Each year, your budget reflects debt repayments and contributions to investment accounts. These cash flows have a direct impact on your liabilities, assets, and net worth or nest egg. The mechanism consists of two factors: increase in total assets, and decrease in liabilities, both of which combine to yield higher net worth.
Over the course of the year, your existing assets increase in value due to capital appreciation (rise in prices), dividends, and interest you receive. Added to these gains are the cash flows you directed to investments during that year. These are the investment contributions documented in that year’s budget.
On the liability side of the balance sheet, debt payments made during the year and documented in your budget reduce the principal on your various loans: mortgage, student loan, car, etc.
In summary, on the asset side there’s an increase in the amount of assets you own, while on the liability side there’s a decrease in the amounts you owe. The net effect is an increase in your household net worth. In other words, your nest egg increases.
The more room there is in your budget for paying down debt and investing, the faster your household net worth grows.
If you live beyond your means, that is, you spend more than you earn, reflected by a negative net income in your annual budget, then you have to consume or use up some of your existing assets to make it through the year. Instead of your assets growing, they shrink. If you opt to make ends meet for that year by borrowing more, using credit cards or by capitalizing interest on existing debt, then your debt balances increase! Either of these effects decreases your net worth and sets you back in your financial planning.
Hopefully, it’s now clear why your balance sheet and budget are so important. Together, they give you crucial insight into whether your financial plans are on track.
The budget tells you whether you are living within your means for any given period, while the balance sheet tells you what the implications are for your household net worth at any point in time.