Let us talk about how you should start building a strong Balance Sheet for your finances. As we saw in the last post, the two aspects of a Balance Sheet are assets and liabilities. Obviously any strong Balance Sheet will have strong assets and less of liabilities. The difference between the assets and liabilities is really the Net worth.
In essence a strong Balance Sheet for your finances will mean the following:-
- Your assets are significant and hopefully growing over time.
- Your liabilities are under control and are reducing as time goes by.
- Your Net worth is having a positive trend and the rate of increase is faster as time goes on.
We will start with the assets part first. As we start our working life we begin acquiring assets in various shapes and forms. In the initial period most of these assets are for consumption such as household appliances when you set up a home, a two wheeler for getting to your place of work etc.As time goes by we graduate to purchasing more expensive assets such as a car and eventually a home. Apart from these physical and tangible assets we will also now start to acquire financial assets. These are essentially financial instruments which can be redeemed to realize monetary value. So any stock that you own is an asset, your units of equity or debt MF are assets and so is the FD that you have in your bank.
You have to spend money to build assets and the best way to do this is out of your income. However, many of us are not in a position to pay for a Bike out of the first couple of month’s salary. An option is to wait for a few months, accumulate the necessary amount and then buy it. As this takes more time than many are willing to give today, an easier way is seen to be to take a loan and pay EMI over the next few years. This simple example would have shown you how a liability is created. If you have bought a car for 6 lacs then it is an asset. However, if you took a loan of 5 lacs to buy the car then it is a liability. Both of these will come in your personal Balance Sheet.
We need to understand the liability of loans in a better manner. Any loan is a liability, even the credit card outstanding amount that you have is a liability. In simple terms you are enjoying the benefit of an asset that you really have not paid for. There are several ads nowadays telling you that you can buy an iPhone with paying a minimal amount and then getting into an EMI payment schedule. This is nothing but creating a liability which will remain in your personal Balance sheet till you pay it off in full. Every time you spend on your credit card you are creating a liability for yourself. If you are paying it off in full when the bill arrives at the end of month it is fine. However, if you are unable to do so this attracts a hefty interest and that increases your liability further. In general, I am in favor of minimizing loans and using them only when absolutely needed.
Why am I not in favor of loans? Well, you see most assets that we purchase reduce in value with time. Let us say you are buying a car today for 8 lacs and a helpful bank is willing to give you the entire loan. Now, the moment you drive the car out of the dealer show room the value has typically gone down by 20 %. In other words if you were to sell the car after just a week or so you will be very lucky to get even 7 lacs. As time goes by the value of this asset will keep depreciating. Your liability unfortunately remains the same. For a 8 lac loan your payment over the years may be 11 lacs and this is your total liability. So just after you own the car your asset value id 7 lacs and your liability is 11 lacs. Therefore on this transaction alone, your new worth takes a hit of 4 lacs on the down side.
Does this mean all loans are bad? In general, I am uncomfortable with taking loans for depreciating assets. Even if you do so, make sure there are no pre-payment penalties and try to pay it off as soon as you can. Also you must minimize your loan needs by being able to make a significant down payment yourself. For assets like home which appreciate in value, taking a loan can actually be a good strategy. However, even in this case the general principles of minimizing the loan amount needed and aggressive pre-payment will stand you in good stead.
I hope this has given all readers some good pointers on how they can start building a strong Balance sheet for their own finances. I did want to share my own experiences with you but as this post has already got long, I will do it tomorrow.
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