A personal finance blog dedicated discussing such topics as budgeting, asset allocation, 401K, IRA, cash flow, insurance, financial planning, portfolio management, and other areas in personal finance.


Wednesday, March 30, 2005

Financial Planning Basics - The Net Worth Statement

Financial planners typically use two financial statements to get a handle on a person's current financial status. Those statements are: the net worth statement (also called the statement of financial position) and the cash flow statement (also called a budget). Today, I'll discuss the net worth statement.
Most people are familiar with following equation:

Assets = Liabilities + Net Worth

Looking at the above equation, you can see that as long as a person's assets are greater than their liabilities, they have a POSITIVE net worth. For example, say that all you have is a house that is worth $100,000 with $70,000 still owed on the mortgage. Assuming that you have no other assets or liabilities, your net worth equation would look like this:

$100,000 = $70,000 + $30,000

So, in this really simple example, your net worth is $30,000 since the house is worth $100,000 and you only owe $70,000. Now, what happens if you make a payment? (Once again, I'm really simplifying this example but the theory is still the same). Let's say you make a $1,000 payment, of which 100% goes directly towards paying off the mortgage. How does this affect your net worth?

$100,000 = $69,000 + $31,000

Since the value of the asset side (the house is still worth $100,000) doesn't change, the other side of the equation must adjust to reflect the payment. Since we are assuming that 100% of the $1,000 payment went towards the mortgage, the liabilities decreased to $69,000, which means the net worth portion had to increase to $31,000 to balance out the equation.

With my next post, I'll show some more example of different transactions and their effect on the net worth statement.