Did you get the chance to take an accounting course in college? Let’s review two basic accounting formulas you may have learned:
Assets = Liabilities + Equity
This “Accounting Equation” is the very basic foundation of double entry accounting. Every transaction has to make sure that this equation is in balance.
Using basic arithmetic principles, it can also be stated: assets – liabilities = equity.
In personal finance, you’ll see equity referred to as net worth. And the goal is to maximize the equity/net worth.
There are two main ways to maximize your personal equity:
- Increase assets
- Decrease liabilities
Really, it’s that simple. In theory.
Add a house (more assets), pay off your mortgage (less liabilities) = net worth increase.
Stock values go up = increased equity.
Of course, reality is a lot harder than this. It can take years to pay off your mortgage. And in order to do that, you need money. Cold hard cash. From your job or other income producing sources.
Which leads to the second basic accounting formula that you need to know.
Revenue – Expenses = Income
In corporate accounting, income (loss) is defined as the revenue minus the expenses. It becomes a loss if the expenses are more than the revenue.
Of course, on the personal finance side, we define income as our salary. Because we are fun like that and like to keep everyone guessing about what we are talking about. No reason to be consistent, right?
In any case, the idea here is that all the money you take in, minus all the expenses you pay out determines whether you are making money.
And we like to make money!
Interplay Between the Two Formulas
If you make money, you can increase the cash in your bank account. Yay for assets! Enough cash and you can buy other assets, like stocks or real estate.
But if you are losing money and piling up credit card debt, you are taking on more liabilities. This will decrease your net worth, leaving less “equity” in the first equation.
In other words, you need to maximize your salary/revenue/inflows and minimize your expenses/outflows. You’ll have more net income to add to your assets or pay off your liabilities and thus increase your equity/net worth.
And that’s really the goal of personal finances, right?