Today’s blog is about record keeping. The focus is on the personal balance sheet. The balance sheet is a record. And what a record it is! Used strategically, your balance sheet not only shows you what you own versus what you owe, it can be a powerful planning tool to help you stay financially solvent, achieve a good balance of assets for liquidity and returns, and accumulate wealth. To gain a better understanding of a personal balance sheet, follow the following conversation between Mark (financial advisor) and his client, Lenny, age 30.
Mark: Lenny, do you know how much assets and liabilities you have?
Lenny: I know what I have, but off-hand, I don’t have the numbers.
Mark: How about some estimates?
Lenny: Not even that, sorry.
Mark: Okay, no problem. But is having a positive net worth to you?
Lenny: By net worth, do you mean the value of my assets minus the value of my liabilities?
Mark: Yes, that is the definition of net worth. Is that something you keep track of?
Lenny: I think my net worth should be positive, else I’m would be in trouble, right?
Mark: Not trying to sound rude, but how can you be sure you are net worth-positive if you’ve not got an up-to-date balance sheet?
Lenny: Should individuals have balance sheet? I thought balance sheets are only for companies.
Mark: A personal balance sheet is like a corporate balance sheet. On the left-hand side is a list of your assets and their values. On the right-hand side is a list of all your liabilities. Just as you would not invest in a firm with negative net worth, so a person with negative net worth is insolvent because his assets aren’t enough to cover his liabilities. Insolvency puts a person at greater risk of being made a bankrupt.
Lenny: Insolvency sounds terrible. Okay, I will need to get down to creating a personal balance sheet. Seems like an easy thing to do.
Mark: It is, but you need to keep tabs of your assets and liabilities so that your balance sheet accurately measures of your net worth and solvency. Assets are stuff you own that has a money value, things like cars, houses, cash, bonds, stocks, mutual funds, CPF savings, the cash value of your life insurance policies, club memberships, even an art collection (using estimated values).
Liabilities are money that you owe to banks, financial companies or individuals. On the balance sheet, you should record only the outstanding principal (i.e., the amount of borrowed money still owing, excluding interest). Interest is an expense that you record in your income and expenditure statement.
Lenny: I see. How often should I update my balance sheet?
Mark: A balance sheet is usually done once a year, say at year-end. It gives a financial snapshot of your assets and liabilities at that point in time. You can refresh your balance sheet yearly (or more frequently) to keep it up to date.
Lenny: Can you give me some examples of assets and liabilities?
Okay, let me start with the assets side. Here are some examples of assets. I’ve put them into different buckets for easy tracking:
- Cash, fixed deposits and Singapore Savings Bonds —> Liquid assets bucket
- CPF, bonds, stocks, mutual funds, gold —> Investment assets bucket
- House and other real property —> Real property bucket
- Car, club membership, jewelley, art collection —> Personal property bucket
Lenny: Great! What exactly should I track?
Mark: The amount of assets, and the type of assets. If your liabilities are constant, and your assets increase, you become richer! After all, your net worth is what you really own (net of all debt). So, net worth is wealth.
It is also essential to track the diversify of your assets since holding too much cash and deposits over the long run will not allow you to grow your wealth as much as a more diversified portfolio that includes higher-return asset types like stocks.
The point here is that your balance sheet is not just a stuffy record. It should be used as a creative planning tool.
Lenny: Cool! What about liabilities?
Mark: Again, for planning purposes, it is useful to group liabilities into current and long-term liabilities. Current liabilities are those which are due over the next year (I’m assuming you update your balance sheet once a year). So, you don’t want overspend and fall behind your current liabilities because that will surely incur heavy penalty charges will swell your bills further.
Typical examples of current liabilities:
- Outstanding credit card bills
- Student loans*
- Personal loans*
- Car loans*
- Housing loans*
An “*” indicates that you should include the short-term portion of these debts if their tenor extend beyond one year. For example, if you have a car loan with a remaining tenor of 3 years and the principal owing for the coming 12 months is $13,000. Then $13,000 is the current portion of your car loan. The remaining two year’s of principal outstanding is recorded as a long-term liability.
The painful thing about long-term liabilities are (1) their size (at today’s property prices, multi-million dollar mortgage loans are not uncommon), (2) their tenor (up to 30 years for mortgage loans). Borrowing large sums for long periods leads to huge interest costs. So one of your priorities should be to pay off your long-term liabilities as quickly as you can. The sooner you do so, the less you lose due to interest going to the bank and the faster your net worth accumulate.
Lenny: That’s a lot to take for one day. Let me try to summarize the key takeaways. The balance sheet is a record of my assets and liabilities at a point in time. It is also a planning tool to manage those assets and liabilities with the goal of achieving a higher net worth over time. And more net worth means more wealth. Am I on the right track?
Mark: Spot on!