I’m a banker. (Please stop booing – we’re not all as bad as you think) So, I deal with Personal Financial Statements (“PFS”) every day. But, to most people I talk with, a PFS is something that is either foreign to them, or something that they are aware of but couldn’t care less about.
For those of you who are unsure, a PFS is essentially a document that determines your Net Worth. And your net worth is what you get when you take all of your assets (anything that you own that is worth money) and subtract all of your liabilities (debt).
Assets – Liabilities = Net Worth
Nothing to it right?
So, why is net worth important in our current quest to determine our financial health? It simply paints a quick picture of our financial situation.
It doesn’t necessarily help us fix our problems going forward like a properly executed monthly budget, but it does give us an idea of where we are right now, and if we look at our net worth every so often, it allows us to see which way we’re trending.
Cupcakes and Credit Cards
Trends offer us important information. In other words, are our debts increasing or decreasing? What about our savings, checking, or retirement accounts?
For example, If we notice that our debt has risen approximately $6,000,000,000,000 in the last 4 years, we should probably re-think the way we’re handling our finances (hint, hint America).
But, a more applicable example to you and I may be our credit card balances. Let’s say that once a year you take a few minutes, determine your net worth, and then compare it to previous years. In 2009 you had $9,000 in credit card balances, in 2010 you had $14,000, and in 2011 it rose to $22,000. This would obviously be a red flag that you were doing something wrong and it’s time to intercede.
However, if we haven’t been keeping track, it’s likely that we would be mostly ignorant of this disturbing trend. Does the frog and the boiling pot ring a bell? It’s easy to miss the big picture because we’re so focused on the every-day stuff.
Sometimes bad situations can sneak up on us (tip-toe, if you will). Let’s say you love cupcakes – and who doesn’t, really? Let’s also say that having an occasional cupcake, only when the situation called for it, was out of the question – I mean you LOVE cupcakes.
Scenario #1: You could gorge yourself on cupcakes like Kobayashi at a hot-dog eating contest. One after another, double fisted, throwing caution to the wind for as long as you can muster the strength. (By the way, some of you are disgusted by the debauchery described here and others just grabbed their calendar and are trying to move appointments around to free up enough time to give it a go.)
The result…Instant diabetes and sugar coma. Possible death. Though your grandkids will have quite a story.
Scenario #2: You could have a couple cupcakes every night after dinner, but limit yourself to some degree and feel good about the fact that you haven’t gorged yourself in awhile. You call it restraint.
The result…You gain weight slowly over time. Diabetes comes later.
Believe it or not, there’s a point to all of this rambling. The point is that we have a hard time noticing big picture trends unless they slap us in the face. The person in cupcake scenario #1 fully understands that what they are doing is not a good idea because they’re hit with the consequences/results immediately.
You could financially compare it to a get-out-of-my-way shopping spree that runs up your Visa balances by $10,000.
The person in scenario #2 shows “restraint” (compared to person #1), so the consequences come later. They start to gain weight, but it comes slower and more steadily, so after the initial shock of what used to be a pretty buff body becoming a little more doughy, they lose track of how much weight they’ve gained. After 10 years they certainly remember how much they weighed back in high school or what size they were on their wedding day, but it’s tougher to recall with the same kind of precision how much they weighed two years ago. Unless you’re weighing yourself every day (tracking the trends) it all sort of blends together. They don’t even realize what’s happening until it’s 50 pounds later. It’s a much more gradual trend and, therefore, more difficult to keep track of.
It’s only a few cupcakes, right?
Financially, it would be similar to someone who uses their credit cards regularly, but only on frequent small purchases and, of course, they fail to pay them off each month. My college days (and shortly after) are living proof that little purchases can build up to big debt. I felt like I was being good by not purchasing a big screen TV or a ticket to Australia, but the movies and restaurants added up just the same. Except it was more difficult to notice until the cards were maxed out and I was in over my head.
If I had been tracking my debt or net worth, I would have seen it coming long before I did and saved myself a lot of heartache.
There’s something different about seeing your finances on paper that makes it more sobering – similar to seeing your weight on a scale.
The Coming Storm
Our net worth also allows us to get an idea of what will happen if life doesn’t go according to plan (lost job, expensive medical procedures, death, etc).
Most of us are going to be just fine if nothing ever changes, our paycheck keeps coming, and life doesn’t throw us any curveballs. But, anyone over the age of 30 knows that last sentence was a waste of space. Life changes, stuff happens.
That’s why the proverbial “paycheck-to-paycheck” system doesn’t work in the long-run.
Generally, a higher net worth reveals a greater capacity to endure disaster. Because, net worth really boils down to what you would have left if you sold everything and paid off all your debt. You’re probably not going to sell everything, but you may have to at least consider your options if disaster struck.
The real question, and the one I tend to focus on, is how many of your assets are “liquid”. The simple, non-text book way to know if an asset is liquid or not is to ask, “Could I convert it to cash in my pocket in the next week or two?”
So, the obvious answers are cash on hand, anything in your checking or savings account, and any stocks or bonds. You could also consider your retirement accounts or a long-term CD, but the technical definition also states that it’s only liquid if there isn’t a considerable discount that has to be applied in order to turn it into cash. Technically, retirement accounts usually have penalties until you reach a certain age, but who cares about being “technical”? We’re not trying to pass Accounting 101, we just want to improve our finances.
In that case, I tend to count retirement accounts as “reasonably liquid” for my own uses because they are composed of cash and, though I will certainly take a hit, I can get the cash if I need to. Just remember that when you’re making your worse-case scenario plan, discount your 401K and other similar accounts accordingly.
Another asset that tends to cause discussion is the equity in our homes. Back before we were forced to come back to reality by the real estate market bubble a few years ago, the equity in our homes was almost as good as cash. Now we know better.
First of all, when you sit down and determine the value of your assets, please don’t think with a 2005 mindset. You’re only fooling yourself. And why would you want to do that? 2005 was when life was good and real estate values were climbing year after year with no end in sight.
In most areas of the country, real estate values have dropped 25% or more since their peak in 2005-2006. In other areas like Las Vegas, homes lost more than 50% of their value!
So, the moral of the story is that, unfortunately, your home isn’t worth what it used to be. So, be honest with yourself when calculating the equity.
I only say this because as a credit analyst, nearly every day I see someone value their home at $160,000 when I know beyond a shadow of a doubt that it’s worth $100,000…max. I think we just keep hoping that the market will get back to where it was, and all of this will blow over soon, but it doesn’t appear to be heading in that direction. Most forecasters believe it will take many years before we see those sort of values again.
All of this to say that home equity is a very valuable asset that could certainly be utilized if needed, but don’t lean on it too heavily. If you’re betting on $10,000 in equity to see you through the tough times, you’re probably not factoring in the difficult real estate market or costs that we often forget about like realtor fees. On the other hand, if you’re being realistic about your home’s current value and still have $50,000 or more in equity, you can add another option to your storm insurance list. Congratulations.
Determine your net worth. Be as accurate and thorough as possible. No one needs to see it but you (and possibly your bank if you’re applying for a loan).
You can use the form I’ve provided on the SFF Net Worth Spreadsheet if you’d like. Make sure you’re on the “Net Worth” tab at the bottom of the excel spreadsheet. Just fill in the total value for each of your assets and liabilities and it will calculate your net worth at the bottom of the page.
The “debt detail” spreadsheet that I included is simply a place to keep track of your debt in more detail if you choose to do so. Just click on the debt detail tab at the bottom of the worksheet to toggle between the two.
Now schedule yourself to fill them out again around this time next year. Write it on a calendar or somewhere that can remind you. Each time you update the spreadsheet(s), date it in the place provided and save it as a separate document (like “Net Worth 2012”), or simply print it out if you’d rather, so that you can compare from year to year.
It’s a great way to see your trends and either fix them before it’s too late or, better yet, celebrate the progress you’ve made.
**By the way, if you find that your net worth is currently negative…don’t worry. Mine used to be negative as well, but that’s why you follow Simple Family Finance, right? To improve your finances. Work on cleaning up your debt and building a savings account and your net worth will follow.