“Okay, so you’ve got a car, that don’t impress me much,” Shania Twain.
Many of us have witnessed it. That couple with the huge house, nice car and latest electronics. Then one day, the gig is up. The car is repossessed and the house is foreclosed. Sometimes they see it coming, and other times they don’t. There can be a variety of reasons that lead to the financial demise of this family, but today, I’ll discuss how you can avoid being fooled with respect to your wealth position. The answer has to do with what may be the least sexy term I know (sorry CPA’s), the Balance Sheet… dun duh daa!
First, a little background on financial statements. If you were making an investment in a company and you were given the opportunity to only see the company’s profit and loss statement (P&L), cash flow or balance sheet, what would you choose?
The right answer is Balance Sheet. A P&L will show how much money was made or lost over a given period of time with revenue and expense categories. However, a balance sheet will show you the cumulative financial position of the company (cash flow is actually just a derivative of the balance sheet). How much money has been made since inception? What are all of the assets worth? And, what debt obligations exist, as well as, are they due soon? Most folks are aware that the world of balance sheets in the corporate world can get extraordinarily complicated. There are forensic accountants, auditors and analysts who make a living off of dissecting, interpreting and reviewing the balance sheet. What many people don’t realize is that balance sheet can be constructed for a person, couple or family.
Fortunately, the balance sheet for people is much simpler to create and track. It carries the same principles as the corporate world, but the level of complexity typically does not exist. I will now explain how to formulate your balance sheet followed by why it’s important.
The balance sheet formula is: Assets = Liabilities + Equity.
Assets are anything of value. This can be straight forward like valuing a bank account or an IRA account. In these cases, it would be the dollar value of the accounts. However, it can get more challenging if you have tougher to value assets such as a car (what would it sell for?) or collectors’ items. Private company stock and stock options can be difficult to value as well.
Liabilities are debts owed. Typical liabilities I encounter are credit card balances, a mortgage, college loans and debt to others (family, friends etc.).
Equity, in the case of personal finance, is net worth. This balance sheet account can be calculated after you figure out your assets and liabilities. If you have more liabilities than assets, your net worth is negative (quite common after college these days). When you have more assets than liabilities, your net worth is positive.
So, why is it important to know what your balance sheet looks like? Well, let’s say a man has a goal to save $5Million for retirement. Fifteen years later he reaches his goal and retires as planned. However, when he retires, he also has a $1.2M mortgage, a home equity loan of $500k, debt to a family member for a failed business startup of $200k, a $70k loan on his Tesla and $30k of back taxes due. Unfortunately, when you net all of these together, his net worth is actually only $3Million. This is 40% lower than the retirement target number. If he doesn’t cut his expenses, he will likely draw down on the principal materially faster than intended, creating a difficult planning situation in his future. If there’s a market pullback, his retirement plans will be turned upside down instantly.
In hindsight, it would have been wise if he had focused on his entire balance sheet before retiring. As a warning, things can definitely get more complicated. For example, figuring out the type and location of your assets: Roth IRA vs. Traditional IRA vs. taxable account vs. illiquid business holding vs. primary residence and the specifics of debt one holds. Regardless, as a starting point, focusing on the balance sheet is a big step in the right direction.
I start every meeting with my ongoing clients by reviewing their balance sheet. This conversation is front and center. There are no illusions as to the wealth of my clients. I think a key to successful financially planning is to track your net worth overtime. Who cares if you have an extra $50K of cash in your bank account if you also have an additional $60K loan? And, that is why I always say, Balance Sheet is King!
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