Use Net Worth to Measure Your Progress

Your net worth is the result of a simple equation: what you own minus what you owe equals your net worth. In accounting terms we call what you own 'assets' and what you owe 'liabilities'. The difference is known as 'equity' or net worth. I will use these terms here and you should learn them so you can speak intelligently to your banker or accountant about increasing your net worth. There are a couple of ways to do this.

First, you can increase what you own. A bigger bank account, a more expensive house, a larger investment portfolio; these would all increase your net worth. However, it's possible to increase what you own and at the same time increase what you owe so in essence you have taken two steps forward and two steps back. In fact, there are few situations besides winning the lottery or receiving an inheritance that will affect only one side of the net worth equation. Most of the time when you add significantly to the asset side you are also adding to the liability side (think of buying a house, you get a big asset and also a big mortgage to go with it). Smart investors know this is their only choice so they add things to the asset side that will increase in value while taking on liabilities that grow at a smaller rate. In accounting terms this means their assets appreciate at a rate greater than the interest on the loans used to acquire them. Think of your house mortgage. If the interest rate is 6.5% and the housing market in general is appreciating at 9.5% your net worth should increase each year by about 3% of the value of your home.

Now focus on the second side of the equation. Reducing your liabilities (what you owe) will also increase your net worth. Again, the problem is that reducing liabilities in almost all cases means giving up assets so it would seem little is done to increase your net worth. However, smart decisions here can increase your net worth. Think of credit card debt. If you owe $10,000 and the credit card has a finance charge of 12% you can use $10,000 of cash to pay the card off and during the next year you will save $1,200 in finance charges. In this case your net worth went up even though all you did was trade $10,000 in assets for $10,000 in reduced liabilities.

The point here is not an elementary lesson in home economics. The point is the need to focus on net worth when setting financial goals. Too often I hear people set targets for increased savings, a bigger home, a larger bank account, but to focus on these goals to the exclusion of net worth is very nearsighted. Net worth is the only measure that takes a holistic view of your situation. Therefor it is the tool you should use to measure long term progress toward your goals.

One final point, when we work with clients who are struggling to increase either their personal net worth or the equity in their business there is one rule we spend a lot of time drilling into their heads.  More money will not fix the problem! People don't believe me when I tell them this but it is true. The person who is financially secure on a $30,000 salary will be financially secure on a $210,000 salary. But a person who cannot survive on $30,000 will have just as much trouble making ends meet when he's making seven times as much. Businesses that can't make it on $1,000,000 in sales will not be able to make it on $2,000,000. The reason is that financial security and success requires discipline and discipline is a function of spending and investment. Don't get caught in the trap of thinking more money will fix your problems, business or otherwise. It will only reveal another set of issues that mask the real problem, your lack of discipline.

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