Why Creating a Personal Balance Sheet is So Important

Hi there to all my Financial Freedom seekers. In this post, I take a break from discussing my dividend investing strategy to talk about something near and dear to my heart, budgeting.  Namely I look to answer the question: why creating a personal balance sheet is so important!  

Why is this topic so important to me?  Simply put, I do not believe one can have their finances in order without having some form of a budgeting process in place.

Budgeting has personally allowed me to become Financially Free at a relatively young age and gave me the confidence and knowledge to be able to break free of a cubicle lifestyle and pursue my own dreams of entrepreneurship.

Specifically, I believe that the most important element that a investor needs in their budget is a personal balance sheet. A balance sheet is a snapshot in time of a investor’s overall financial picture. I happen to believe that this is the most important financial document in a financial repertoire, as investors able to do many different things with the balance sheet.

Don’t forget to pick up your copy of Simple Budgeting!  In it, I detail my entire budgeting process complete with images and examples to build and refine your budget! 

The Top 4 Benefits In Creating A Personal Balance Sheet

Calculating Net Worth

First off, the balance sheet is a great way for an investor to be able to calculate their net worth. Since this document tracks total assets and total liabilities, it  is an easily calculation. To find out the net worth, take total assets minus total liabilities.

I believe that discovering and tracking net worth  is important as it is a solid calculation that someone can undertake to show whether or not they are making headway towards becoming Financially Free. Simply put, if net worth happens to be going up, the investor is doing something right; if the net worth begins to go down, something needs to change.

Remember though, you are not your net worth.

Effect of Upcoming Purchases

Another solid benefit of having a well done balance sheet is that knowing what effect a new purchase will have on one’s financial situation.

Oftentimes, especially when looking at large dollar value items, it is challenging to know whether or not we can afford the product. Guesstimation is often used, where a person reasons, “if I buy this car for $40k, I believe that I can afford the $700 a month payments.  We’ll see what happens.”

While some people can actively be able to say this is true, I personally believe it is not a great way to function. Rather, the well done balance sheet will definitively show an investor whether or not they can actually afford that extra outlay per month.

This is where the balance sheet really comes into play.  Before I make a big purchase or any big decision financially speaking I always consult my balance sheet to see what the numbers say.  It will tell me whether or not I can afford to take on that purchase.  

Liquidity Calculations

The balance sheet allows for liquidity calculations.

Liquidity is best described as the ability to meet day-to-day obligations through cash on hand. The more liquid someone is, theoretically the more cash they have on hand; the more cash they have on hand, the easier it is to meet those day-to-day expense obligations.

The one big benefit for me of having a balance sheet is to be able to calculate my working capital and working capital ratio, these two numbers simply tell me where I am at from a current assets / current liabilities perspective.

If the ratio happens to be over one, that tells me that I can more easily meet my day today expenses. Is that number happens to be under one, there could be some challenges in meeting expenses. This is a ratio that I pay very close attention to.

My ideal situation is to have a working capital ratio that is over 10.  This tells me that I am very liquid relative to debt owed.

One Stop Shop For Upcoming Payments

Last but not least, I find that the balance sheet provides a one-stop-shop for upcoming payments.  The great about that I have found is that in doing my budget balance sheet once a week, I’m able to quickly look and see what bills are coming due what bills are paid and which ones are on auto payment and then take care of the rest. I feel like this one stop shop for bill’s due and the ability to pay them really simplifies my bill payment capabilities.

In my personal balance sheet, I have a section where I go in and input when a bill is due and whether or not it has been paid or whether or not is on auto payment.

In unison with this, I usually put payment due dates in my calendar as well. 

The 5 Most Important Ratios when Creating a Personal Balance Sheet

Cash Position

First and foremost, it is very important for investors to know their cash position.  This is, after all, the absolute ‘liquid’ measurement of an investor’s portfolio.

The typical rule is: the more liquid you are, the better.

Now, this can change from situation to situation; some individuals might have their portfolio tied up in liquid items: real estate, CDs, IRAs/401ks, etc.

I personally classify ‘cash’ position as anything that could be easily liquidated for cash within a day.  Key in on the word ‘liquidated’.  If it is going to take a good amount of time to turn the investment into cash, then it is better to take the conservative route of classifying these items outside of your cash position.

A few examples of what I would classify as cash:

  • Cold, hard cash
  • Cash held in checking or savings accounts
  • Stocks held in a brokerage account
  • Un-redeemed Cash back bonuses on credit cards
  • Gift Cards that can be used immediately
  • Cryptocurrencies

Cash Less Current Liabilities

The next metric I would recommend calculating would be Cash Less Current Liabilities.

We define a current liability as anything due within the month.  Being the conservative investors that we are, we can make this ratio stretch out a bit further too – we could increase our current liability calculation to include anything due within the next two, three, four months, etc.

Personally I find that taking into account bills that are coming due within the next month to be the most helpful proposition to me.

The Cash Less Current Liabilities helps you see that if everything you owed within the month came due immediately, would you be able to cover the liabilities.

The goal in this calculation is to have a positive number; the higher, the better.

For instance: if you have $5,000 in cash, and $2,500 in current liabilities, you have a $2,500 cushion.  However, if you have $2,500 in cash, and $5,000 in current liabilities, you are in the hole by $2,500, and this is a much more precarious financial position to find yourself in.

Working Capital

Working capital is a similar calculation to Cash less CL, it only differs in the fact that it gives you a bit more leeway with what you calculate as covering your current liabilities.

Whereas Cash less CL only takes into account cash, working capital allows you include accounts receivable, inventory, and other intermediate assets.  Things like salary, items you are holding for quick sale, etc. are all included in this figure.

I like to calculate the working capital as this ratio gives me a more realistic picture of my financial well-being.  Cash less CL is a much more drastic ratio that doesn’t always tell the full picture.

If I am being paid well at my job or business, working capital will reflect this in my figures and I can rest assured that so long as I am being paid for my efforts, then I will be well on the way towards a positive financial picture.

Working Capital Ratio

In unison with the working capital calculation (WCC), which gives me the actual dollar figures of my liquidity position, I like to calculate the working capital ratio, which gives me the ratio of current assets to current liabilities.

I find that this ratio helps me to better understand my working capital position.  If I only use the dollar amount working capital, it seems that I am only getting half of the story.

For instance, I have seen companies that have $500,000,000 in working capital, and while it seems like a lot, that might actually be $1.5B in CA and $1B in CL.  The reality is that the ratio is only 1.5x.  While this is still good, it helps put the overall dollar figure into better perspective.

Debt Ratio

Finally, I calculate the debt ratio.  This might be one of the most important ratios as it provides a picture into my overall leverage situation.

The closer I can get to 0 on this ratio, the better.  While some might think the absolute ideal situation is 0, I tend to disagree.  While I desire to be relatively debt-free in my life, there are some areas where debt can help us as financial freedom seekers.

For instance, in regards to credit cards, I anticipate always utilizing credit cards to purchase goods and services.  This is because there are so many benefits to doing so.

Being that this is the case in my financial life, I will have debt of some type, though the end goal is to not incur much, if any ‘interest-bearing’ debt.

What does this mean?  The end goal is to avoid expensive mortgages, loans, and other mechanisms.  While home ownership is a great thing, I have found that taking on a 30 year mortgage has just not made overall financial sense in and of itself.  I have paid about the same in interest costs over the past 10 years than I have gained in equity.

The debt ratio helps me keep track of my overall leverage position in my personal life.  If I feel like I am incurring too much debt that is not producing a positive ROI, then it is time for some changes.

Summary

So there you have it, these are some are the big benefits of creating a personal balance sheet. 

If you’d like to know my entire budgeting process, I encourage you to go out and purchase my book, Simple Budgeting: A Minimalist Guide to Setting Up Your First Budget

In it I explain my process in thorough detail and provide examples of how to create your own personal budget which includes a balance sheet, income statement, ratios, etc. 

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