In business school, we often examine four financial statements to give us an overview of the financial health and conditions of a business. These four statements are income statement, balance sheet, statement of cash flows, and statement of retained earnings. The balance sheet represents the assets, liabilities, and equity of the business. It offers a broad overview and in examining a business, it offers information about the liquidity and capitalization of an organization. For personal finance, a balance sheet provides an overall glance at an individual’s net worth at a specific point in time.
Personal Balance Sheet Components
Assets: What you own. Can be broken down into three separate categories:
- Liquid Assets: Either cash, or things that can easily be sold or turned into cash. Examples: checking accounts (cash), savings accounts, money market accounts.
- Large Assets: Substantial items you own. Examples: houses, cars, boats, expensive electronics, furniture, and artwork.
- Investments: An item that is purchased with hope that it will generate income or appreciate in value. Examples: bonds, stocks, CDs, mutual funds, and real estate
Liabilities: What you owe. Examples include currents bills, payments owed, credit card balances, student loans, mortgages, car loans.
Net Worth: Assets minus liabilities. In other words, it is the difference between what own and what you owe. Net worth is an individual’s measure of wealth because it represents what you as an individual owns after everything you owe is paid off.
Two Ways to Increase Net Worth
- Increase Assets: Increase cash flow or increase the value of something you own. Increasing your net worth through asset increase will only work if the referenced asset is of higher value than the increase in liabilities.
- Decrease Liabilities: Increasing your net worth through liability reduction only works if a decrease in what you owe is greater than a reduction in assets.
Too many individuals do not understand that often times, an individual will increase liabilities along with acquiring an asset. For example, upon the purchase of a house your assets will increase however you have just taken out a mortgage on the house so your liabilities will increase as well. This is precisely how so many people go wrong. They think a house purchase is a great thing and overall it can provide a positive return. However, there are a tremendous amount of variables here to consider and purchasing a house to live in is completely different than purchasing an investment property.
Cash Flow: Using Personal Capital, you can see how a positive influx of cash flow can increase your net worth. If an individual has a positive cash flow, the individual can use the cash to either increase assets or decrease liabilities; which will both have a positive impact on your net worth.
In all honesty, I was not aware of my personal balance sheet until a few years ago upon entering business school. Once I acquired Personal Capital, which is a wonderful personal finance tool, I was able to truly understand my personal balance sheet.
Assess spending habits and understand your balance sheet. Creating a personal or household budget is important and I encourage everyone to do so. However, a budget will only encourage an individual to live below their means. An individual can only cut costs so much. However, understanding your personal balance sheet will teach you to build wealth. And that folks… is the bottom line.