1.3 Balance Sheets
Personal Finance. Provided by: Saylor Academy. Located at: https://saylordotorg.github.io/text_personal-finance. License: CC BY-NC-SA: Attribution-NonCommercial-ShareAlike
Balance Sheet
In business or in personal finance, a critical piece in assessing the current situation is the balance sheet. Often referred to as the “statement of financial condition,” the balance sheet[10] is a snapshot of what you have and what you owe at a given point in time. Unlike the income or cash flow statements, it is not a record of performance over a period of time, but simply a statement of where things stand at a certain moment.
The balance sheet is a list of assets, debts or liabilities, and equity or net worth, with their values. In business, assets are resources that can be used to create income, while debt and equity are the capital that financed those assets. Thus, the value of the assets must equal the value of the debt and the equity. In other words, the value of the business’s resources must equal the value of the capital it borrowed or bought in order to get those resources.
assets = liabilities + equity
In business, the accounting equation[11] is as absolute as the law of gravity. It simply must always be true, because if there are assets, they must have been financed somehow—either through debt or equity. The value of that debt and equity financing must equal or balance the value of the assets it bought. Thus, it is called the “balance” sheet because it always balances the debt and equity with the value of the assets.
In personal finance, assets are also things that can be sold to create liquidity. Liquidity is needed to satisfy or repay debts. Because your assets are what you use to satisfy your debts when they become due, the assets’ value should be greater than the value of your debts. That is, you should have more to work with to meet your obligations than you owe.
The difference between what you have and what you owe is your net worth[12]. Literally, net worth is the share that you own of everything that you have. It is the value of what you have net of (less) what you owe to others. Whatever asset value is left over after you meet your debt obligations is your own worth. It is the value of what you have that you can claim free and clear.
assets − debt = net worth
Your net worth is really your equity or financial ownership in your own life. Here, too, the personal balance sheet must balance, because if
assets − debts = net worth,
then it should also be
assets = debts + net worth.
Alice could write a simple balance sheet to see her current financial condition. She has two assets (her car and her savings account), and she has two debts (her car and student loans). We show this below in Table 1.3.1.
| Asset | Amount | Liability | Amount | |
| Car | 5,000 | Car Loan | 2,700 | |
| Savings | 250 | Student Loan | 53,000 | |
| Total | 5,250 | Total | 55,700 | |
| Net Worth | (50,450) |
Alice’s balance sheet presents her with a much clearer picture of her financial situation, but also with a dismaying prospect: she seems to have negative net worth. Negative net worth[13] results whenever the value of debts or liabilities is actually greater than the assets’ value. If
liabilities<assets then assets − liabilities>0; net worth>0 (net worth is positive)
If
liabilities>assets then assets − liabilities<0; net worth<0 (net worth is negative)
Negative net worth implies that the assets don’t have enough value to satisfy the debts. Since debts are obligations, this would cause some concern.
Net Worth and Bankruptcy
In business, when liabilities are greater than the assets to meet them, the business has negative equity and is literally bankrupt. In that case, it may go out of business, selling all its assets and giving whatever it can to its creditors[14] or lenders, who will have to settle for less than what they are owed. More usually, the business continues to operate in bankruptcy, if possible, and must still repay its creditors, although perhaps under somewhat easier terms. Creditors (and the laws) allow these terms because creditors would rather get paid in full later than get paid less now or not at all.
In personal finance, personal bankruptcy[15] may occur when debts are greater than the value of assets. But because creditors would rather be paid eventually than never, the bankrupt is usually allowed to continue to earn income in the hopes of repaying the debt later or with easier terms. Often, the bankrupt is forced to liquidate (sell) some or all of its assets.
Because debt is a legal as well as an economic obligation, there are laws governing bankruptcies that differ from state to state in the United States and from country to country. Although debt forgiveness was discussed in the Old Testament, throughout history it was not uncommon for bankrupts in many cultures to be put to death, maimed, enslaved, or imprisoned. The use of another’s property or wealth is a serious responsibility, so debt is a serious obligation.
However, Alice’s case is actually not as dismal as it looks, because Alice has an “asset” that is not listed on her balance sheet, that is, her education. It is not listed on her balance sheet because the value of her education, like the value of any asset, comes from how useful it is, and its usefulness has not happened yet, but will happen over her lifetime. It will happen in her future, based on how she chooses to use her education to increase her income and wealth. It is difficult to assign a monetary value to her education now. Alice knows what she paid for her education, but, sensibly, its real value is not its cost but its potential return, or what it can earn for her as she puts it to use in the future.
Current studies show that a college education has economic value, because a college graduate earns more over a lifetime than a high school graduate. Recent estimates put that difference at about $1,000,000. So, if Alice assumes that her education will be worth $1,000,000 in extra income over her lifetime, and she includes that asset value on her balance sheet, then her net worth is positive, just unrealized.
This looks much better, but it’s not sound accounting practice to include an asset—and its value—on the balance sheet before it really exists. After all, education generally pays off, but until it does, it hasn’t yet and there is a chance, however slim, that it won’t for Alice. A balance sheet is a snapshot of one’s financial situation at one particular time. At this particular time, Alice’s education has value, but its amount is unknown.
It is easy to see, however, that the only thing that creates negative net worth for Alice is her student loan. The student loan causes her liabilities to be greater than her assets—and if that were paid off, her net worth would be positive. Given that Alice is just starting her adult earning years, her situation seems quite reasonable.
Let’s try one together…
Ron is taking stock of his assets and debts and has come up with the following information. Ron has a car which could be sold for $15,000. He still owes $12,000 on the car. He has $2,000 in savings and has $3,000 in an investment account. He also still owes $20,000 in student loan debt. He has decided not to include the value of the college degree as an asset. Create a balance sheet for Ron and determine his net worth.
Answer: See video for table; net worth = -$12,000
Let’s try one together…
Jeremy has just graduated college and currently has $10,000 in student loan debt. After graduating, he purchased a new Ford F150 Super Cab for $35,000. The truck could be sold today for $25,000 and Jeremy still owes $31,000 on the truck. Additionally, he purchased a Polaris Sportsman 850 with low, low monthly payments. The quad could be sold today for $6,500. He still owes $9,000 for the remaining quad payments. Finally, he has purchased a variety of things on his credit card. These things have no significant resale value but currently owes $7,000 in credit card debt.
Create a balance sheet for Jeremy and calculate his net worth.
Answer: See video for balance sheet; net worth = -$25,500
Some software/programs that may be useful for tracking your finances:
- Quicken
- Mint
- YNAB
- Mvelopes
The Dave Ramsey Show: Good versus Bad Financial Decisions (all rights reserved)
