If you run a business or work for a large business, you would know that managing the balance sheet of a company is a key success factor.
There are essentially two sides of a balance sheet – assets and liabilities. Assets comprise cash, fixed assets, property, etc that a company owns and liabilities is what a company owes to other people such as loans, etc. In any balance sheet, the sum of liabilities is equal to the sum of assets and the difference between the two if the owner’s equity. Any imbalance where liabilities are greater than the assets will cause owner’s equity to reduce significantly.
If we apply the same principle to ourselves, we also have two sides to our personal balance sheet – assets and liabilities. Assets comprise our house, personal belongings, investments, bank deposits, cars, etc. and liabilities comprise all the loans that we may have such as home loans, credit cards and personal loans. The difference between the two is our personal net worth. As we use loans to build assets, we are essentially building our personal balance sheets – increasing the size of both our assets and liabilities.
You would argue that this is the best way to build personal wealth over a long period of time, it comes with risks that are very important to understand. For example – if you buy a house using a home loan, you have an asset (i.e. – the house worth lets say 100) and a liability (i.e. – the home loan for say 80). As long as the price of the house goes up, you are fine and are building your net worth. But if the value of the house starts to come off, your net worth starts to reduce to the point that if the value drops below 80, you have lost all your equity.
Although this may all seem very basic, the implications of this approach are far reaching. During the bull run from 2004 – 2007, a lot of people were building their personal balance sheets assuming that things will be good for ever but after the financial crisis in 2008, they have realized that this was a biggest mistake of their lives. They have lost a significant portion of their net worth and are now consigned to a significantly poor lifestyle compared to what they were accustomed to.
You need to work on the following to ensure that you maintain your personal balance sheet well:
1. Keep a tight control over all loans that you have including their costs and if there are any opportunities to switch to cheaper loans.
2. Whenever you have money lying idle, it is better to pay off a loan rather than investing it in another property or buying another car. This will help you reduce the size of your balance sheet and build your net worth.
3. Ensure that you have enough cash stowed away in a place to cater to a 10 – 15% drop in all your assets.
4. Pay all your credit cards and other loans in full every month, else the late payment and other charges start to build very quickly.
Preeti H Bhambri is the Managing Director and founder of MoneyCamel.com - UAE’s leading personal finance website.
MoneyCamel.com is a comprehensive personal finance website that guides users through banking and financial services in the UAE. Managing personal finances can be a difficult for even the best brains and the site aims to simplify personal finance and provide tools, information and calculators that will help users improve their financial health.
Preeti is a veteran in the retail financial services industry and has worked with some of the leading institutions such as American Express, GE Capital and Standard Chartered Bank over the last 13 years. During her stints with these institutions, she has managed several roles in sales, relationship management, client servicing, financial planning, product development and risk management. She has a Master’s degree in Business Administration and a Bachelor’s degree in Commerce from Delhi University.
She is based in Dubai, UAE.