Rethinking Retirement  

FM 101: Your Balance Sheet

Understanding Your Personal Balance Sheet

A Personal Balance Sheet (PBS) is one of two basic financial statements that are vital to one's financial security. Along with the Personal Cash Flow Statement (PCFS), understanding these two financial statements is the first step to gaining the knowledge necessary for financial maturity.

A PBS is nothing more than a listing of all assets and debts that a person or family owns (as is the case with an asset) or owes (as is the case with a debt.)   All assets are listed on the left hand side of the page, (or in some formats, the upper part of the page) and all the debts are listed on the right hand side (or lower portion) of the page.   

Subtracting the total of all debts from the total of all assets provides the Net Worth for the individual or family unit. 
Not all assets and debts are the same however.  Different types of assets have different characteristics and are used for different purposes, just as different types of debts also have various characteristics and purposes.   Let's start by examining the different types of assets.

If we look at the basic outline of a balance sheet,  you'll see that assets can be classified into three broad categories.
Cash Flow Assets are things like checking accounts, savings accounts and money market accounts.  These accounts are used to make your day-to-day purchases and pay your everyday bills.  The goal of this money is to be liquid and safe.  Liquid (meaning readily available) so you can get to it at a moment's notice, and safe so that it is there when you need it.  We figuratively "pay" for these two features (safety and liquidity) in the form of a lower interest rate.  That's OK.  This money is typically short-term money so we are not as concerned about the rate of return we receive on it.  It's primary purpose is to be there and available when we need it.

Important Point:  There are three qualities that can be associated with any investment - safety, liquidity and the potential for a high(er) return.  Unfortunately, any investment can provide only two of these three with absolute certainty.   There is no investment that is completely safe, completely liquid, and provides a definite high return.  (If someone offers you an investment that promises all three, don't walk, run away.)  There are however, many investments that attempt to balance the three.  But remember, any investment that attempts to balance safety, liquidity and a high return, is compromising at least one of these to some degree.    If it's completely safe and completely liquid, it won't provide much of a return.  If it's completely safe and has a good return, it's probably not liquid without a penalty. (Meaning you have to leave it there for some period of time.  If you attempt to take your money before that time period is up, there is usually a penalty for early withdrawal.)  If it's liquid and has a good potential return, it probably (almost assuredly) carries some risk of losing some portion of your principal.

The second category of assets are Investment Assets.    These are the assets that you will eventually draw your retirement income from and build your future financial security around. These are things like your brokerage and investment accounts, 401k's, IRA's and rental real estate.
It's important at this point to understand the difference between the actual investments and the accounts those investments are held in.    When you invest in the stock or bond markets through mutual funds or individual stocks and bonds, you must first open an account at a brokerage firm, mutual fund company, insurance company or similar institution.  The account acts like a cup that you can then put an investment into, just as you might put coffee into a cup.  Your account can hold different types of investments such as stocks, bonds or mutual funds, just as your cup might hold coffee, tea or water.  It's important to understand this because too often people make the simple mistake of closing an account because they don't like the performance of an investment inside that account.  In doing so, they often incur withdrawal penalties, taxes or tax penalties.  It's like tossing out a very expensive china cup because you don't like the tea that was served.  Just dump the tea (the investment) and fill the cup (the account) with a new beverage (a new investment) more to your liking.  The bottom line is to make sure you understand the fees and tax implications between the account and the investment before you make a move.
The account also does two other things of vital importance:  It signifies both the ownership and tax treatment of the assets held in the account.  The account registration lists the names of the account owner(s) and determines what happens to the account (i.e. - who gets it) when the account owners pass away.    The registration will also determine what type of tax treatment the account will receive regardless of what type of investment vehicle (stock, bond or mutual fund, etc) is inside the account. 
To understand the tax treatment aspect further, our Investment Asset category can then be broken down further into qualified versus non-qualified accounts.
Qualified accounts are those that receive (i.e. - qualify for) special tax treatment under IRS rules.  These are typically intangible investment accounts such as 401k's or 403b's.  While not technically considered qualified accounts, IRA's carry virtually identical basic characteristics, so we will include IRA's in this discussion as well. One of the benefits of this special tax treatment is that the earnings generated from the investments inside the account do not have to be included in taxable income in the year those earnings are received.   In fact, all the earnings in the account are tax-deferred until the money is eventually withdrawn from the account.  Some qualified accounts also receive additional preferential tax treatment in the fact that the contributions may be tax deductible.  In other words, the money you contribute from your earned income may be eligible to be deducted (subtracted) from your current year taxable income. 
To receive this special tax treatment, however, there is a trade-off.  Under current rules, the IRS requires that you leave your money inside these qualified accounts until you are 59 1/2 years old.  While there are some exceptions, generally any money withdrawn from a qualified account prior to age 59 1/2 is subject to ordinary income taxes and a 10% penalty tax.  Because combined federal and state ordinary tax rates often reach up to 30% or more, the addition of a 10% penalty often means losing 40% or more of your early withdrawal to taxes.  For this reason, most financial advisors will recommend leaving your qualified money in these accounts until you reach age 59 1/2 or are otherwise eligible to withdraw them without penalty.
Non-qualified accounts are simply those that do not qualify for, and therefore do not receive, any special tax treatment.   The disadvantage of course is that you pay taxes on the earnings these accounts generate every year.  The advantage is that these accounts are also liquid for you to use at any time, for any reason you choose.   
Because the tax treatment of qualified and non-qualified accounts is so different, it's important to differentiate between the two on your PBS.   While putting money into qualified accounts will help to reduce your current tax burden due to the tax-deferral, your non-qualified accounts give you more flexibility today to use the money as you choose.  Understanding the qualified status of your accounts and the amounts you have in each will help you to formulate and evaluate your options going forward.
The Investment Asset category also includes rental real estate and perhaps other types of tangible assets.  For real estate to be considered an investment asset however, it must pass two tests:
1.    It must have the ability to produce income, and
2.    It must have the potential to appreciate in value.
If it does not pass both these two tests, then it should not be considered an investment asset.  Instead, it will likely fall into the third category - Other Assets.
Other Assets are things like your home, other non-income producing real estate, cars, boats and other personal property.  We tend to refer to these as "bad" assets because they don't pass both of the tests that investment assets do - produce income and have the potential to appreciate in value.  Furthermore, these bad assets often have the nasty habit of costing you money in the form of interest paid on loans to acquire the asset, property taxes, licensing fees, maintenance, and so on. 
Let's take home ownership for an example.  There is no doubt that millions of Americans have made millions of dollars worth of profit buying and selling their homes, so there is no question that your home is an asset.   But as an asset, it has the potential to do just one of the things that investment assets do - appreciate in value.  (Hopefully. There are also hundreds of thousands of homes in foreclosure because they didn't appreciate, but rather, depreciated in value over the last few years, but that's another topic.)   Since price appreciation is not guaranteed, the ability to produce income is the only sure positive thing an investment asset has - assuming a reasonable vacancy rate of course.  Most of us, however, don't rent out the basements or any other portion of our homes to produce income from them, and therefore we shouldn't classify them as investment assets.    If in fact you do rent out your home part of the year and generate an income from it, then you can reasonably classify your home as an investment asset.

Important Point:  Let's also be clear that just because an asset is not considered a "bad" asset, that does not necessarily make it a "good" investment.  A good investment is one that provides a reasonable rate of total return over time.  Many investments that have the ability to produce income and the potential to appreciate in value, often fail to do either.   Those are clearly not good investments. Many homes on the other hand, based on price appreciation alone are good investments.  But if it doesn't pass the first test - to produce income - we won't call it an Investment asset.
With all that said, it should come as no surprise then that things like cars, boats, and most other personal property are considered "bad" assets .  They generate no income, usually depreciate in value, and cost you even more money to license or maintain.  Instead of having the ability to bring cash flow to you, they'll typically cause cash to flow away from you.  That's a bad asset.
Let's now turn our attention to the debt side of the PBS.  Our debts can be divided into three categories, short-term debt, intermediate-term debt, and long-term debt.  As the names imply, the distinction lies in the length of time it will take to pay off each type of debt.
Short-term debts are usually things such as credit cards or personal loans that will be paid off within six months.  Larger credit card balances or personal loans that will take longer to pay off are considered intermediate term debt.
Intermediate-term debts typically include auto loans or leases, and many student loans that will be paid off within 5 years.  Long-term debts include mortgages, real estate loans and any other loans or debts that will take longer than 5 years to completely re-pay.

It's helpful to divide our debts into these timeframe-based categories so we can create a strategy to plan our cash flow around when each debt will be paid off, and the corresponding monthly payment will be freed for other  purposes.   For more information on this, see "Understanding Your Personal Cash Flow Statement."
As mentioned earlier, when you add up the total of all your debts, and subtract that figure from the total of all your assets, the resulting number is your Net Worth.  While many people tend to judge their financial progress from year to year based on the amount of income they earn, the real measure comes in watching your Net Worth.  Your Net Worth grows by both accumulating assets (hopefully Investment Assets) and by paying down debts.   Many people with large incomes have equally large expenses that do not allow them to save and grow their assets.  Often these same people will leverage their assets with debts that obligate large portions of their income, further limiting their ability to save and grow assets.  Others, who have very modest incomes, are able to control their expenses and carry very little debt, which allows them to save and grow their assets which continue to grow their net worth.
Since a PBS is a snapshot of assets and debts at any given moment in time it does not show any trend by itself.  But by comparing your PBS and bottom line Net Worth figure over a series of PBS's created over time, you can begin to judge your overall financial progress as you watch your net worth grow.

Click here to download an MS Excel format Balance Sheet template.

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