Personal finance is no different from running a Fortune 500 company. You’re essentially a one- or, for couples, two-person company. And whether it’s You, Inc. or Apple, Inc., it all boils down to these two fundamentals:

• Net Worth; and
• Cash Flow.

Net Worth

Your net worth is simply what you own (assets) minus what you owe (liabilities). It’s what you’ve been able to accrue and hold onto after all these years of working. You want a positive, growing net worth, and the bigger the better. For most of us, assets likely include cash and cash equivalents, stock and bond investments in taxable, 401K, and IRA accounts, 529 Plans, ESOPs, stock options, home equity, other real estate, the value of a closely-held business, and the value of your “stuff” such as household items, cars, boats, etc. Liabilities include your home mortgage, credit card balance, and student, car, business, or any other type of loans (rental real estate loans, for example).

There are a few net worth benchmarks out there, but my favorite is the following (imperfect) rule-of-thumb:

Target Net Worth = [(Age – 27) * Annual Gross Income] / 5

An example: let’s say the average age for you and your spouse is 45, and your combined gross income is $125,000/year. Your rule-of-thumb net worth should be on the order of $450,000. This equation allows for: (1) a slower start when we’re young (and likely with student loans) and (2) a growing income as we get older and more established in our careers.

A note about the assets that make up your net worth. While home equity is indeed an asset, there are a few caveats, the main being that your equity is tied up in the walls of your house. Most of the time, equity just transfers from your old house to your new (bigger, more expensive) house, where it’s again locked up in the walls. Until you turn your place into a rental property, or sell your place and buy a much cheaper one, the only way to tap into your equity is through a home equity loan. For many of us, our home equity is locked up in the house until we die (!) – at which time our heirs finally tap into the equity if they sell it or rent it out.

Also, while the value of your “stuff” (car, boat, household items, etc.) add to your net worth today, these are depreciating assets, and will one day depreciate to near zero. If most of your net worth is made up of illiquid home equity and/or depreciating assets, you have a problem. To help balance this out, try to have a good chunk of your net worth in cash and cash equivalents, and stock and bond investments in taxable and retirement accounts, because they’re relatively liquid and accessible, and have a chance to grow in real (i.e., inflation-adjusted) terms.

Cash Flow

Cash flow is the difference between income and expenses, including taxes, on an annual basis. It’s essential to know your cash flow, for two reasons: (1) it dictates how much you can save and invest; and (2) your annual expenses will drive when you reach financial independence (FI).

If you have more income than expenses, congratulations, you have positive cash flow. And the bigger the positive cash flow, the better. This is what you save and invest in order to build your wealth. If it is negative, there’s work to do. You can either work on your earning capacity, cut expenses, or both. But cutting expenses is the most practical, immediate solution.

Cash flow illustrates the importance of working hard in school and work, and choosing a practical career, because the end result is a decent, growing income (for more, read this post and this one, too). Just as important is keeping your expenses modest, so that cash flow is large, positive, and growing. This is what you save and invest over the years to reach financial freedom (it’s your savings rate that we talked about here).

Notice that reducing expenses has the following double-barreled benefits: (1) you can invest the savings to grow additional wealth, and (2) you’ll have more modest expenses to meet in retirement, so you’ll need less passive income to cover it.

The idea is to set up both sides of the cash flow equation so that you automatically build wealth in a steady, predictable way, with the goal of becoming financially independent, at which time working is optional and you can do whatever you like (within reason). Some of us may reach FI at a relatively young age. For others, it may take quite a while longer, if at all, because FI can only be achieved if you plan for it ahead of time – it won’t happen by accident. That’s one of the main reasons we’re here today.

In the end, wealth building is based on four things:

• Maximize your income;
• Keep your expenses modest;
• Save and invest the difference in a handful of low-cost total market index funds; and
• Stay the course.

It’s as simple as that, but it requires an adjustment in how we think about money. Most of us think that money is just something we earn to buy more and more stuff. With this mindset, we work to earn money, and once it’s in our hands we run out and spend it.

But really we should view money as capital, where money is used to generate more money. Of course, we all need to spend some money on basic needs (a quiet, comfortable place to live, food, clothes, transportation, etc.) and a few creature comforts, but any surplus should be viewed as capital, to be saved and invested in order to grow in real terms. We should only resume spending on additional comforts and, if we’re interested, increase our standard of living (nicer car, bigger, more expensive house, exotic vacations, routine eating out, etc.) when we’ve saved and invested sufficient capital to throw off enough passive income to pay our basic annual expenses.

There is a trick to this, however: to balance living a good life today, while still saving and investing capital for your later years. There’s a risk of saving and scrimping at the expense of enjoying life today, only to be hit by a bus on day one of FI. The point is this: try to find a balance between living a nice life today and saving and investing capital for the future.