Applying Corporate Accounting Terms to Our Personal Finances
Corporate accountants and CPAs commonly use a lot of terms, ratios, and acronyms that can be confusing to anyone without a four-year degree in the field. Though the figures that accountants calculate and discuss are important for reporting on the financial health of businesses, their definitions and different applications might seem out of sight to the average American.
Here on Tepom.com, I preach the importance of financial planning, budgeting, and overall fiscal responsibility in a way that's meant to be easy to read and applicable to any average person with a roof over their head, a checking account, and a credit card. The purpose of today's post is to define some of those esoteric accounting terms that are used by big businesses and show you how they relate to the finances of you and your family. I'll discuss both terms and ratios, both of which are used by corporate accountants to report to shareholders and Boards of Directors on the monetary wellbeing of organizations.
Terms
Assets: Anything that you own that is worth money, be it your house, cash in your checking account, or money that someone owes you. It should be noted that for reporting purposes, the value of an asset is independent of any debt associated with it, such as a mortgage.
How it applies to you: The value of your assets is the most primitive of financial calculations. Basically, it measures how many things you have, how much money you have, how much your house is worth, etc. Simply put, the more assets you have, the better off you are.
Liabilities: The amount of money that you owe people or businesses, be it a credit card balance, an auto loan, a mortgage, or a personal loan from your mother. Like assets, it is important to report on liabilities independent of any associated assets, such the value of the house related to the mortgage.
How it applies to you: Liabilities are a fundamental part of the equation when it comes to your financial health. Measuring liabilities basically brings you back down to earth for those of you with lots of expensive stuff. Unlike assets, liabilities are not nearly as visible because they're not tangible; they kind of hide in the dark. All too often we judge one's wealth on his or her assets without considering the liabilities. If you walk into someone's home and see HDTVs, nice cars, and expensive art, you may think he's rich. But if he bought it all on credit, your perception is quite the contrary to reality; which brings us to equity.
Equity: Also referred to as Net Worth, this is simply all of your liabilities subtracted from your assets. As an example, let's say you own a house worth $150,000, a car worth $10,000, and have $5,000 cash in your checking account. You also owe $100,000 on your home in a mortgage, have no car loan, and have $3,000 in credit card debt. Your total assets equal $165,000 (150,000+10,000+5,000) and your total liabilities equal $103,000 (100,000 + 3,000). Therefore, your equity equals $62,000 (165,000 - 103,000).
How it applies to you: Equity may be the most important accounting term for you to be familiar with. It's by no means a difficult concept, but it is a key component of your financial health and something that we should all be aware of. For example, my wife and I currently have negative equity, meaning that we have more liabilities (debt) than we have assets. Mostly, this is because each of us has student loans and the value of our house has gone down since we bought it. Negative equity is common among young Americans, but as they get older, it generally becomes positive as you continue to spend less than you make. I like to track my equity (Net Worth) here on NetWorthIQ.
Though negative equity is less desirable than positive equity, it isn't the monster that you may think it is. My wife and I wouldn't have the jobs that we have today without having gone to college. And we wouldn't have been able to afford college on our own, so we took out student loans, which in turn pushed our equity down into the red. But because the education that we purchased increased our earning potentials, we will be able to more rapidly push our equity back into the green and [optimistically] into the clouds.
Current Assets: Assets that can be converted into cash within a short period of time (usually one year or less). Examples include cash, of course, as well as items that can be quickly sold and money that is owed to you that you expect to be paid within a year. For example, if you have a baseball card collection that could be sold rather quickly for $10,000, you could classify that as a current asset. Also, if you own an occupied rental property, you could classify a year's worth of rent payments as a current asset (FYI, monies that you are owed are called Receivables). On the other hand, money saved in controlled retirement accounts that cannot be cashed in for a number of years as well as the value of your home would not be considered a current asset.
How it applies to you: It's important to separate current assets from the pack because they represent your current buying power. Current assets control how much you might be ale to afford to spend on an upcoming purchase, such as a vacation or an investment. Let's say that you have a 401(k) worth $100,000. If you're considering buying a house and need a down payment, that $100,000 won't do you much good because it isn't current -- you can't touch it until you're 65 (without a penalty). In this type of situation, only your current assets will be able to help you.
Current Liabilities: Liabilities (debts) that must be repaid within a short period of time (usually within one year). Examples include credit card balances that you intend to pay off within a year, your next year's worth of mortgage and auto loan payments, the current year's taxes, etc.
How it applies to you: These have an affect on your current buying power, just like current assets. Even if you have a tremendous level of current assets you must consider your current liabilities -- the things that you're going to have to pay in the next year -- before making any real decisions. Let's say you want to buy a new computer for $2,000. Even if you have $2,000 in the bank, you still may not be able to afford it after you take into account your upcoming $1,000 mortgage payment and $300 car payment. This brings us to net current assets.
Net Current Assets: Similar to Equity and Net Worth, Net Current Assets (also known as Working Capital) is your current assets minus your current liabilities. It is a measure of your true current buying power. In the previous example, we mentioned a person with $2,000 in the bank (current assets) and upcoming mortgage and car payments totaling $1,300. This would leave the person with Net Current Assets of $700.
How it applies to you: A failure to recognize Net Current Assets, in my opinion, is one of the biggest reasons people get themselves into trouble financially. When they're deciding whether or not an item is affordable, they will only consider their current assets rather than their net current assets. In the end, when bills come due, once-eager shoppers will resort to increasing their debt because they didn't plan ahead and take the time to really decide if they could afford what they were buying. So before you make that next big purchase, consider not only what you have in the bank, but what you're going to have to pay in the near future.
Gross Income: The amount of money that you earned during a certain period minus the amount that you spent during the same period. I calculate this number in my own personal finances once a month. Free web-based software, like Mint.com, makes it very easy to see how much I bring in and how much goes out.
How it applies to you: Unlike assets and liability figures that measure assets and debts at a particular instant -- like, "today, I have $2,000 in my checking account and a $1,500 credit card balance," gross income is a measure of behavior during a period of time, be it an hour, a day, a month, a year, etc. It shows us how much money we make versus how much money we spend. The value of gross income is very easy to calculate in a given month by looking at your bank and credit card statements and adding all the "plusses" and all the "minuses." If you find that you're spending more than you make, it will be important for you to create a budget. If you find that you're spending less than you bring in, you can pat yourself on the back, knowing that you're doing better than a lot of other folks!
Financial Ratios
Professionals also like to use ratios when they're evaluating a corporation's financial health. They simplify the evaluation and can help compare current health with that of previous years or with the health of competing companies. In the stock market, ratios help when investors compare some ratios of two or three different companies when they're trying to decide where to put their money. Some of these ratios can be very helpful when applied to our own personal finance objectives:
Current Ratio: Equals current assets divided by current liabilities. Much like net current assets, it shows you how well off you are today and indicates your current buying/investing power.
How it applies to you: This is similar to your net current assets, but just in different terms. Net Current Assets will basically tell you specifically how much you can afford to spend or invest in the next few months, while the current ratio gives you a relative value, which can help you see how your buying power increases or decreases over time. So if one is "good," the other should be good, too. Keeping track of your current ratio over time is a good way to see how your spending and saving habits and financial health are related. For example, back in college, I had some serious spending issues. I had nearly no money in the bank and about $9,000 in credit card debt. As you might imagine, both my Current Ratio and my Net Current Assets stunk. My net current assets would have been negative because I had a lot more credit card debt than I had money in the bank. My current ratio would have been less than one. Your current ratio will never be negative, but if it gets below one, you should start to worry because it means that you might not have enough in the bank to cover you next few months of expenses (much like the American automakers).
Debt Ratio: Total Liabilities divided by Total Assets. It shows the relationship between all of your debt and assets, including both short and long-term values. Unlike the Current Ratio, it's better to have a debt ratio less than one. Basically, any value greater than one means that you're worth more dead than alive (just kidding). Any value less than one means that you have more assets than you have debt.
How it applies to you: Some people will argue that any and all debt is bad and should be avoided at all costs. I tend to disfavor debt myself, but it should be noted that debt is important and useful if it is controlled and maintained. This ratio is meant to show you an easy-to-read relationship between how much debt you have and how much all of your stuff is worth. This is the precise equation you would use to determine whether or not you are "upside down" on your house (you owe more than it's worth). Younger people tend to have higher debt ratios, but over time, as long as they live a life of on-time loan payments spending less than they earn, the ratio will eventually shrink to a level below the threshold value of one.
As an example, let's say you buy a home for $150,000 and put zero money down. In your first month you will owe exactly what the house is worth. So your total assets and total liabilities would both be $150,000, creating a Debt Ratio of exactly one. Then as you make your mortgage payments, the amount that you owe will start to go down, slowly at first, and then more rapidly as time goes on. Meanwhile, the value of the house will begin to rise because of inflation and maybe even more if it's in an up-and-coming neighborhood. Before you know it, the house will be worth $200,000 and you'll only owe $100,000, making your Debt Ratio .5 (100,000/200,000). Like I said before, the lower your number, the better. When you have all assets and zero debt, your debt ratio will simply be zero.
There are a plethora of financial terms and ratios that I won't get into today that can be applied to the average American's personal finances. If there are any accountants out there, I'd welcome any feedback or additions to my analysis.
Here on Tepom.com, I preach the importance of financial planning, budgeting, and overall fiscal responsibility in a way that's meant to be easy to read and applicable to any average person with a roof over their head, a checking account, and a credit card. The purpose of today's post is to define some of those esoteric accounting terms that are used by big businesses and show you how they relate to the finances of you and your family. I'll discuss both terms and ratios, both of which are used by corporate accountants to report to shareholders and Boards of Directors on the monetary wellbeing of organizations.
Terms
Assets: Anything that you own that is worth money, be it your house, cash in your checking account, or money that someone owes you. It should be noted that for reporting purposes, the value of an asset is independent of any debt associated with it, such as a mortgage.
How it applies to you: The value of your assets is the most primitive of financial calculations. Basically, it measures how many things you have, how much money you have, how much your house is worth, etc. Simply put, the more assets you have, the better off you are.
Liabilities: The amount of money that you owe people or businesses, be it a credit card balance, an auto loan, a mortgage, or a personal loan from your mother. Like assets, it is important to report on liabilities independent of any associated assets, such the value of the house related to the mortgage.
How it applies to you: Liabilities are a fundamental part of the equation when it comes to your financial health. Measuring liabilities basically brings you back down to earth for those of you with lots of expensive stuff. Unlike assets, liabilities are not nearly as visible because they're not tangible; they kind of hide in the dark. All too often we judge one's wealth on his or her assets without considering the liabilities. If you walk into someone's home and see HDTVs, nice cars, and expensive art, you may think he's rich. But if he bought it all on credit, your perception is quite the contrary to reality; which brings us to equity.
Equity: Also referred to as Net Worth, this is simply all of your liabilities subtracted from your assets. As an example, let's say you own a house worth $150,000, a car worth $10,000, and have $5,000 cash in your checking account. You also owe $100,000 on your home in a mortgage, have no car loan, and have $3,000 in credit card debt. Your total assets equal $165,000 (150,000+10,000+5,000) and your total liabilities equal $103,000 (100,000 + 3,000). Therefore, your equity equals $62,000 (165,000 - 103,000).
How it applies to you: Equity may be the most important accounting term for you to be familiar with. It's by no means a difficult concept, but it is a key component of your financial health and something that we should all be aware of. For example, my wife and I currently have negative equity, meaning that we have more liabilities (debt) than we have assets. Mostly, this is because each of us has student loans and the value of our house has gone down since we bought it. Negative equity is common among young Americans, but as they get older, it generally becomes positive as you continue to spend less than you make. I like to track my equity (Net Worth) here on NetWorthIQ.
Though negative equity is less desirable than positive equity, it isn't the monster that you may think it is. My wife and I wouldn't have the jobs that we have today without having gone to college. And we wouldn't have been able to afford college on our own, so we took out student loans, which in turn pushed our equity down into the red. But because the education that we purchased increased our earning potentials, we will be able to more rapidly push our equity back into the green and [optimistically] into the clouds.
Current Assets: Assets that can be converted into cash within a short period of time (usually one year or less). Examples include cash, of course, as well as items that can be quickly sold and money that is owed to you that you expect to be paid within a year. For example, if you have a baseball card collection that could be sold rather quickly for $10,000, you could classify that as a current asset. Also, if you own an occupied rental property, you could classify a year's worth of rent payments as a current asset (FYI, monies that you are owed are called Receivables). On the other hand, money saved in controlled retirement accounts that cannot be cashed in for a number of years as well as the value of your home would not be considered a current asset.
How it applies to you: It's important to separate current assets from the pack because they represent your current buying power. Current assets control how much you might be ale to afford to spend on an upcoming purchase, such as a vacation or an investment. Let's say that you have a 401(k) worth $100,000. If you're considering buying a house and need a down payment, that $100,000 won't do you much good because it isn't current -- you can't touch it until you're 65 (without a penalty). In this type of situation, only your current assets will be able to help you.
Current Liabilities: Liabilities (debts) that must be repaid within a short period of time (usually within one year). Examples include credit card balances that you intend to pay off within a year, your next year's worth of mortgage and auto loan payments, the current year's taxes, etc.
How it applies to you: These have an affect on your current buying power, just like current assets. Even if you have a tremendous level of current assets you must consider your current liabilities -- the things that you're going to have to pay in the next year -- before making any real decisions. Let's say you want to buy a new computer for $2,000. Even if you have $2,000 in the bank, you still may not be able to afford it after you take into account your upcoming $1,000 mortgage payment and $300 car payment. This brings us to net current assets.
Net Current Assets: Similar to Equity and Net Worth, Net Current Assets (also known as Working Capital) is your current assets minus your current liabilities. It is a measure of your true current buying power. In the previous example, we mentioned a person with $2,000 in the bank (current assets) and upcoming mortgage and car payments totaling $1,300. This would leave the person with Net Current Assets of $700.
How it applies to you: A failure to recognize Net Current Assets, in my opinion, is one of the biggest reasons people get themselves into trouble financially. When they're deciding whether or not an item is affordable, they will only consider their current assets rather than their net current assets. In the end, when bills come due, once-eager shoppers will resort to increasing their debt because they didn't plan ahead and take the time to really decide if they could afford what they were buying. So before you make that next big purchase, consider not only what you have in the bank, but what you're going to have to pay in the near future.
Gross Income: The amount of money that you earned during a certain period minus the amount that you spent during the same period. I calculate this number in my own personal finances once a month. Free web-based software, like Mint.com, makes it very easy to see how much I bring in and how much goes out.
How it applies to you: Unlike assets and liability figures that measure assets and debts at a particular instant -- like, "today, I have $2,000 in my checking account and a $1,500 credit card balance," gross income is a measure of behavior during a period of time, be it an hour, a day, a month, a year, etc. It shows us how much money we make versus how much money we spend. The value of gross income is very easy to calculate in a given month by looking at your bank and credit card statements and adding all the "plusses" and all the "minuses." If you find that you're spending more than you make, it will be important for you to create a budget. If you find that you're spending less than you bring in, you can pat yourself on the back, knowing that you're doing better than a lot of other folks!
Financial Ratios
Professionals also like to use ratios when they're evaluating a corporation's financial health. They simplify the evaluation and can help compare current health with that of previous years or with the health of competing companies. In the stock market, ratios help when investors compare some ratios of two or three different companies when they're trying to decide where to put their money. Some of these ratios can be very helpful when applied to our own personal finance objectives:
Current Ratio: Equals current assets divided by current liabilities. Much like net current assets, it shows you how well off you are today and indicates your current buying/investing power.
How it applies to you: This is similar to your net current assets, but just in different terms. Net Current Assets will basically tell you specifically how much you can afford to spend or invest in the next few months, while the current ratio gives you a relative value, which can help you see how your buying power increases or decreases over time. So if one is "good," the other should be good, too. Keeping track of your current ratio over time is a good way to see how your spending and saving habits and financial health are related. For example, back in college, I had some serious spending issues. I had nearly no money in the bank and about $9,000 in credit card debt. As you might imagine, both my Current Ratio and my Net Current Assets stunk. My net current assets would have been negative because I had a lot more credit card debt than I had money in the bank. My current ratio would have been less than one. Your current ratio will never be negative, but if it gets below one, you should start to worry because it means that you might not have enough in the bank to cover you next few months of expenses (much like the American automakers).
Debt Ratio: Total Liabilities divided by Total Assets. It shows the relationship between all of your debt and assets, including both short and long-term values. Unlike the Current Ratio, it's better to have a debt ratio less than one. Basically, any value greater than one means that you're worth more dead than alive (just kidding). Any value less than one means that you have more assets than you have debt.
How it applies to you: Some people will argue that any and all debt is bad and should be avoided at all costs. I tend to disfavor debt myself, but it should be noted that debt is important and useful if it is controlled and maintained. This ratio is meant to show you an easy-to-read relationship between how much debt you have and how much all of your stuff is worth. This is the precise equation you would use to determine whether or not you are "upside down" on your house (you owe more than it's worth). Younger people tend to have higher debt ratios, but over time, as long as they live a life of on-time loan payments spending less than they earn, the ratio will eventually shrink to a level below the threshold value of one.
As an example, let's say you buy a home for $150,000 and put zero money down. In your first month you will owe exactly what the house is worth. So your total assets and total liabilities would both be $150,000, creating a Debt Ratio of exactly one. Then as you make your mortgage payments, the amount that you owe will start to go down, slowly at first, and then more rapidly as time goes on. Meanwhile, the value of the house will begin to rise because of inflation and maybe even more if it's in an up-and-coming neighborhood. Before you know it, the house will be worth $200,000 and you'll only owe $100,000, making your Debt Ratio .5 (100,000/200,000). Like I said before, the lower your number, the better. When you have all assets and zero debt, your debt ratio will simply be zero.
There are a plethora of financial terms and ratios that I won't get into today that can be applied to the average American's personal finances. If there are any accountants out there, I'd welcome any feedback or additions to my analysis.
Labels: apply, average, current assets, current liabilities, current ratio, debt ratio, financial ratios, gross income, net current assets
posted by Scott Bliss @ 10:49 AM
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