Many people keep some form of a budget. We use our favorite budgeting tool, YNAB. Others use a spreadsheet or pen and paper. Whatever the approach, a budget helps you understand your income and expenses.
Fewer people track their net worth. A net worth statement tracks your assets and liabilities. It’s the scorecard of personal finance. If you’re not tracking your net worth, start today.
What even fewer people realize, however, is how a budget and net worth statement work together. They each affect the other in important ways. Understanding how they interact is the focus of today’s podcast, and an important aspect of building lasting wealth.
The 2 Key Personal Financial Statements
It goes by many names. Corporations call it a Statement of Operations or Income Statement. Some refer to it as a cash flow statement. Most just call it a budget.
A budget, like an income statement, reflects income and expenses over a period of time. Most budgets are tracked on a monthly basis, but they could also be tracked on a quarterly or annual basis.
Net Worth Statement
Just like a corporation’s balance sheet, a net worth statement tracks your assets and liabilities, how much you own and how much you owe. Unlike a budget, a net worth statement is as of a specific day. They can be easily track with a spreadsheet or a more advanced tool such as Personal Capital.
A Budget & Net Worth Statement are Linked in Important Ways
While we tend to think of a budget and net worth statement as tracking different aspects of our finances, they actually work together in some interesting ways. Understanding how they interact can teach us a lot about how small financial decisions can have a big impact on our finances.
Here are some common monthly transactions and how they affect both our budget and net worth.
Paycheck: Payday affects both your budget and your net worth. Your paycheck is of course income for your monthly budget. But the deposit into your checking account also increases the cash balance on your net worth statement. Of course, much of this money will likely be spent over the course of the month through expenses. If you spend less than you make, however, the difference goes to improve your net worth (either through increased assets, lower liabilities or both).
Withholdings: Each paycheck has certain expenses automatically deducted. These typically include taxes and health insurance. While many, myself included, budget on an after tax basis, these are real expenses that affect our budget. We may not track them separately, but they are significant expenses.
In the case of 401k or 403b contributions, however, these payroll deductions affect our net worth. They increase are assets (investments) by the amount of the contribution. In other words, while we may not pay a lot of attention to our withholdings each month, they can have a significant affect on our financial statements.
Monthly Expenses: Our monthly expenses ranging from groceries to gasoline of course hit our budget. These expenses lower our net worth (by decreasing our checking account or increasing a liability such as a credit card) and increase our expenses in our budget. They affect both financial statements.
Dividend and Interest on Investments: Dividends and interest on investments present an interesting case. Most of us don’t give much thought to either, particularly if we reinvest both (do you know how much in dividends your investments generated last month? YTD? Last year?). But they are both important to building wealth and technically affect both our budget and net worth. Payment of dividends and interest are both income, whether we reflect them in our budget or not (most non-retirees probably don’t). If we reinvest this income (as we should) then it flows right back to our net worth statement and goes back to work earning us even more dividends and interest in the future (compounding).
Car Payment: When we make a car payment, the transaction affects both our budget and our net worth statement. First, the interest expense hits our budget, while the principal payment lowers our liabilities. Of course, the transaction doesn’t increase our net worth. We used cash (an asset) and lowered our liabilities by the amount of the payment that went to principal. The rest went to the interest portion of the payment.
What Does It All Mean?
So what’s the point of all of this? Good question. The first point is to drive home the fact that our budget and net worth are inextricably intertwined. How we handle our budget has a huge impact on our net worth. But also how we handle our investments and debts can have a big impact on our budget. This leads to two important things to understand:
At first, your budget powers your journey toward wealth. Starting out all we have is our income less expenses to sock away for emergencies, retirement and other savings. It’s slow going at first as we try to improve our finances while avoiding debt.
But if you do it right, eventually your net worth, not your budget, builds your wealth. Over time, through the magic of compounding, the assets in your net worth statement should be powering your wealth building even more than the income from your job. It takes some time to get there, but once you do, it’s a beautiful experience.