The first step to investing has nothing to do with investing.
Before getting into any strategies, concepts, or tactical investment planning, we need to take a good look around and survey exactly where we (you) are.
The best way to objectively do this is through the construction of a personal balance sheet. (Don’t worry, no need to be a CPA to put one of these together!)
- Balance sheets aren’t just for companies. They are powerful for individuals as well.
- Understand your current situation before stepping into investing.
- Run your own life’s financial ‘operation’ like a company.
- Jump directly to the excel here to start hacking away.
What is a balance sheet?
A balance sheet is a powerful tool and one of the core financial documents companies use to assess and communicate their health.
A balance sheet takes a current snapshot of a company’s assets, liabilities, and equity. This information is used to understand the overall financial liquidity (working capital, cash, etc.), risk (cost ratio, leverage, etc.), and ownership of assets. It’s important to note that the balance sheet doesn’t convey performance for a given period. But…we don’t really care about that for now.
We can draw parallels, then, from the corporation to you and your family unit. The purpose of going through this exercise is to understand precisely the same information that a company seeks, by taking a detailed photo of your current financial state. In other words, we are going to determine your net worth.
Why is this important?
First, going through the process of composing a personal balance sheet forces you to organize and observe your entire financial ecosystem.
This captures the current state of affairs across all your accounts, which I’m willing to wager, is not information you have readily on hand. Regardless of the ‘results’ of the exercise, simply completing a balance sheet is empowering. Whether you are put at ease by your net worth, or it is a confrontation of some more difficult truths, your confidence as an investor will increase in both cases.
The more tactical reason behind balance sheet construction is to understand your current risk and liquidity profile. Specifically, we want to find out the following:
- Outstanding debt versus assets: This ratio gives us an idea of your personal leverage. Put differently, what percentage of your assets are owned by others on paper? (Debt Ratio)
- Short-Term debt and/or revolving credit: What percent of assets and debt is composed of credit card debt or other high-interest debt? We want this to be zero or within spitting distance before entertaining more risky investments. The ratio between short-term debt and cash assets is also important to note (Current ratio).
- Safety Net aka Emergency Funds: Liquid cash and equivalents. Basically, what can you convert into cash easily, and what percentage of your assets are in this liquid form (stocks but not selling real estate for instance).
Understanding this information will be invaluable when we begin formulating an investment strategy. For example, if your liquidity is low, it would be better to invest in higher-volume equities in lieu of bonds or Certificates of Deposit (CDs). On the same track, if your liquidity is low, and your ratio of cash on hand versus short-term debt is also low (< 1), then putting any further assets at risk is probably not a great idea at this moment.
The balance sheet provides an objective and unbiased view of your current risk position. When we begin building a more personalized investment philosophy, qualitative factors will shape the rest of your risk profile. Combined, we will have clear guardrails established to guide the right ‘mix’ or allocation of investments (more on this later).
Ok, back to the show.
Let’s dig in.
What is a balance sheet constructed of? In the corporate world, it is made up of three components: assets, liabilities, and shareholder’s equity. In equation form, assets = liabilities + equity. Everything is in ‘balance’. Thus the name.
For a personal balance sheet, it’s pretty much the same, just simplified. Assets = liabilities + creditor’s equity. For our purposes, everything doesn’t need to perfectly balanced1, and the only outside equity we will need to think about will be long-term debt, e.g. mortgages.
Let’s start by looking at assets. For purposes of illustrating this in practice, we’ll model out a made-up balance sheet for ‘Jim’, an office worker in his mid-twenties, perhaps a moderately successful paper salesman from Pennsylvania.
There are four main asset classes we care about.
- Cash & Cash Equivalents: cold hard cash, savings/checking accounts, CDs, money market.
- Marketable Securities: brokerage accounts, stocks, etc.
- Retirement Accounts
- Property: Real estate, cars, and other tangible assets that have measurable value.
These are also structured in order of liquidity, or how quickly each can be turned into currency. The larger amounts you have in categories 1 and 2 reduce any risk in paying short-term debt and improve your liquidity and ability to handle rainy days. However, having too large a percent of your assets in these categories comes at the expense of diversification and realizing very healthy long-term gains.
Download the Personal Balance Sheet template to follow along with the upcoming steps.
#1 Cash & Equivalents.
Let’s start with the most basic assets: cash.
Cash isn’t just greenbacks. This category will capture any cash on hand, savings accounts, checking accounts, joint accounts, money markets, Certificates of Deposit (CDs), redeemable bonds…you get it. You should also include any cryptocurrency in this section. It is a form of currency after all.
Looking at our example, Jim has a total of $36,512 in Cash & Equivalents. He keeps at least $500 in cash safely stored at home, and has saved $35k over the past 5 years with the hopes of having enough for a down payment in the next year. Jim also recently purchased a 1-yr CD from his bank. This is pretty straightforward, nothing complicated here.
Many of us have multiple accounts or sources for each of these, so simply aggregate those up into their relevant category as simulated above. Easy peasy.
#2 Marketable Securities.
Marketable securities capture all assets that can be sold relatively quickly and confidently, typically on an exchange or through a broker.
Jim is pretty cautious, so he hasn’t jumped into these types of investments yet. But for those of us who have, make sure to enumerate any of your holdings outside of retirement accounts.
This will include any brokerage accounts, stock certificates left from a relative, and any cash or money market balances that are held as part of a brokerage account.
Again, pretty straightforward exercise. It’s perfectly fine to round or estimate market values, or use an average balance over the last few months. If the market has recently gone through a sizeable ‘correction’ as we have recently (Spring 2020), it’s better to be conservative and adopt the current value of your portfolio(s) and not take the average over the last several months or year.
#3 Retirement Accounts.
We will discuss the ins and outs of retirement accounts later on. For now, just as we have done previously, we’ll tabulate the values of the following accounts:
- Roth 401(k)
- Roth IRA
- Traditional IRAs
- Pension Accounts
We need to treat these assets differently. Since retirement vehicles can’t be accessed until retirement age (typically 59 1/2) without penalty (typically 10%), we need to classify them as illiquid. For purposes of calculating solvency, we will need to discount these assets. We’ll get to that in a minute.
But what about Jim? He started saving through his employer-sponsored 401(k) plan three years ago and has amassed $15k. The power of consistent investing of even small amounts is real. Nice going Jim.
#4 Real Property.
So far, the exercise has been objective. More science than art. Check your account balances, and plug in the values.
But when it comes to real estate and other property, we’ll need to make some estimations.
If you own your home or a rental property, you’ll want to calculate a conservative market value. You can use a resource such as Zillow or RedFin to get an estimate or simply look at some comparable listings in your neighborhood. It doesn’t have to be perfect, but err on the side of a lower sales price.
Same deal for your vehicles. Use a fair trade-in value here as well. For a quick estimate, use TrueCar.
When we are considering other property assets like jewelry, collectibles, or similar items, it becomes more complicated. Typically I would ignore any of these assets worth under $500 in value to keep things simple, or use a rough estimate for furnishings and small collectibles. Imagine you had an estate sale, what would you be able to convert into cash in a weekend?
Other usual suspects in this category would be life insurance, jewelry, heirlooms, and art. Use your best judgement on what you should include or not include. If you choose to include life insurance, make sure it’s just the cash value (no term policy limits here or anything of that sort).
As we heard earlier, Jim is saving for a down payment, so his assets are pretty basic. His 2015 Subaru Impreza Wagon has a market value of $8,200, and he has a childhood baseball card collection with an estimated value of $850. His current furnishings are a mix of IKEA-like furniture and second-hand items, which carry a rough estimated value of $500.
Ok. We’re halfway there!
The other half of the equation, and not the fun half.
For our purposes, we’re going to look at two main categories of liabilities:
- Short-Term Debt: Credit cards and whatnot. Also called ‘current liabilities’ in corporate jargon.
- Long-Term Debt: Loans that need to be paid back over periods longer than a year.
#1 Short-Term Debt.
The main subject here is credit cards and revolving credit. Now, I probably don’t need to tell you that a growing credit card balance is pretty much the worst thing you can do financially. However…we will save that lecture for another time. (If this is a major problem you want to tackle, there are some helpful links at the bottom of the post. The first step in working down debt is knowing where you stand and building a new budget, so this exercise will help kickstart that process!)
For now, you want to just tabulate all outstanding debt from credit cards owned by you and your household. If you are diligent about paying off your credit card balance every month without fail, then you can either put a zero dollar balance or simply insert your low balance from the last 3 months.
Other types of short-term liabilities include personal loans, cash advances, short-term financing for furniture or electronics, home equity lines of credit (HELOCS), and rent or lease agreements (dwellings, not vehicles).
Now, this last item is technically not a liability in its true sense, as you can walk away from a lease with relatively no obligation. However, it’s not practical to ignore such a common expense category. What I suggest for this exercise is to include at least 3 months of your rent. The idea being that if you wanted to break your lease, there’s typically a month’s rent penalty, and you would need some time to move in with a friend or relative.
So let’s take a look at Jim’s situation. Like most Americans, he has a credit card balance, but don’t worry, he’s racking up rewards points and paying off his balance each month. He also shares a townhouse rental with a roommate, which sets him back $1500 a month.
#2 Long-Term Debt.
Personal long-term obligations fall into 3 main categories: real estate, vehicles, and student loans.
Starting with real estate, you will want to tabulate the outstanding mortgage principal balance on any homes and investment properties you own. The same holds true for vehicles and student loans – nothing fancy here. Be sure for both vehicles and loans that you include the total remaining balance and not just the monthly payment (but, you knew that).
Outside of these core buckets of long-term debt, you will also want to include any P2P loans that you are the recipient of, loans against your retirement accounts or life insurance, and also any personal business loans (sole-proprietor or pass-through LLC).
Back to our example, Jim has $3,000 remaining on his car payments and $24,000 outstanding principal left on his student loans. Racking all of this up, Jim has $32,750 in total liabilities.
Now, the moment we’ve all been waiting for.
If you’ve been following along and have tallied up all personal assets and liabilities, then you should have a nice new shiny net worth calculated. Perhaps it looks something like Jim’s here, but I’m guessing it will be wildly different as we all have very unique financial situations.
Let’s start with Net Worth. This is simply Assets less Liabilities.
We can see right away that Jim has a positive net worth, so kudos to Jim. If you are one of the millions of households that has a negative net worth, well, knowing is half the battle, and you are not alone. Simply going through this exercise is a powerful first step in increasing your net worth and taking control over your financial future.
Effectively, all financial decisions can be viewed in how they affect your overall net worth (we want to maximize this or increase it with any new investment) as well as how they will create or mitigate risk.
As mentioned previously, the Personal Balance Sheet will provide additional insight with three objective metrics:
- Debt Ratio: Liabilities to Assets. This gives an indication on how much ‘leverage’ or outside credit you have used to build your assets. The closer this is to zero the better, and should be well under 1 for nearly all households.
- Quick Ratio: Similar to the debt ratio, but focused on the short-term and gives a sense of your ‘working capital’. How much risk do you have in paying off near-term debt?
- Liquidity %: Out of all your assets, how quickly can you turn them into cash to cover unexpected emergencies or personal ‘black swan‘ events?
If we look back at Jim’s situation, what can we observe?
- He has a positive net worth, which is an indication he is building wealth and should keep saving as planned.
- His debt ratio is healthy, so there isn’t much risk in over-extending himself if he needed to take out a new loan.
- Prior to the ‘great recession’, super-risky loans flowed like the Amazon. Simple exercises and metrics like this can highlight those risks before you are coaxed into a position that is too risky for you and your family.
- Working capital for Jim show he has more than enough cash to cover short-term debt obligations. This actually seems to be a bit too high, and suggest Jim should move some cash into marketable securities, retirement, or real estate.
- Again, liquid assets are healthy, almost too healthy. Depending on your income and total savings, targeting around 50% of your total assets being in cash and securities is a good starting place.
- The caveat here is that you should amass a safety net savings fund pretty much before doing anything else with your money. Some say 3 months of expenses, some say 6, some say 9. It just shouldn’t be zero.
Now it’s your turn to dig in.
Start putting this into practice today. The entire exercise shouldn’t take more than 1-2 hours, at which point you will have a newfound confidence in your financial future, and will have taken a very tangible step in building your future wealth. A Super Moment.
Grab the template here. It’s a Google Sheet link so either download or make a copy to edit. Enjoy!
Dig A Bit Deeper.
Credit Card Debt.
Working on a Negative Net Worth.
1Our balance sheets won’t be perfectly balanced since we are calculating a net worth which will not be zero. For example, if you own a home, the market value of your home will be different than when you purchased it. That asset will be worth something different than the sum of the outstanding mortgage balance and equity in the home.