you want. You know what holds value in your life and what doesn’t, so it’s really a matter of personal preference.
Net Worth = Assets – Liabilities
For those who aren’t familiar with accountant speak:
Net Worth = Anything of Value – Anything You Owe
Assets include things like cash on hand, checking account, savings account, CDs, 401(k), IRA, brokerage account, house, car, jewelry, collectibles and designer items (i.e., bags, wallets, shoes, accessories that have a decent resale value).
Liabilities include things like a mortgage, car loan, student loan debt, personal loan, outstanding credit card balances, home equity loan and medical debt.
Cash flow, on the other hand, is much less subjective. Cash flow is very straight forward. It’s the amount of money you have coming in minus the amount of money you have going out. Cash flow is all of your income less all of your expenses. A budget is essentially a cash flow manager. The most important part of cash flow is what you have left after you’ve paid all of your expenses.
The Relation Between Net Worth and Cash Flow
While net worth and cash flow sound very similar, they are actually very different. A high net worth doesn’t have any bearing on your cash flow. The same way that having a high income doesn’t mean you have a high net worth. How is this possible?
Let’s break this down using some examples.
Scenario 1: Gordon has an annual take home salary of $120,000 or $10,000 in gross monthly income. Gordon has the following loans outstanding: $500,000 mortgage and $40,000 car loan. Gordon has $100,000 saved in a retirement account; $50,000 in bank accounts; his car is worth $50,000; and his house is worth $600,000. He spends $9,500 every month. His net worth is $260,000 and his positive cash flow at the end of the year, which he contributes to retirement, is $6,000.
Scenario 2: Mary has an annual take home salary of $120,000 or $10,000 in gross monthly income. Mary has the following loans outstanding: $500,000 mortgage and $40,000 car loan. Mary has $100,000 saved in a retirement account; $50,000 in bank accounts; her car is worth $50,000; and her house is worth $600,000. She spends $5,000 every month. Her net worth is $260,000, but her positive cash flow at the end of the year, which she contributes to retirement, is $60,000.
Scenario 3: John has an annual take home salary of $60,000 or $5,000 in gross monthly income. John has the following loan outstanding: $100,000 mortgage. John has $100,000 saved in a retirement account; $50,000 in bank accounts; his car is worth $5,000; and his house is worth $300,000. He spends $2,500 every month. His net worth is $355,000, but his positive cash flow at the end of the year, which he contributes to retirement, is $30,000.
Scenario 4: Cindy has an annual take home salary of $60,000 or $5,000 in gross monthly income. Cindy has the following loans outstanding: $240,000 mortgage, $20,000 car loan and $35,000 in credit card balances. Cindy has $30,000 saved in a retirement account; $10,000 in bank accounts; her car is worth $25,000; and her house is worth $300,000. She spends $6,000 every month. Her net worth is $70,000, but her cash flow at the end of the year is -$12,000 because she’s spending more than she’s making by charging things she can’t afford on credit cards.
A few things to note here.
1) A higher salary does not necessarily mean you are increasing your net worth quicker. You need to minimize expenses to the best of your ability in order to have more money to save.
2) A lower salary does not necessarily mean you have less money to save. You can still live below your means and save a lot. As you can see in Scenario 3, John is making less money, but his positive cash flow is higher than Gordon’s in Scenario 1.
3) There is not a direct relationship between income and net worth. So many people experience lifestyle inflation when they receive a salary increase and end up spending more money and saving the same amount or less than they previously were. Some people do save more when they make more but it isn’t a given.
4) Regardless of income, you can actually spend more than you making thereby decreasing your net worth as your liabilities increase at a faster pace than your assets are increasing.
So, what matters more: net worth or cash flow?
Personally, I think cash flow is more important, but not necessarily how much the actual income is. More important than how much money you are bringing in is what you are doing with that money. Yes, a higher income is a great thing to strive for because it would make it easier to save more money. However, spend more time focusing on living below your means, but comfortably, and you’ll find yourself saving more than you thought you could. And the more you save, the more your net worth will increase.
Net worth is a fun number to calculate because it’s subjective and it’s something I think people should know because it gives you a snapshot of your value in dollars. That being said, if you were really in need of money, your net worth shows you how much you COULD have if needed at any given time if you liquidated all of your assets.