The Financial Basics – Where to Start

In my last post – What is Your Why? – I discussed a systematic approach to discover the root reason driving each of us to strive toward improving our financial lives. What will be the guiding principal to focus on while traveling the path toward achieving financial goals?

In today’s post we will take the first step on the path to gaining full control over our finances. First, we must determine our present location – where are we starting from?

Determining your present financial location

In personal finance, the way to do this is to create a “Statement of Financial Position” more commonly known as a “Net Worth Statement.” Many people dread the thought of doing this as they fear it may be difficult. Some also fear what they may discover.

Having helped many people with this task, I have found that most are pleasantly relieved that 1) creating a Net Worth Statement was easier than they thought and 2) the final result was better than they feared.

I want to take a step aside here for a moment and discuss a mental framework for this activity. If you were the CEO (Chief Executive Officer) and/or CFO (Chief Financial Officer) of a business, you would expect to have at your disposal a few financial statements to help you manage your business.

The same is true for individuals. After all, you are effectively running your own business from a financial perspective – I like to refer to this as being the CEO & CFO of Me, Incorporated.

In business the two primary financial statements are the Balance Sheet and the Income Statement.

The Balance Sheet is a snapshot of a company’s financial position at a specific point in time. For personal finances, this financial statement is referred to as the “Net Worth Statement.” This statement is typically produced as of a year-end, quarter-end or month-end date.

The second primary financial statement for business, the Income Statement, tracks Income (inflows of money) and Expenses (outflows of money) for a given period of time. I will be discussing how this translates to personal finance in a later post. The Income Statement covers a calendar period of time (such as one month, three months, or one year) and typically coincides with the year-end, quarter-end or month-end date and is consistent with the date of the Balance Sheet.

Now let’s dive into the Net Worth Statement. It is a very simple concept and only requires basic addition and subtraction skills. An individual’s Net Worth equals the value of everything owned less everything owed – easy as that. The equation can be further defined as Assets minus Liabilities equals Net Worth.

Putting it all down on paper

Take out a sheet of paper and draw a line vertically down the middle of the page. On the left side is where everything owned (Assets) will be listed. On the right side is where everything owed (Liabilities) will be listed.

Net Worth Statement - Template

The totals of the two sides need to equal – hence the term Balance Sheet used in business. The way this is accomplished is by solving for Net Worth. The final Net Worth figure will be placed at the bottom of the right-hand side of the page. Note this can be a positive or negative figure depending on the total value of the Assets and Liabilities. (If Assets exceed Liabilities, Net Worth is positive – if Liabilities exceed Assets, Net Worth is negative.)

How is the information organized on a Net Worth Statement?

On the Asset side (left-hand side), I like to group assets into three categories: Cash & Cash Equivalents, Investments and Use Assets. What is included in each of these?

Cash & Cash Equivalents include hard currency, checking and savings account balances, CD’s (Certificate of Deposit), money market demand accounts and money market mutual funds. Basically any cash-like instrument that has a fixed dollar value and can be converted to cash immediately. These instruments are very liquid.

Investments include savings bonds, individual stocks and bonds, and mutual funds. These will typically be held in investment accounts such as those at a brokerage firm, but also include retirement accounts like IRAs, 401(k)s, 403(b)s, 457s, etc. This investment category will also include investment property and business ownership.

When organizing these figures, I like list them in order of ease of liquidity – so taxable investment accounts might be first, followed by retirement accounts, investment property and business ownership. If you aren’t sure about the relative liquidity of a particular investment, no need to worry. The important point here is to list all investments and include them on the asset side of the Net Worth Statement.

Use Assets include non-financial assets that are not for investment purposes. This would include the value of a primary home, vehicles and other items such as a boat, RV, etc. A miscellaneous catch all category of Personal Property can be used for items that will not be individually listed, such as the estimated value of your home contents, like furniture and fixtures.

All values assigned to assets without a identifiable figure should be the fair market value (i.e. what they could reasonably be sold for in an arms-length transaction) as of the date of the Net Worth Statement. Some of these values may be hard to determine, but when making estimates it is best to be conservative.

Once all of your assets are listed with their corresponding values, add them up to determine the total value of all assets. Place this number below the last item in the asset list on the left-hand side of the page and label it “Total Assets.”

Now move over to the right-hand side of the page and list all Liabilities. These include everything that is owed such as credit card balances, auto loans, student loans, home equity loans, home mortgages and any other debts outstanding. Here you are listing the total debt owed not a minimum payment or monthly payment.

The best way to organize liabilities is to list them in order of when they are due. Since credits cards are what is referred to as revolving debt (meaning there is no set maturity, or final payment date), these would typically be listed first. Then depending on the term of the loan, list those with the shortest maturity date first and those with the longest maturity date last. As before, list the balances owed as of the date of the Net Worth Statement.

Once all liabilities are listed with their corresponding values, add them up to determine the total amount of all everything owed. Place this number just below the last item on the liability list and label it “Total Liabilities.”

Now for the fun part – Calculating Net Worth

This is very simple, take the Total Assets figure and subtract the Total Liabilities figure and you have solved the Net Worth equation. Again, this may be a positive or negative figure. Put this figure at the bottom of the right-hand side of the page and label it Net Worth. Task complete!

Your net worth figure is simply a value as of a point in time. The goal going forward is to increase your Net Worth figure. How frequently you calculate your net worth is completely up to you, but most people will choose to do this exercise a minimum of once per year, usually at year-end (12/31). However, it can be helpful to track your progress more frequently, such as semi-annually (6/30 & 12/31) or quarterly (3/31, 6/30, 9/30 & 12/31), but any more frequently may be a little overkill.

Here is a very basic Net Worth Statement example:

Net Worth Statement - Example

How may this information be used to make financial improvements?

In the example above, let’s assume the checking account does not pay any interest and the credit cards have an average interest rate of 15%, the auto loan 5%, the student loans 7% and the home mortgage 4%. One easy improvement would be to pay off the higher interest credit card balances in full using funds in the checking account.  The next option would be to pay down some of the next highest interest rate debt, which would be a portion of the student loan balance, while being sure to leave enough of a cushion in the checking account to cover ongoing expenses.

Doing this won’t change the net worth value because it reduces Total Assets and Total Liabilities by the same amount, but it will reduce the cost of servicing the debt. What would change the Net Worth value going forward is the amount of money no longer paid toward credit card interest every month and instead being added to the checking or savings account balance. Increasing the cash asset would have a positive effect on Net Worth. We will see how this activity flows through to improve the overall financial picture when discussing the Income Statement in a following blog post.

Now that you have acquired the skills to do this, give it a try!

Create your own personal Net Worth Statement. I promise this will be a satisfying activity. You may find that you are in a better position than you expected or at least not in as difficult a position as you thought. But regardless if your net worth is a positive number or a negative one, you will know exactly where you stand and this is the very first step in traveling along the path to reaching your financial goals.