Budgets & Balance Sheets

Yes, I know it's a bit late in the year to talk about budgeting. I can almost hear you asking: Isn't that one of those "New Year's resolutions"-type things? But we're not that far past tax season, so hopefully our far-flung financial documents are still tucked away in one easy-to-access place. Let's use those lazy (hah!) days of summer to crunch through some personal finance numbers and get a feel for where you're at and where you might be going, money-wise.

My basic point in this piece is: Wealth is created from wise use of excess in your budget and your balance sheet, so your first step is to figure out whether or not—or how much—excess exists on your balance sheet, and how your spending patterns are increasing or reducing that excess.

How Much Should I Save, and How Long Will It Take?

People often ask me: How much should I save for retirement? When can I retire? Should I focus on paying off my debt, or on investing first? How much should I put aside for education costs? And I'm sure that secretly a lot of us daydream: I wonder if I could ever be a millionaire (or, for those of us already in the seven-figure category, a billionaire)? And other similar questions. These are important topics, but it'll be nearly impossible to prioritize them or timeline them until you have a handle on two things:

1. Your personal balance sheet
2. Your essential budget

These two basics are the starting point for developing your personal financial strategy, since they answer the questions: What have I got to work with? And, what should my financial priorities be? How long will it take me to reach my goals? What will I need to change or sacrifice to meet my target deadlines?

Where Am I Now?: The Power of the Personal Balance Sheet

Strategies for building wealth require healthy balance sheets, so a personal balance sheet statement is really all about checking your and/or your family's financial condition. Companies are used to producing balance sheets as part of their accounting procedures, but for most of us as individuals, it's not an exercise we're accustomed to. It's not too terribly complicated, and even if—or rather, especially if—you suspect your household's financial situation is precarious, a balance sheet statement is critical for pinpointing the areas that most need attention.

A balance sheet just compares the value of your assets and your liabilities.

Assets

Assets are the "plus side" or "positives" on your balance sheet. You'll begin by listing all of your assets, and their rough current value. It's helpful to organize your assets by how "liquid" they are, i.e. how easily they can be converted to cash. I think it also helps to indicate a rate of return or rate of growth (or depreciation) next to each asset—even if it's only a rough estimate.

Your asset list should include things like:

• Checking accounts
• Savings accounts
• Money market accounts/money market depository accounts
• Taxable investment accounts
• Retirement and tax-deferred accounts
• Cash value of various policies (annuity, life insurance, etc.)
• Vehicles
• Real estate
• Jewelry
• Artwork or collectibles
• Business ownership

Once your assets are listed, they'll be much easier to review for:

• Liquidity
• Risk
• Return
• Diversification

Liabilities

Liabilities are the "minus side" or "negatives" on your balance sheet, and are typically obligations of some sort, usually debt. Once again, you'll want to begin by listing all of your liabilities, and their rough current value. It's helpful to organize your liabilities in reverse order of how easy they are to defer or change. For liabilities, it's particularly important to note the interest rate on your obligations.

• Your liabilities may include:
• Consumer debt (such as credit cards)
• Car loan
• Student loan debt
• Mortgage
• Business-related debt

Once your liabilities are listed, it'll be much easier to review whether or not your household's overall debt ratio is too high, and to prioritize "payoff priorities" of existing liabilities, based on type of debt and interest rate.

Net Worth

Your "net worth" is simply your total assets minus your total liabilities.

You'll want to monitor the overall trend in your household's net worth—I suggest monthly check-ups when you're first getting started, and quarterly thereafter—to see if tweaks need to be made to your household's spending and investment patterns (more on this below).

This "bird's eye view" of your financial situation should start you thinking about any changes or reallocations that may need to be made, and help you start to strategize a specific financial approach to meet household financial goals such as becoming debt free, saving for retirement, putting away money for education, etc.

For example, if your liabilities significantly outweigh your assets, it's likely that you'll want to focus on reducing the liabilities side of your personal ledger (i.e. pay down debt) first, rather than building up your assets. (One significant exception to this rule of thumb is the asset I'm going to call the "emergency cash stash," which should be roughly the equivalent of three to six months' worth of income/expenses, and should be one of your household's top priorities.)

On the other hand, if your assets significantly outweigh your liabilities, you have more flexibility to explore a wider range of wealth strategies.

In either case, you/your family will need to prioritize:

1. Your goals for your assets. These goals should be specific, and include rough amounts and timeframes.
2. Which, if any, of your liabilities you want to minimize or remove, and how quickly. Again, the liability attack plan should be specific and include amounts and timeframes.

The balance sheet helps you decide what to focus on, but it's the excess in the budget that makes it all happen.

How Quickly Can I Get There?: The Personal Budget

Budgets get a bad rap. Ask someone to make up a budget, and you'll probably get a groan and some exaggerated eye-rolling in response. So maybe we should call "budgets" something else, like "personal cash flow statement," which sounds much more impressive. An analysis of your personal balance sheet tells you how close (or far) you already are to your financial goals; a review of your personal cash flow statement will help you estimate a timeframe—and perhaps how aggressively you may need to change your income situation or spending habits—to finish reaching those goals.

Again, I can only repeat that wealth is created through the wise use of excess. If you do not have excess in your budget, your existing assets will bear the full burden of wealth creation, as well as the full burden of managing your payment obligations for your liabilities. If your balance sheet is healthy, this may not be an issue. But if your balance sheet is not healthy, your budget needs to "pick up the slack," so to speak, so that your finances can turn around.

I think this idea of needing excess to create wealth is what makes most of us cringe when we think about making up a budget: I think many of us may be concerned we're overspending rather than underspending our incomes. And we'd rather not have our bad spending habits outlined for us in black and white. I sympathize with this ostrich-ism! Budgets do highlight what our priorities and behaviors are, and while it can be painful to confront our own spending patterns, we can't identify ways to create excess in our budgets until we do.

It's also very difficult to estimate how much your household should be saving for retirement without having a clear idea of how much you're spending as a household in today's dollars. This is another very important reason to develop a household budget.

Inflows

Much like a business, your household has "cash flow," or an ongoing stream of income that is used to pay for expenditures. You can start your budget by listing your income sources; I suggest indicating whether or not they are fixed or variable. Your list of "inflows" may include:

• Salary
• Bonus/commission
• Dividend income
• Interest income
• Rental income
• Business income
• Social Security income
• Pension income
• Annuity income
• Legal settlement income
• Child support income

Outflows

Excess in your budget will come from "living within your means," or spending less than your income. The other side of your "cash flow statement" is your expenditures; as with your income sources; I suggest indicating whether or not they are fixed or variable, as well as essential or optional.

Your list of outflows may include:

• Housing
  
  • Rent or mortgage payment
  • Renter's or homeowner's insurance
  • Homeowner's fees
  • Home improvement
  • Home maintenance
  • Property taxes
  • Utilities
• Food
  • At home
  • Dining out
• Transportation
  • Car payments
  • Car insurance
  • Car maintenance
  • Vehicle taxes
  • Fuel
  • Public transportation
• Healthcare
  • Health insurance
  • Medicare/Medigap
  • Copayments
  • Uncovered medical expenditures
  • Prescriptions
  • Medical supplies
• Personal insurance
  • Life/other
  • Long-term care
• Personal
  • Child support payments
  • Clothing
  • Products and services
  • Entertainment
  • Travel
  • Hobbies
  • Family care
  • Education
  • Income taxes
  • Charitable contributions
• Other financial obligations
  • Other mortgages
  • Credit card payments
  • Retirement plan contributions
  • Education savings contributions
  • Personal/household savings contributions

Much like with your personal balance sheet, your personal cash flow statement will help you pinpoint areas of possible overspending.

Inflow < Outflow = Negative cash flow; overspending your income

Inflow > Outflow = Positive cash flow; underspending your income

Excess = The amount by which you are underspending your income.

Creating or Increasing "Excess"

People I talk to always want to know how long it will take them to save $X amount for college, or for retirement, or to buy a home. While part of the equation calculating these timeframes is certainly out of their—and your—direct control (rates of inflation, rates of return), what is in their—and your—direct control is the amount you are contributing toward the goal, and the frequency of the contribution. So a large part of the answer to "how long will it take me to save for …" depends on you.

Meeting Your Financial Goals May Involve Sacrifice

Your commitment to your financial goals may be measured by your willingness to make sacrifices or change behaviors to achieve them. For example, if your personal cash flow statement is "cash flow negative," meaning you're overspending your income, I suggest taking immediate action. Review your outflows, and see where spending might be able to be reduced. This may involve a change in lifestyle, or living location. If spending cannot be reduced, perhaps you may need to review your income situation to see if income can be increased. This may mean working another job, or going back to work. Yes, I did say that: you may have to go back to work, or change your work, to meet your goals.

Putting $1,000 a month steadily into an account of some kind will grow to $10,000 much more quickly than just putting in $100 a month.

Obvious, right? Sure.

But a lot of us have no idea what our monthly excess is, so we have no idea if we have more along the lines of $100 a month to work with to meet our goals, or $1,000 a month to work with. And we won't know until we get over our queasiness about outlining our balance sheet (gulp!) or figuring out our budget (horrors!). Before you take the first step toward financial security, you have to know what it looks like on the word "Go!" So, go to it!