Many people judge themselves financially by their annual income. A true test of financial success is not have much they make, but how much they have. Money does not necessarily bring happiness, but a monetary cushion can provide peace of mind and security.
There are two important factors in measuring financial strength. The long-term financial position described as net worth, and the short term situation known as working capital, or the difference between short-term assets and liabilities.
Assets and Liabilities
A quick definition of assets and liabilities: Assets are items that are owned, and liabilities are owed to someone else. A car is an asset, a loan on the car is a liability. The difference between those two is the net worth on that asset, and the difference between all assets and liabilities is net worth.
Short term assets and liabilities are items that are expected to last one year or less. Money in a bank account is short term, money in a 401(k) for retirement 20 years from now is long term. A personal house is a long term asset, the mortgage is a long-term liability.
Building a Personal Balance Sheet
A balance sheet should not be a laundry list of every item a person owns. The assets should be items of value that could be converted to cash. Clothes and furniture are necessary, but usually would not generate much cash after use, and should be excluded.
For simplicity, focus on bank accounts, investments, vehicles, and property. Fairly assess the value. It is best to have a true measure of financial standing. This is not for any else’s use, so be honest.
Now, list all liabilities: all credit cards, car payments, mortgages, and personal loans. Separate them into those due within a year and those longer. For true accounting, items can be split between current and long term, but for simplicity, just allocate mortgages and the like to long term.
Net Worth and Working Capital
To find net worth, subtract total liabilities from total assets. To find working capital, subtract current liabilities from current assets. The goal is for both numbers to be as high as possible.
If either number is negative, it is time for serious financial introspection. Negative net worth means that over the long term, you have spent more than you have accumulated in valuable assets. Toys, clothes and electronics can provide fleeting pleasure, but cannot be converted to cash in a crisis.
Negative working capital means that there is not enough cash to meet current needs. This will result in maintaining credit card balances and not having cash to take advantage of opportunities when they present themselves.
Even if working capital and net worth are positive, they may not be at a level appropriate for your age or situation. Knowing the truth about your financial situation is the first step in doing something positive about it.
