Net worth is one of the most widely used metrics to report financial progress. This calculation is commonly used in part because it’s a simple and easy metric to understand and apply:
Net worth = total assets – total liabilities
Your net worth value will provide you with an indicator of your financial situation. High net worth means your assets far exceed liabilities; that’s a great thing. Low or negative net worth means you owe significant amounts of debt; not desirable. Getting out of debt is desirable and there’s many ways to do it. Monitoring your net worth over time will provide you with an indicator if you’re trending in the right direction but it may not provide you with all the financial freedoms you are looking to fund in the future.
Let me explain…
A house worth $500,000 in Toronto or Ottawa or Vancouver (I don’t think they exist in Vancouver?) has a small consolation prize if you owe $400,000 on that house and have $0 invested. A house can be a home but it’s also a place to live after all. Including house assets and mortgage liabilities as part of net worth, while technically correct, is misleading because it says little about the prospects of long term success, much like a small business. I think a household is like a small business in many ways; you have income and expenses to manage. In my example above, you may have $100,000 in net worth but if your expenses are equating to or exceeding your income for too long, you’re going to suffer. Small businesses that have a large net worth on paper might look pretty impressive but if they have meagre or negative cash flow over time, they aren’t going to be in business very long. A good way of managing your household finances is always thinking like a small business. For this reason, I suggest investors would be better off focusing on building and increasing cash flow year after year through better budgeting and investing practices, than focusing on net worth.
Years from now, I’ll gladly take the ability for my portfolio to generate money and distribute money over anything else because I can’t spend my net worth, at least not for long, withdrawals from capital only last so long. On the other hand, increasing cash flow year after year is like getting frequent raises at work (if you get them), steady, increasing paychecks give you more predictability to plan and live your life how you want. To me, while a high net worth is impressive and I’m striving for it, increasing cash flow demonstrates an investor’s ability to manage money effectively and efficiently and that’s real financial progress in my opinion.
In closing, maybe I can conclude my thoughts this way – I never want to behave like a spoiled athlete who spends all their net worth. I’m focusing on increasing my cash flow over time and living within that. If I do that, I’ll be financially free because of it.
What are your thoughts about cash flow and net worth? Do you prefer to measure your progress using one over the other? If you don’t use either measure, which ones do you use to monitor your financial health?