This is Part 2 of my nine-part series connecting financial frameworks with personal growth.

1.      Finance as a Framework

2.      Assets = Liabilities + Equity: What You Own Comes with Strings Attached

3.      Assets = Liabilities + Equity 2: What You Have vs. What You Can Use and the Importance of Liquidity

4.      Time Value of Money 1: The Power of Compound Interest

5.      Time Value of Money 2: Why Humans Use Bad Discount Rates

6.      Risk and Return 1: No Risk, No Return

7.      Risk and Return 2: Why Humans Are Bad at Calculated Risks

8.      Risk and Return 3: Diversification and Building Multiple Pillars of Resilience

9.      Conclusion: The Emotional Balance Sheet

This week, we are talking about financial statements, specifically balance sheets. Any time I am teaching finance to someone, whether ordinary people or business students, I always start with what a balance sheet is. It’s the most basic concept in finance.

Financial Concept: The Balance Sheet Identity

Assets = Liabilities + Equity

This basic formula is known as the “balance sheet identity.” A balance sheet is a financial statement that describes a person or business entity’s possessions (assets) and claims against those possessions (liabilities) at a specific point in time. It also shows how much the possessions outweigh the claims (equity).

·         Assets are things you OWN. Your house, car, cash (physical or in a bank account), 401(k) account, guitar, Pokemon card collection, etc., are all assets.

·         Liabilities are things you OWE. For people, this is usually debts—credit cards, mortgages, student loans.

·         Equity is the difference between things you OWN and things you OWE. In other words, it’s what would be left over if you sold all your assets and satisfied all of your debts.

Assets and Liabilities are Inseparable

Acquiring assets above and beyond what you already own usually involves incurring liabilities as well. These are “strings attached.”

If you want to buy a house or a car, for most people, that involves taking on a matching liability—a mortgage or a car loan. You might say, “well, what if you buy the car using cash?” Buying a car with cash is just trading one asset (cash) for another asset (a car). It doesn’t make the balance sheet increase in size.

It is possible to increase assets without corresponding liabilities (making equity go up) but that usually takes time. Prudent investments produce more cash every year than they consume, allowing you to build up a pile of cash over time. We will return to this concept momentarily.

Equity Matters, not Assets

People looking for financial security often go wrong in that they try to accumulate assets, rather than build up equity.

Owning a $5 million dollar home is pointless if all your spare cash flow goes to liabilities connecting to maintaining the house—your mortgage, property taxes, maintenance, utilities, etc.

Equity comes from assets that are unencumbered from corresponding liabilities. Meaning, you subtract liabilities from assets (the balance sheet identity above) and what is left over is equity. Equity is your net worth, or what is left over for you after your creditors have been satisfied.

Equity is true wealth. This is what we want to increase over time. Assets with no strings attached.

Nonmonetary Assets and Liabilities

These concepts extend to things that aren’t financial or physical possessions and aren’t usually recorded on a traditional balance sheet.

Personal non-monetary assets include skills, knowledge, relationships, reputation, family, physical health, etc. These are all things that people want. (An interesting corollary: none of these things can be bought with money.)

Non-Monetary Assets Also Come with Strings Attached

Your personal non-monetary liabilities are the time, energy, and emotional commitments related to building or sustaining the above. Relationships must be nurtured; skills and knowledge continually refreshed and updated. Maintaining high physical health requires a significant, ongoing expenditure of time.

This is where a lot of people tend to go wrong, in my view. People often set goals to acquire several non-monetary assets at once— “this year, I’ll learn a new language, get in shape, and work on my side hustle.” While all of these things might ultimately be valuable, people tend to discount the up-front investment in time and energy needed to acquire these assets. If you are already burned out from your job, where are you going to find the energy to exercise, work on your Etsy store, and learn Spanish?

“If You Are Already Burned Out from Your Job”

Worthwhile assets are those that over time, have value exceeding the liabilities attached to them. This means that the asset has positive equity or is contributing to total net worth. In other words, you are getting more out of it than you are putting in.

This is another one where people often go wrong, particularly in career and relationships. Being overleveraged, emotionally or financially, leads to burnout and chronic stress. Recognizing where “the balance sheet doesn’t balance” is the first step to recalibrating your personal balance sheet.

If you are working in a job that pays you money, but at the end of the day you are totally burned out and have no spare time or energy for anything else, is this actually a positive net worth investment? Once our basic survival needs are met (food and shelter), time and energy are more valuable than money.

Relationships can be even worse. Most people have experienced a relationship where the costs exceed the benefits. Having a romantic partner comes with benefits—connection, physical intimacy, etc.—but the costs (the corresponding liability) can also be significant. If your romantic partner is emotionally volatile and conflict-prone, abusive or needy, or contributes bad habits to your daily life, this is probably a case where the value of the liability exceeds the value of the asset. Some people realize this equation is not in their favor and end the relationship, but many people don’t.

Building equity requires us to say no to destructive liabilities as much as it requires us to say yes to beneficial assets.

Equity: What’s Left Over for You

In the context of personal growth, equity is your mental or emotional reserve—the part of you that is free to pursue growth and happiness once obligations are met.

Like in the financial sphere, we want to look for assets that grow in value over time while the corresponding liabilities shrink. Much like financial assets, the equation may not look favorable at first. Shifting careers or accepting a position with greater responsibility often requires a big time and energy investment up front, but starts to pay dividends once you get the hang of what you’re doing.

Reputation, relationships, expertise, and physical health all take time to build. The liabilities attached to all of these things seem big at first, but down the road, we end up with more and more left over for us.

It’s also important to acquire assets that are regenerative and net positive in the short-term. Assets that increase our mental or emotional reserves—like a good friend or healthy romantic relationship—are priceless. Having hobbies that are just fun also fits into this category. We don’t want all of our assets to be long-term oriented, because that exposes us to a different form of risk (we will discuss this more when we get to diversification).

Ultimately, equity represents freedom. A large equity reserve cushions us from negative shocks and enables us to take risks.

The Balance Sheet Needs to Balance

Balance is the key to long-term happiness here.

In finance, when the “balance sheet doesn’t balance,” that means something on the sheet isn’t being recorded correctly. One of either assets, liabilities, or equity are being over- or underestimated.

If you feel constantly burned out and low-energy, that means your emotional net worth is negative. If that surprises you, it probably means that you are overestimating your assets or underestimating your liabilities. In order to get back into balance, and ideally flip your net worth to a positive figure, you probably need to cut liabilities or gather better assets.

Balance also applies to having different types of assets and liabilities (a concept we will return to next week). I’ll argue that no liabilities at all isn’t good—it leads to stagnation and a lack of contribution to the world. Too many assets with very long-term payback periods feels like too much delayed gratification. Too many short-term oriented assets doesn’t set a foundation for a secure future.

Next week, we’ll look at how liquidity fits into this equation—because even the best assets are useless if you can’t use them when you need them the most.

Separately, if you want to organize your personal finances, I have a balance sheet template you can use.

Exercise

Journal on the following or discuss with a friend.

1)      Assets

What are your personal non-monetary assets?

What is the state of your career, your knowledge and skills, your relationships, your reputation, and your physical and mental health?

2)      Liabilities

What liabilities are attached to your personal assets?

How much time and energy do your job, family, relationships, and other areas of activity consume?

Where are you overleveraged? Where does it feel like the liabilities exceed the value you are getting from the corresponding asset?

3)      Equity

Review your assets and liabilities in totality, with a column of assets on the left and liabilities on the right.

What can you do to increase your equity?

Where can you invest in more meaningful assets?

Which assets have liabilities that exceed their value, and need to be jettisoned? Remember that some assets have very delayed payment profiles—investing in your children and physical health are choices that people almost never regret, but the up-front costs can feel very high.