Now that you’ve taken an inventory of your finances and determined your net worth, I can tell you that the number is meaningless. Well, there is a point to your net worth, but it’s not the most important number to your finances. Your net worth tells a very small part of the story that defines who you are.
Let’s say my net worth is $100,000. Am I in good financial shape, poised well for the future? It’s impossible to say because we don’t have enough information. $100,000 means different things to different people. For example, starting retirement with $100,000 in the middle of Kentucky will go farther if you relocate to Kentucky or Argentina than if you move to New York City or London.
But more importantly, your net worth is nothing more than a snapshot at some particular time. If you’ve recently climbed out of credit card debt, $100,000 is good. If you have hospital bills to pay without insurance, $100,000 might not be enough to last the next year. When you view your net worth in combination with your income and expenses, you will be able to better define your finances. You’ll have an idea of where your money is going.
In today’s society, almost everyone needs income. Most people acquire money by trading their time and effort. I give eight hours of my day, five days each week, as well as a portion of my brain power during that period, to an employer. The employer is (usually) grateful and provides me with money in return. It’s kind of a strange system, but it works. Chances are you do something similar, but perhaps you receive income from investments or a pension.
With one source, it’s easy to calculate income. On a monthly basis, how much money do you receive? Some incomes are steadier than others. I receive a predictable paycheck from my employer each week. But I also earn money from a side business. The side business is highly unpredictable, so I don’t rely on counting that income each month.
The reason we trade of time and effort for money is often because we need to use money to trade for items that allow us to survive, like food, water, and shelter. If we’re lucky, we’ll have some money left over after paying for necessities to spend on luxuries like furniture, internet access, and hot air balloon rides, or to save for the future.
Your expenses should be less than your income. Put another way, spend less than you earn, or live within your means. If you do, your financial situation will gradually improve. If you do not; that is, if you spend more money than you have each month, then you will dig yourself a hole that gets more treacherous each month.
Determine about how much you spend each month in a number of categories to determine whether you’re sinking, treading water, or winning a gold medal in breast stroke. For now, until you actually track every financial transaction you make, these numbers can be estimates.
These are expenses you have to pay, the necessities for living. I use these categories but you may have some others you’d like to include. Like the net worth calculation, create a two-column list. The first column contains the category and the second column contains the monthly amount you spend in each category.
- Automobile/Transportation: This includes parking, tolls, and train tickets.
- Food and Groceries: If you have a family to feed, this could be very high.
- Healthcare: How much do you pay each month for doctor’s visits and prescription drugs?
- Household: Some household expenses are non-discretionary. I include clothing in this category.
- Interest and Fees: If you have loans, credit cards, or any service that charges a fee, then include the amount you spend in this category.
- Insurance: Health, car, and life insurance should be placed in this category.
- Rent: I rent an apartment, but you may not.
- Utilities: You pay for power to your home. Perhaps you would include cable television here, but I would consider that discretionary.
- Tax: It’s almost impossible to avoid paying tax.
- Debt payments: Each month you must make at least the minimum payments on all your debt.
Everything else is a discretionary expense. You don’t have to spend this money every month. Dining out, gifts, charity, and your vacation are discretionary expenses.
The goal is to be able to start with your monthly income, subtract your non-discretionary and discretionary expenses, and still have some money left over. This calculation is your “net income” if it is positive; if the number is negative, you can call it a “net loss.” Net income can be saved, invested, or used to pay off your debt faster. Here’s what your income and expense report might look like. Note that income is positive while expenses are negative.
This person is in bad shape. With a monthly income of $2,000, he has only $175 after non-discretionary expenses. During this time period, including all expenses, he spent a total of $2,175 while earning only $2,000. If this is a pattern, he is probably increasing his debt load every month, and the non-discretionary debt payments expense will grow.
If this is you, this should be the first sign that it may be time to change your behavior. This individual has some flexibility, but everyone’s situation is different. Assuming that the month observed here is typical of other months, we can predict fairly accurately that net worth, if not buoyed by investments, will decrease every month.
This is the opposite of anyone’s financial goal. It’s time to take action.
Image source: specialkrb
Updated January 16, 2010 and originally published November 12, 2008. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @flexo on Twitter and visit our Facebook page for more updates.