Take a moment in time and freeze it. Tally up all your assets and liabilities, and that snapshot is your balance sheet. So what is a balance sheet good for? Tracking your financial health, of course!
In the business world there are the four main statements: profits & losses (aka the income statement), statements of shareholders' equity, balance sheets, and cash flow statements.
You should already be tracking your cash flow every month, and statements of shareholders' equity don't apply for personal finances. Out of the remaining two, today I wish to focus on the balance sheet.
Balance sheets are a useful tool that complement cash flow statements. A balance sheet is a snapshot of all your money and debts at a point in time. The change between two balance sheets is the cash flow. If balance sheets are like pictures, cash flow statements are like the motion between two frames of a video.
One of the benefits of tracking both cash flow and balance sheets is that you build in an error detecting mechanism. One balance sheets plus the cash flow for that month should equal the next month's balance sheet. If it doesn't, then you missed accounting for something.
I believe that tracking balance sheets helps in personal finance because it forces you to get familiar with all your myriad financial accounts. It also forces you to check into them regularly, so that you can notice any messages or problems sooner rather than later.
Balance sheets are good for building a basic understanding of financial health. They also help with tracking several metrics such as the current ratio, net worth, and asset allocation.
Which leads to an important foundational bit of knowledge: balance sheets are mostly broken down into assets and liabilities. Assets are things you own that possess value, and liabilities are bills or debts you owe.
A balance sheet is called such because it's supposed to balance according to the equation "Assets = Liabilities + Shareholder's Equity," where shareholder's equity is also known as "net assets." However, shareholder's equity is more relevant in the business world than in the personal finance world, so we'll neglect it here.
Let's look at an example balance sheet that's simplified for personal finance use:
The fist thing to understand about this sheet is the difference between current, non-current, and fixed assets. Current means that the asset or liability is relevant within a year's time, i.e. you plan on converting something into cash within a year or paying down a debt. Non-current means it is longer-term, beyond a year in time. Fixed assets are long-term assets, but also specifically physical items like houses, manufacturing equipment, computer hardware, and so on. Fixed assets tend to be more illiquid than non-fixed assets, since they're actual goods and property.
Let's look at the example to understand it better. In the liabilities column there are two lines for the mortgage: current and non-current. For this example it's a $1,000 a month mortgage split with 12 months for the current category and the remaining $200k amount in the non-current category. Cash and investments are both liquid assets, although cash is a current asset and stocks are non-current. The house itself is a fixed asset, which is illiquid as it can take months to sell it.
Next, let's take a look at some of the metrics we can extract from a balance sheet:
The first and most obvious number that jumps out is the net worth. I dislike using it as a metric because it likes to lie about your financial health, but it's still a fun thing to watch climb.
Your net worth is as simple as "Total Assets - Total Liabilities = Net Worth."
The next measure is the current ratio, which is a liquidity ratio. I like to use it as a quick indicator of my cash runway. If you have 50% current ratio, then you likely have just under half a year of cash runway. I like to keep my current ratio around 125%, because there are other expenses than just current liabilities.
The current ratio is "Current Assets / Current Liabilities = Current Ratio."
Third is the cash percent balance, which is an asset allocation ratio. It's useful for knowing how heavily weighted your portfolio is towards cash. I like to keep this ratio low, in the 10% - 20% region. Cash doesn't offer good returns when I'm still in the growth stage of the financial life cycle.
The cash percent balance ratio in this example has the formula: "Cash / (Cash + Investments) = Cash Percent Allocation."
There are plenty more ratios and metrics that make use of the information on the balance sheet, but these will serve for the time being. I recommend getting started with just these three simple ratios, and expanding to fit your needs. For instance, I found that I liked tracking my non-fixed assets amount separately from my total assets, since I don't believe the home you live in is an investment vehicle.
When reading a balance sheet to my dearheart, I like to answer an escalating series of questions:
Are we in an emergency? Do we need cash?
Can we handle normal expense ebb & flow?
Are we in a position to expand, or downsize?
Is our trajectory speeding up or slowing down?
How close are we to our goals?
These questions are really the goal of keeping the balance sheet: to have numbers to back up whatever answer we find for each question.
As for getting started with balance sheet tracking, I recommend doing monthly balance sheets for a couple months in a row to get comfortably acquainted with all your accounts. After that, you can take more time between balance sheets – i.e. quarterly, if you want to be closer to a business timetable.
There are all sorts of software solutions to tracking your finances, but especially for beginners I recommend starting with pen & paper or spreadsheets to avoid automation biases. Doing your balance sheet should be a mindfulness exercise that takes perhaps thirty minutes at the most, and you should answer several questions by the time you're done with it.
I hope you find this helpful for getting started with balance sheets, and that it gives you several ideas on how to run your own life like a business.