Monday, March 26, 2012

The Personal Balance Sheet


The average individual is in a lot of trouble with his/her personal balance sheet. Since the financial crisis started in 2007 and 2008, the average value of an individual's assets has dropped dramatically and the value of an individual's liability has increased substantially. Personal financial literacy is the first step towards developing true financial security and realizing a dream of quitting a job or having a comfortable retirement. In my previous post, I describe how most retirement advisers give fundamentally flawed advice about managing cash flows in the retirement years.

The balance sheet is the main starting point for understanding finances. It was my starting point when I was working on my MBA and the educational requirements for the CPA exam and it is a logical starting point to show people how finances work from the bottom up. In my previous post, I described some regular activities in terms of stocks and flows and the balance sheet represents the stocks at a single point in time. Ultimately the balance sheet follows the fundamental accounting equation:

Assets = Liabilities + Equity

Conceptually, this means that everything that has an economic value or can produce some sort of future economic benefit (assets) are composed of the owner's economic interest (equity) and items that will trigger future economic sacrifices (liabilities). Common assets on a set of personal financial statements are cash, receivables (typically salary or interest from bonds and insured savings), real estate, retirement savings, and vehicles. Common examples of liabilities are student loans, mortgages, credit cards, and most regular expenses like auto insurance, utilities, etc. Equity gets interesting in the business context, but for a personal financial statement is mainly a placeholder for showing the difference between assets and liabilities and can reasonably be thought of as wealth at a point in time.

Let's look at a couple of examples. The first example is a college student that financed his/her education with loans and is about to graduate. This student also purchased a new car to get to a job. Assume that the student is at the end of an apartment lease and used $5,000 on a credit card on eating out over 5 years.

Assets Liabilities Equity
Cash (checking account): $1000 Car Loan: $15,000
Car: $15,000 Credit Card: $5,000

Student Loan: $100,000

Total Assets: $16,000 Total Liabilities: $120,000 Total Equity: ($104,000)

This is a bad way to start out, I know a lot of people who have ended up here and the graduating classes for the foreseeable future will have the same sort of financial position. The main difference between the people I graduated with and the people in the newer graduating classes are that the newer graduates will be dealing with an unemployment rate of more than 8% and few job prospects that will pay the amount required to service the liabilities generated from being a student. Ultimately this cost will either be taken by private investors or taxpayers when students default on education loans after a failed job search.

Let's look at an example of a homeowner who isn't currently under water with their loan. Assume they bought their house 10 years ago for $200,000 at a rate of 6% and  have just paid off a car with a carrying value of $10,000. This homeowner has no other liabilities. His/her financial position, not including rainy day/retirement savings, might look like this:

Assets Liabilities Equity
Cash: $3,000 Home Mortgage: $167,371.45
Car: $10,000

Home: 200,000

Total Assets: $213,000 Total Liabilities: $167,371.45 Total Equity: $45,628.55

What's interesting here is that the homeowner has paid almost $144,000 to generate about $32,000 in equity (meaning that $112,000 of interest has been paid on a $200,000 home over 10 years, see this post for how this is calculated). Yikes!

What if this homeowner bought in 2007 and had their home depreciate to a value of $100,000:

Assets Liabilities Equity
Cash: $3,000 Home Mortgage: $167,371.45
Car: $10,000

Home: 100,000

Total Assets: $113,000 Total Liabilities: $167,371.45 Total Equity: ($54,371.45)

In this case the owner has paid more interest than the home is worth (same amount as above) and they are underwater on the home loan. Is it any wonder that they simply walk away at this point. Anyway, what we see here is that the financial situations of typical people are more difficult than most people understand, especially politicians who were hand picked from Wall Street. Understanding the personal balance sheet is the first step to controlling and improving personal finances.

See Also,
Retirement in the 21st Century
How Much Interest Are You Paying?

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