2 Formulas for Building Your Net Worth

Building long term wealth is actually quite simple when you think about it.  Today we’ll look at really the only two formulas you need to know in order to build wealth (sorry, I literally mean formulas).  Along with these two formulas, the last part is the psychological…you really have to want it.

The Accounting Formula

Day 1 of Accounting 101 teaches you a basic accounting formula:

A-L= OE

or put another way

Assets- Liabilities= Owners Equity

It’s a basic formula for figuring the equity in a company.  You can also use it for calculating your net worth.  For today, I want you to make some substitutions to the equation to make it apply to your monthly budget.  We’ll substitute Assets for Income, Liabilities for Expenses, and Owners Equity for Surplus or Shortfall.

With these substitutions, we are making a simply definition of showing our personal cash flows for a given time frame:

Income – Expenses = Surplus or Shortfall $

Ideally you want this equation to be positive for each month.  For example, monthly income of $4000, minus monthly expenses of $3000, equals a surplus of $1000.  The excess cash flow allows for flexibility.  With the positive cash flowing in, you can buy things, save for a rainy day, invest, etc.

If your doing this equation, and the answer works out to be negative…you need to either increase your income (which can be hard to do) or look at ways to cut down on expenses.  Also, if your monthly budget is coming up short, this is an emergency.

For those with surplus money at the end of each month, this allows you to go into the finance formula to building long term wealth.

The Finance Formula

The second equation to building long term wealth is taught in day one of finance.  For simplicity sake, we’ll use the future value of a single cash flow.  It looks like this:

FV = PV(1+r)^t

or put another way

Future Value = Present Value (1+rate of return)^time

What this formula is used for, is to calculate the future value of you current investment over a specified time frame.  For example, the $1000 surplus mentioned above invested for 10 years and earning 8% would be worth $2158.92.

Now I should be using the future value of a series of payments, but don’t want to scare off readers with that formula.  But so far we have just used one month as an example.  Now imagine instead of just doing this for one month, you did it every month for 10 years.  Hopefully you see the point here.

We can even combine the formulas and come up with:

Income – Expenses = Surplus(1+r)^t

Meaning investing your excess monthly income each month to build future wealth.

That’s really all there is to it, when you think about it.  The first accounting formula says to live on less that what you make (live below your means) and the second formula says invest your extra money and let it grow and have compounded growth over time (even Einstein thinks compounded growth is cool).  Doing these two things will get you on the correct direction for building long term wealth.  Don’t forget the last part…you have to want it and put the effort to make it happen.

Being that my site is focused on stock investing, this is my personal preferred way of having your money grow over time (the “r” in the second formula).  But there are other ways as well, such as real estate or starting a business.

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Readers Comments (2)

  1. Great explanation of the formulas.

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