When it comes to managing personal finances, two key metrics often come into play: net worth and cash flow. While both are essential for understanding your financial health, they serve different purposes and offer unique insights. But which one is more important to track? In this article we’ll talk about the differences, the pros and cons of each, and ultimately how they work together to provide a complete picture of your financial well-being.
What is Net Worth?
Net Worth is the difference between what you own (assets) and what you owe (liabilities). In simple terms, it’s your total wealth at a given point in time. Assets can include cash in savings, investments, property, and any other valuables you own, while liabilities are things like mortgages, credit card debt, student loans, and other obligations.
Net Worth Formula:
Net Worth = Total Assets − Total Liabilities
Pros of Tracking Net Worth:
- Long-Term Perspective: Net worth provides a snapshot of your financial health over time. It’s a useful measure for long-term financial planning and can help you track your progress towards financial goals like retirement or buying a home.
- Comprehensive View: It accounts for all your financial assets and liabilities, giving you a holistic view of your wealth.
- Goal-Setting: Knowing your net worth can motivate you to reduce debt, increase savings, and build wealth over time.
Cons of Tracking Net Worth:
- Lack of Short-Term Insight: Net worth doesn’t provide a clear picture of your day-to-day financial health. You might have a high net worth but still struggle with cash flow issues.
- Market Dependency: Your net worth can fluctuate based on the value of investments or property, which might not reflect your actual financial situation.
What is Cash Flow?
Cash Flow is the movement of money in and out of your accounts over a period of time. It reflects your income (money coming in) and expenses (money going out), offering insight into your ability to manage your daily and monthly financial obligations.
Cash Flow Formula:
Cash Flow = Total Income − Total Expenses
Pros of Tracking Cash Flow:
- Immediate Financial Health: Cash flow gives you real-time insight into your financial situation. It helps you understand whether you’re living within your means or overspending.
- Budgeting Tool: By tracking cash flow, you can create and adjust your budget to ensure that your income covers your expenses, with some left over for savings or investments.
- Debt Management: Positive cash flow can help you pay off debts faster, while negative cash flow might signal the need to cut back on spending.
Cons of Tracking Cash Flow:
- Short-Term Focus: Cash flow primarily looks at the short term, so it doesn’t provide a complete picture of your long-term financial health or wealth accumulation.
- Can Be Misleading: A high income might create the illusion of financial security, but if it’s not managed properly, it won’t necessarily lead to a higher net worth.
Which is More Important to Track?
Deciding whether to prioritize net worth or cash flow depends on your financial goals and situation. For long-term financial planning, net worth is crucial as it shows your overall financial standing. However, for day-to-day management and ensuring you can cover your expenses, cash flow is vital.
For example:
- If your goal is to retire early, tracking your net worth will help you measure how close you are to achieving financial independence.
- If you’re focused on getting out of debt or saving for a specific short-term goal, tracking cash flow will be more beneficial.
How Net Worth and Cash Flow are Related
Although net worth and cash flow are different, they are interrelated, and both play a role in your financial well-being. Positive cash flow allows you to pay off debts, save, and invest, which in turn increases your net worth. Conversely, a higher net worth can generate more income (through investments, rental properties, etc.), improving your cash flow.
Example:
- If you regularly contribute to a retirement account (positive cash flow), the value of that account grows over time (increasing net worth). As your net worth grows, the income generated from your investments can further improve your cash flow, creating a positive cycle of wealth building.
How I Use Both
When I first learned about this, I was intensely interested to see where I stood and check both my Net Worth and Cash Flow. This started to allow me to see how well I am faring towards my goals.
Luckily, there is a great company that allows you to track your net worth for free called Wealthfront (This is an Affiliate Link that I will receive monetary value from if you sign up through this link). Once you follow the prompts to register, you can connect your checking and savings accounts, any investment accounts you have (401k, IRAs, stocks), loans (mortgage, student loans), credit card balances, and anything else that has value (or money you owe) to get your net worth calculated. This is by far the simplest way to figure out how well you are doing financially with your Net Worth.
For my monthly Cash Flow, I use a simple budget on Excel Sheets. Many banks and other companies like Wealthfront have automated technologies to track your daily and monthly Cash Flow. Personally, I like inputting my own income and expenses into an Excel Sheet because it constantly makes me look at and analysis my habits.
There are a lot of differing debates on which is more important, as mentioned above in the beginning of the post. Some people and experts believe Net Worth is the most important gauge to track your finances and others disagree where others believe Cash Flow is more important. Both are important and both work together to create a full understanding of your financial wellbeing.
I hope this is useful for you and allows you to get a better understanding of how well you are doing financially. It continues to help me on my path to financial freedom and I hope it helps you as well!
To the New World and the New You, much success in finding your financial freedom.