Where are you? Figuring out your finances.

“You can’t really know where you are going until you know where you have been.”

– Maya Angelou

So where to start?

Step one if figuring out where you are right now. Even if I could give you a perfect map to financial independence, if you had no idea where you were starting from you’d find yourself driving into a lake with the SatNav beeping frantically in no time.

So what do I mean figuring out where you are? What I mean is figuring out your net worth, what you’re making and what you’re spending.

This post will concentrate on the putting together a personal balance sheet. This is super important, not least because its far from obvious how much any one person’s net worth is. If you and I, dear reader, were face to face right now, I would bet you a crisp £10 note that you would be at least 25% out if I asked for your net worth. I wouldn’t be surprised if you were more than 50% out.

This is important.

Knowing how much you’re worth not only lets you place yourself on the map. Its also highlights potential issues you’ve been unaware of. This could be student loans you’ve been ignoring, credit card debts you thought were under control or quite how much of your mortgage you still owe. Alternately, you could be pleasantly surprised how much you’ve saved in your pension. Either way, you should know and that’s what I’m here to help you do!

As an aside, I’m going to assume my readers have previously been pretty uninterested in finance and the wonderful world of accounting and will be explaining each concept as I run through them. If you’re a financial wunderkind and already know all of this, feel free to skip ahead.  

Alright, first question, what’s a balance sheet? A balance sheet is one of the three key accounting statements which apply to individuals all the way up to the world’s largest companies: the balance sheet, the income statement and the cash flow statement.

The balance sheet is the one we’re looking at now, as its sole purpose is to tell the reader how much is owned, how much is owed and which of those two is bigger (i.e. do you have more stuff, or owe someone else more than you have).

What goes into a balance sheet?

Assets

First, assets. Assets are things that will or can bring future economic value (the economic bit is important). Let’s unpack that a bit. Cash is an asset, you can buy stuff with it, invest it, spend it. It’s the most versatile of all assets. A house is an asset, you can live in it or rent it out (spoiler: the picture will muddy when we look at liabilities below).

Liabilities

Second, liabilities. Liabilities are things that will or can bring future economic costs. The most obvious one is debt. This includes credit card debt or loans. It also includes mortgage debt, which is a big reason why people guess their net worth wrong. If you have an 80% loan to value mortgage, you don’t own your house. Your bank owns 4/5 of your house, you only own 1/5. You’re paying them for the privilege of living there and if you ever stop, they’ll kick you out and sell it. What else?

How about your car? But no, you protest, my car is an asset, I could sell it! Sure you could, but every day you don’t sell your car, you pay insurance, road tax, car payments (if you didn’t buy it out right). So what is your car really? A liability. Same for your big TV (electricity, insurance), your holiday home (a second mortgage, taxes, bills). In fact, almost all of things people think they should buy when they get more money, end up taking that money from them.

This is important, if every time you get a raise you buy more liabilities, what happens? The amount of money you have to spend every year just to keep what you have goes up. This is not a good cycle.

Equity

Lastly, we have equity. This is what’s left over from “Assets – Liabilities”. You want this to be positive and ideally as big as possible. This is the thing that will help you reach financial independence. For some people this will already be positive, for others, this may be below zero.

A positive equity means more assets than liabilities, which in turn means you’re worth more than you owe. A negative equity means the opposite. You want to have a positive equity. If you have a negative one (and I’ll shortly provide a sheet so you can work this out) that’s not good. However, don’t feel too bad because what’s awesome is that now you know! You can’t solve a problem if you don’t know it exists after all.

OK, enough theory. Let’s look at an example.

Let me introduce our fictional reference character, Sarah.

Sarah is a late twenty something, with a job in PR and she’s just bought a flat in London. She has a pension but doesn’t really care about it or contribute much into it (have a look in the investments section for why you should. Summary: free money!). She has an investment account but doesn’t really know what she’s doing so most of her money is in a savings account. She likes clothes, eating out and has a car.

First, assets:

Wow, looks like Sara is doing pretty well! She has £280K of assets, looks like she’s well on her way to FI.

However, we’re giving her credit for her car and all her furniture, clothes and jewellery. We just talked about how these things don’t bring value, they cost value. Rather than calculating car payments, insurance etc for the car, we’re just going to delete these things out as they’re not real assets.

Note, you can include these items and calculate the related liabilities if you want. We’re not doing that here as its much more time consuming and needs a lot more data. Overall however, these items won’t move the needle much so we don’t need to concern ourselves.

Ok, still very good! Now, lets look at the liabilities.

So Sara has a fair few liabilities. What’s more, she owes a lot of short term items, just over £16K in total, more that her cash, savings and investments combined.

Finally, lets look at her equity.

Sara is worth £38,150.

The good news is that its positive! The bad news is that it’s a lot less than the total assets of £269K! The other item Sara needs to be careful about is that her short-term borrowing are greater than her available cash. If she needed to pay these liabilities she wouldn’t be able to.

This is why people estimate their net worth wrong. Sara is not worth over £200K. Sara is worth under £40K.

So now its your turn! How much are you worth…?

In my next post we look at how to grow your equity! See you there.