How Strong is your Balance Sheet?
As a securities analyst and portfolio manager over the last 25 years, there is an accepted procedure we go through to analyze how good a particular company is as an investment. This process reveals how strong the company is financially and how well it will be able to withstand any adverse economic or market conditions. There are certain fundamentals we research thoroughly to get an idea of the company’s finances. The strength and sustainability of your personal financial condition can and should be analyzed in a very similar way. The balance sheet is a very important indicator of the company’s current financial condition. These are the elements that financial analysts look at. See how well your financial condition compares.
Net worth is the measure of how much the company’s assets exceeds their liabilities. All of the cash and investments plus all of the property, plant, and equipment it owns minus all of the debts, mortgages and accounts payables is the net worth. Similarly, your net worth would be all of your savings and investments, your house, your car (if you own or are buying and not leasing) and any other property that you could readily determine the value minus all the debt obligations you have including mortgage(s) and leases. The downside of leasing a car is that you incur a debt obligation but you never build any equity or own the car at the end of the lease; so it’s not an asset of yours.
Current Ratio is cash and short-term investments are compared to short term liabilities (those bills that are payable within the next 12 months). It’s called the current ratio or current condition. This is a measure of the company’s ability to meet short obligations. You should have enough cash and short term investments for 6-12 months of your personal expenses. In addition, you should be able to put at least 10% of your income into long term savings after building up your short term savings.
Cash flow is the measure of how much revenue or sales exceed the company’s payables, debt obligations and other operating expenses. A financially strong company produces excess cash flow to reinvest back into the business or make other investments. Your excess cash flow is a measure of how much your personal disposable income exceeds your debt payments and personal living expenses. Your excess cash flow should allow you to first add to your savings and then make any discretionary expenditure you want to without creating more debt obligations. (in other words cash purchases)
Debt ratio is the percentage that long term debt is of total assets. A company is considered financially strong if its long term debt is 50% or less of total capital. Your own debt obligation/payments should not exceed 35% of your gross salary.
So, how strong is your balance sheet? Are you savings 10% of your salary? Do you have six months of living expenses in short term savings? Are your debt obligations 35% or less of your monthly salary? Even though you may be fortunate enough to be making a lot of money; are you financially independent?