PERSONAL FINANCIAL STATEMENT ANALYSIS: A MODEST BEGINNING
Reynolds Griffith, North Texas State University (1)
This paper represents an initial attempt to develop a comprehensive set of measures for the analysis of personal financial statements.
THE PERSONAL FINANCIAL STATEMENT
The first step in developing a set of ratios for analyzing personal
financial statements is to examine the form of the statement itself. Like
a business balance sheet, a personal financial statement must include assets,
liabilities, and net worth, but a survey of 22 personal finance and financial
planning books showed that there is no standard form.
Even the title varied from one source to another. Slightly over half used simply "balance sheet". Other titles used were "personal balance sheet", "family balance sheet", "net worth statement", "personal financial statement", and "statement of financial position". Does the title matter? I think it does. We should seek forms which make the client feel comfortable rather than intimidates. to those of us with accounting or finance training and experience, "balance sheet" seems a natural term, but to the client it may seem cold and corporate. "Personal balance sheet" and "family balance sheet" are improvements, but still retain the accounting terminology. "Net worth statement" seems too narrow. We are concerned with analyzing asset and liability relationships, not merely calculating net worth. "Personal financial statement" seems to be clear, descriptive, and non-intimidating. The only possible disadvantage which I see to it is that to those of us familiar with accounting usage, "financial statement" can include other statements besides the balance sheet.
A second element to be considered is the organization of the statement into categories beyond the major ones of assets, liabilities, and net worth. About a third of the sources surveyed had no sub-categories, merely listing all the assets, for example, and totaling them. About a third had a dual breakdown of assets, but with no general agreement as to what the two categories should be. The following category headings were used:
monetary assets / fixed assets
fundamental assets / investment assets
financial assets / non-financial assets (two)
financial assets / real assets
liquid assets / other assets
liquid assets / fixed assets
The other third had three or more categories (e.g. liquid assets, investment portfolio, and fixed assets).
It seems to me that the financial statement form should be organized into categories which will facilitate analysis. That is, the categories should represent aspects which we are interested in measuring and provide subtotals for them. Figure 1 illustrates such a form.
The first asset category is liquid assets - what the client owns that is in spendable form or is easily converted to spendable form without disrupting other plans.
Financial assets are those represented by paper certificates or bookkeeping entries. This category is called "other" financial assets because the liquid assets are almost entirely financial assets as well. It is further subdivided into fixed dollar and equity assets because these categories are important for analysis and decision making.
Tangible and Personal Assets
Tangible assets are those you can see and touch. HOme ownership is the most common, though many clients would have other tangible assets as well. Personal assets are in a sense tangible also, but are those such as clothes, that decline in value as they are used, generally fairly rapidly. the assets in the tangible category are held partly or wholly as investments, the personal assets to use.
In preparing the financial statement, we enter (or have the client enter) the current value of each kind of asset owned and total each category. then we sum the categories to find the total value of all the assets owned. Total assets is a useful figure in deciding how well off someone is financially, but the amounts in each category are more important in financial analysis and planning.
Personal Financial Statement
Cash on hand
Money market fund or account
other liquid assets (Savings Account)
|Other financial assets:
Fixed dollar assets
Certificates of deposit
Cash value of life insurance
Other real estate
Furniture & appliances
|Deferred assets (notation only)
Value of pension plan
Value of IRA or similar plan
Credit card balances
Other current liabilities
Personal property less installment
contracts & other related debt
Tangible assets less mortgage and
other related debt
Liquid and financial assets less
accounts payable, credit card balances and
other current debt
|Total Liabilities and net worth||
The handling of pension fund interests and similar assets was split
almost evenly between those who show their current value on the balance
sheet and those who do not (four of those showing them on the balance sheet
specified the vested portion only, the other made no distinction between
vested and unvested interests.) Such "deferred assets" belong to the client,
but could not, for the most part, be made use of currently. The treatment
in the suggested financial statement recognizes that they are important
in long range planning by entering them on the statement, but recognizes
their deferred nature by not adding them into the total. The two most common
deferred assets, as listed on the illustrative statement, are pension plans
and Individual Retirement Accounts.
Net worth is the amount of the assets which belong to the client after
subtracting liabilities and is almost always shown as a single figure.
The net worth section of the sample financial statement in Figure 1 is
unusual in having net worth categories instead of a single net worth figure.
this division helps to see the client's financial position more clearly.
In each subdivision we take an asset category (or categories) and subtract
the debt related to it. For example, if the client bought an auto on credit
and is making payments on it, subtract the balance owed on it from the
value of personal assets. Note that Accounts payable and other debt which
must be paid shortly are subtracted from liquid assets in the third category
even though the amounts may be owed for personal assets. The net amounts
for each subdivision are added together to get the total net worth. Of
course, the total liabilities and net worth should equal the total assets.
If the two totals are not the same, you made a mistake in your calculations
and need to recheck them, since total net worth in this form is not a plug
If most of the client's net worth is i n the personal property category, they are not in a good position yet to achieve goals which require financial resources. If the liquid portion of net worth is low, the client is in greater danger of getting into financial difficulties than if it is a more substantial amount. These relationships will be explored further in the latter part of the Ratio Analysis section.
The survey of personal finance and financial planning books found virtually no coverage of ratio analysis of personal financial statements. One of the leading texts suggested a few proportions as targets or limits. Another presented three specific ratios ("solvency, liquidity, and savings" ratios). None of the others included any coverage of ratio analysis of personal financial statements as far as I could find.
What aspects of their financial position should we be interested in analyzing for clients? Two obvious ones are the client's liquidity and the burden of debt undertaken. In some respects these elements are related, so some measures may overlap the two. I would suggest that two other aspects are the degree of potential protection against inflation and what the net worth segments tell of progress toward meeting financial goals. The importance of the inflation measures would depend on our or our client's expectation of the likelihood of continued inflation. It seems to me unwise to ignore the substantial possibility of more inflation.
The determination of standards for judging ratios is not an easy task. The judgment of corporate financial ratios, even after decades of usage, is still somewhat subjective. There are some accepted rules of thumb (e.g. a 2:1 current ratio) and comparison with similar companies or industry averages can be useful. The work by Altman and others using discriminant analysis has contributed to the understanding and quantification of corporate ratio standards. However, an analyst's judgment often comes down to what he or she is comfortable with. At this stage in the development of personal financial statement ratios, we are confined to subjective judgments. For many of the ratios discussed below, I will indicate my ideas of what levels might be acceptable.
A Case Example
To illustrate the suggested ratio analysis I will use a couple who live in the hypothetical Midwestern city of Rockfield, whom I will call Tom and Lisa cook. They are in their mid-thirties and have two children - Ann, age 8, and John, age 5. Tom is an attorney who works for a local law firm. Lisa has not been employed full time since Ann was born, but writes computer programs rom time to time on special contracts with two firms. A few years ago when Tom and Lisa became aware of the need for better financial planning, they prepared the financial statement presented in Figure 1. They bought their house several years ago for $50,000 and have a monthly payment of $410. They were running about $1500 per month.
A basic measure of liquidity can be formed by relating liquid assets to the monthly expenses which must be met:
Liquid assets/monthly expenses
For Tom and Lisa this would be:
4,154/2,010 = 2.07
A target of 2-3 would seem to me to be reasonable for this measure.
That is, liquid assets should cover 2 to 3 months of expenses and debt
A similar measure would recognize that the other financial assets are to some extent liquid also:
Liquid & other financial assets/monthly expenses
However, I would question the advisability of counting assets such as stocks, bonds, and mutual funds at their full current value i such a calculation. Counting only a moderate portion of their value would allow for their lower liquidity and, even more important, the possibility of declines in their market values. Taking the bonds at 40 percent and the mutual funds at 30 percent of current value would give the following measure for Tom and Lisa:
(4,154+1,500+4,400+600)/2,010 = 5.30
A minimum standard of 6 for this measure would correspond to the rule of thumb of having a reserve fund or emergency fund equal to six months income or expenses.
Next, we examine the debt burden, including the relationships between
liquid assets and debt position. It is important that liquid assets provide
a sufficient cushion to help handle debt if necessary. We can look first
at a very general relationship:
Liquid assets/total debt
For Tom and Lisa this would be:
4,154/39,695 = .105
It is difficult to set an exact standard on such a measure, but having over 10 percent as Tom and Lisa do should be comfortable.
The next measure combines liquid and financial assets:
For Tom and Lisa:
(4,154+14,500)/39,695 = .47
Perhaps 20 to 30 percent should be a minimum target for this ratio, which suggests that Tom and Lisa are in good shape.
The mortgage loan is a long-term debt, so it is worthwhile to look at
the relationship of l liquid assets to debt other than the mortgage debt:
Liquid assets/non mortgage debt
For Tom and Lisa this would be:
4,154/1,595 = 2.60
Anything over 1.00 could be considered excellent. a similar measure
could take into account the payments that must be made on long-term debt
over the next year:
Liquid assets/short-term debt plus 12 months payments on other debt
Tom and Lisa were paying a $410 a month house payment plus $100 a month on the installment debt, so this measure for them would be:
4,154/ (95+6,120) = .67
Again it is hard to set an exact standard, but I think that anything
over 50 percent is good. The cushion to handle these commitments can also
be judged using liquid plus financial assets:
Liquid & other financial assets/short-term debt plus 12 months payments on other debt
Again I would suggest counting only a portion of stocks and bonds, which for Tom and Lisa would be:
(4,154+1,500+4,400+600) / (95+6,120 = 1.71
Maintaining a 1.00 ratio for this measure should be adequate.
Another way of judging the debt position is to relate it to net worth:
Total debt/net worth
Tom and Lisa's ratio of total liabilities to net worth was:
39,695/66,159 = .60
A goal should be to hold this measure below 1.00, although that would
not be feasible for most people soon after buying a house. Again it is
worthwhile to look at nonmortgage debt separately:
Nonmortgage debt/net worth
Tom and Lisa's position was:
1,595/66,159 = .024
Tom and Lisa have a very low ratio. A maximum of 30 to 40 percent would
As with corporate financial ratios, we can come to an overall conclusion
an aspect of financial condition from the ratios related to it. Tom and
Lisa were moderate in their use of debt. None of the measures calculated
for them show them to be in financial danger.
Next, we should consider some measures that give a rough indication
of how well the client's financial position is protected against inflation.
The first ratio compares the total of assets which may give some protection
against inflation to net worth:
Equity, tangible, and personal assets/net worth
Equity assets don't automatically increase with inflation, but they have the possibility of doing so which fixed dollar assets don't. Owning a home gives considerable protection against increases in housing costs. Like equities, other tangibles don't necessarily increase in value with inflation, but have the possibility of doing so. Personal assets provide insulation from the effect o inflation in the sense that they can be used without the need to buy their services at the higher prices which occur with inflation.
For Tom and Lisa this measure was:
(2,000+75,000+12,200) /66,159 = 1.35
A suitable figure for this ratio depends largely on how concerned you
are about the danger of inflation. If you expect inflation to be similar
to that of the late seventies and early eighties, a ratio of 1.00 would
seem to be a minimum goal.
A similar comparison can be made omitting personal assets and home in order to view the investment aspect separately:
Equity plus tangible assets minus home/net worth
This would be Tom and Lisa's position:
(2,000+75,000-75,000) /66,159 = .03
It is also worthwhile to make a comparison of equity and tangible assets with fixed dollar ones:
Equity plus tangible assets/fixed dollar assets
Tom and Lisa's position in this regard was:
(2,000+75,000) /16,654 = 4.62
The same thing can be done omitting the home:
2,000/16,654 = .12
Someone expecting inflation would think the latter ratio inadequate
if less than 1.00 - 2.00.
From these measures we could conclude that Tom and Lisa have a reasonable
degree of overall protection against inflation because of their home ownership,
but that their investment program has very little potential for being a
good inflation hedge.
Net Worth Segments:
As suggested above it is useful to see what proportion of net worth
each of the net worth segments is in order to help judge how well situated
the client is for meeting goals. For each of the net worth segments on
the proposed financial statement form, we can calculate:
Net worth segment/total net worth
The personal property portion for Tom and Lisa was:
10,700/66,159 = .16
It is a good idea also to consider the relation of total personal assets to net worth:
12,200/66,159 = .18
If a substantial portion of a client's net worth consists of personal
assets it shows that they are not making much progress toward fulfilling
their financial goals. Tom and Lisa's personal assets are a moderate proportion
of their net worth so this was not a problem for them.
The relation to net worth of assets other than their home (or the amount
set aside for a down payment) and personal assets can also indicate how
well clients are advancing toward their goals other than the important
one of home ownership.
This relation for Tom and Lisa was:
(4,154+12,500+2,000) / 66,159 = .28
This figure is not bad for a couple as young as Tom and Lisa.
The next net worth segment is tangibles which made up
36,900/66,159 = .56 of Tom and Lisa's net worth.
Finally the liquid and financial asset portion was:
18,559/66,159 = .28
These seem in reasonable balance since they have attained their home ownership goal.
The ratios suggested above do not, of course, represent a complete listing of all the ratios which could be calculated for individuals. It seems to me, though, that this is a reasonable number and variety of measures which would be of help to a financial planner or counselor in analyzing a client's position. I hope that from this modest beginning we will see further research in the development of ratios for personal financial statement analysis, including empirical work to help us set standards for them.
1. Associate Professor of Finance