Friday, October 11, 2013
Hoping Your Net Worth Looks Better than This
We tend in looking at our household finances to think in terms of two flows, incoming and outgoing. We get paid a salary, and we pay some bills. On payday we have x amount of cash on hand, but we have several bills that we must pay. The wages we have in hand are our assets and the bills we must pay are our liabilities. But normally these assets and liabilities don't equal each other. If we have more wages than bills due, then we have some retained earnings left over, which we can save or spend as we please.
This is why a balance sheet has three components. Looking at Classy Company we see all their assets are on the left hand side and total $910,000.
All the liabilities are on the right side and the liabilities total $450,000. So wait a minute, this doesn't balance. The assets are $460,000 higher than the liabilities, which is kind of a good thing. But still, a balance sheet has to equal the same on both sides. This is why there is a third part and it is on the right side under liabilities. On Classy's sheet this is called Stockholder's equity. It could be called other things, such as Capitol, Reserves, Position. This third section can be simply defined as funding that doesn't need be paid back. If this were a non-profit you might see Restricted Funds and Nonrestricted Funds listed rather than Capital Stock and Reserve rather than Retained Earnings.
But where does this come from? In our personal case this was the money left after we paid our bills, (and could be other things as well such as property we own). Looking at business, Capital Stock might be obvious, the par value of stock the company issued to raise funds. In a non-profit the term Fund will be there and this will mean perhaps an endowment or donation or grant. Retained Earnings is most easily thought of as profit that has not been reinvested or paid out to stockholders. Non-profits, despite the title, have to make a profit, too, or they will not exist for long. Essentially what is called Retained Earnings by a business is called a Reserve by a non-profit. These are monies available for use if the outfit chooses to use them for some purpose.
Notice that Chair Depot has Revenues, which they call Gross Profits, of $76,000 and total Expenses of $56,000, a difference of $20,000. That is their profit and most likely will be posted to the line Retained Income on their Balance Sheet. (I am simplifying for illustration purposes. Not all of that $20,000 necessarily goes to Retained Earnings.)
It is a little difficult to translate this to ourselves because we are not a business (more like a nonprofit, I suppose) and Balance Sheets and Income Statements aren't in our normal vocabulary. Some of us (hopefully most of us) do some form of budget and maybe even a Cash Flow analysis. I use financial software to track my cash flow so I know when I might have to be careful. These may be similar to the Income Statement for us. People probably seldom if ever do a Balance Sheet.
But let's assume a very rudimentary balance sheet, one with only a couple of items. On the left under Assets we have a house valued at $250,000. We say we own the home, but in reality we don't fully own it, a bank does, because we have a $200,000 mortgage, which shows on the right side of our Balance Sheet as a Liability. This simple Balance Sheet is out of balance. How do we rectify that? By showing in the third section of our sheet, just below Liabilities, our Equity of $50,000. This is our funding that doesn't need to be paid back. We could obtain that $50,000 for use by selling our home. If we sold our home for more than $250,000 we might pay any broker fees or other selling costs and actually walk away with that $50,000 after paying off the Liability. If we sell for $250,000 or less, we may get a smaller portion of the $50,000 back.
We could borrow against the equity, this would create a new Liability and reduce the equity left, so we should use caution in doing this. Don't use it for an expensive vacation, for instance. Sometimes we must do something like this in an emergency, the house needs a new roof or there are sudden medical expenses. Of course, we might also resort to credit cards to raise money for ourselves, but doing too much borrowing could lead to a Balance Sheet Like this:
Assets (including the value of the house) of $270,700 and Liabilities of $1,749,270, and no equity, leaving us with little possibility we can pay off that enormous debt load. I mean, we got debt 526% higher than all our assets. If we sold everything we owned we'd still be in deep do-do. Frankly, we'd be in bankruptcy.
Would you want our personal balance sheet to look like that? I wouldn't.
That was a negative Net Position (think New Worth) of $14,785,400,000,000 in 2011. It's almost 2 Trillion (yes, I said Trillion) dollars more negative today.
I wonder if we should be concerned?