A commenter on my post on Net Worth asked me if I could do an example.

Here it goes.

First I do it as done by national accountants as per 2008 SNA – the System of National Accounts and then by the method used by the Federal Reserve’s Z.1 Flow of Funds Accounts.

The example is from a Levy Institute working paper by Antonio C. Macedo e Silva and Claudio Dos Santos with tables created more neatly here.

Let us assume that a single firm starts with the following balance sheet.

In the above Net Worth is defined as we did earlier by treating equities as liabilities of a corporation. As we saw in the table Transactions Flow Matrix in the post Sources And Uses Of Funds, firms finance investment by retained earnings, and incurring liabilities. It was a simplified matrix of course and firms may also by sale of assets they hold.

An important point in the analysis is that this is for a single firm not the consolidated corporate sector as I am going to assume it will purchase physical capital from another firm for which it is a part of current receipts and hence a source of funds for the latter. That is, in the Transactions Flow Matrix, “I” appears both in the current and capital account of the consolidated production firms sector but here we are interested in a single firm.

Let us assume in an accounting period the firm retains $90 of earnings and finances a purchase of physical capital of $400 by this and issuing $50 net of corporate paper (net), taking $150 of new bank loans,  issuing $40 of equities in the markets and selling existing financial assets worth $70.

The closing balance sheet will be as follows:

We assume away capital gains i.e., asset prices haven’t changed for the sake of clarity. As you see, net worth has increased from $50 to $140 and this is due to the firm’s saving – undistributed profits of $90. In general, asset prices change all the time and there will be holding gains and/or losses in both assets and liabilities.

What about flows such as the financial balance?

Here Saving = +$90

Net Incurrence of Liabilities = (+$50) + (+$150) + (+$40) = +$240

Net Acquisition (or Accumulation) of Financial Assets = (-$70)

because of the sale of assets and hence

Net Lending by the firm = (-$70) – (+$240) = (-$310)

(This is also called NAFA in old terminology, instead of splitting Net Lending into Net Accumulation of Financial Assets and Net Incurrence of Liabilities.)

To check: this is equal to Saving Minus Investment which is +$90 – $400 which is equal to -$310 – the “financial balance” of the firm.

So even though we have a negative financial balance, the firm’s net worth has increased. However note that by doing so, the firm’s financial assets/liabilities ratio has reduced – increasing its fragility somewhat.

As mentioned earlier, the purchase of physical capital was from another firm and we have not consolidated the corporate sector and hence the above balance sheets are for a single firm only.

Alternative Approach

The Federal Reserve will do this differently because equities issued by corporations are treated as if they are not liabilities in its Z.1 Flow of Funds Accounts of the United States and accordingly the example will need to be modified to look like this:

I have added Equities in “Memo” as per the Federal Reserve’s practice and the Net Worth at the beginning of the period is $500. With the same set of transactions – a purchase of physical capital of $400 by this and issuing $50 net of corporate paper (net), taking $150 of new bank loans,  issuing $40 of equities in the markets and selling existing financial assets worth $70, while retaining earnings of $90 in the period, the closing stocks will be as below:

Here Net Worth increased by $130 from $500 to $630 because of retained earnings of $90 and issuance of equities of $40 in the period.

The second approach is more like an “own funds” approach.