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.