The asset, liability and net worth balance sheet: a financial yardstick to determine solvency
A balance sheet is a worksheet used to list in dollar amounts all the homeowner’s assets and liabilities to set the homeowner’s net worth (formula: assets minus liabilities equals net worth). It is an ideal tool to decipher a homeowner’s, and by extension the family’s, financial health. [See first tuesday Form 207-1]
The balance sheet analysis reveals whether the family is on track to meet long-term financial goals, or whether the family is insolvent and in need of a change in behavior – or assets. It also helps the family determine which assets they best spend their earnings on and should keep and which assets they should discard.
A balance sheet distinguishes the relation between two basic financial things, assets and liabilities. Assets are tangible and intangible property rights of value held by the homeowner. Among them are liquid assets which take the form of cash or something easily converted to cash and include money held in a savings account or tradeable stocks and bonds. [See first tuesday Form 207-1 §1 and 2]
Generally, the largest dollar-valued asset a homeowner will ever own is his home. It is historically considered an illiquid asset as its equity, if positive, cannot quickly be converted to cash. With a positive equity stake in the home, the owner treats it as a valued asset and thus maintains and improves it. Over time, the property’s equity buildup can be cashed-out by either further financing or sale, time consuming and uncertain in amount.
Other items make up a homeowner’s assets, such as funds held in retirement accounts, ownership interests in businesses and trust deed notes owned. Vehicles and equipment owned are also assets, as well as furniture, electronic equipment and any other item of recognized value, such as collectibles. [See first tuesday Form 207-1 §5 through 9]
Liabilities are the flipside of the financial coin. Together, liabilities and net (or negative) worth are equal to the value of the assets. Liabilities included in a balance sheet are financial obligations – debts – owed to others, including real estate mortgages and auto loans, charge accounts, credit card balances, one year’s amount of alimony/child support/lease payments and loans collateralized by stocks, bonds or notes. [See first tuesday Form 207-1 §11 through 15]
A homeowner’s net worth is revealed when his total liabilities are subtracted from the current fair market value of his assets. The net worth is a primary determinant of financial wealth and should be known by all individuals, homeowners and otherwise. When net worth is positive, the homeowner is “worth” more than he owes to creditors – he is solvent.
However, this balancing act is immediately upended when a high-value asset, such as the homeowner’s residence, has a negative equity (the mortgage debt exceeds the home’s FMV). If the negative equity is large enough, the homeowner’s value of other assets is overwhelmed; his net worth appears as a negative figure. Instead of a positive measure of wealth, the negative net worth is a measure of insolvency. [For more information regarding the negative equity condition and the options available an insolvent, negative equity homeowner, see the April 2010 first tuesday articles, The underwater homeowner, his future and his agent: a balance sheet reality check – Part I and Part II.]
But how does the real estate agent fit into this arrangement?
A competitive and high-functioning agent may assist homeowners who complete the balance sheet by being available to answer questions about their home’s market price and rental value, all as a part of his standard farming practice. The confidential financial discussions between the homeowner and agent that result from a review of a completed balance sheet build long-term good will which the agent will reap the next time the homeowner considers or hears about a real estate transaction.
At the bottom of each page of the balance sheet, space is provided for the agent to enter his contact information. Thus, whenever the homeowner reviews his financial status by referring to the balance sheet, he will be visually reminded of the beneficial real estate related services provided by the agent. [See first tuesday Form 207-1]
And when the homeowner next needs representation in a real estate transaction, the friendly real estate expert who provided sage advice on price and rental values will be the first agent to come to mind (and the agent who will get a fee).