March 9, 2007

Personal Finance 101 - Know Your Financial Picture

For many people including myself, spending one's limited free time on personal finances can feel like a major drag. After all, who wants to spend a beautiful weekend afternoon entering in receipts? The obvious response to this is that the more you know about your own financial situation, the more empowered you will be in making informed financial decisions for yourself and your family. I wish I had a more clever response than that, but I don't. In any case, here are some fundamental metrics to get you started on understanding your financial situation:

1) Net Worth

Net Worth = Assets - Liabilities; or in English, net worth is the overall snapshot of your financial situation -- it's where you stand when you line up all the "stuff" you have against all the money you owe.

To calculate net worth, I would recommend creating a spreadsheet or using commercial software such as Quicken or Microsoft Money. If that sounds like too much of a pain, check out NetWorthIQ, where you can figure out your net worth online.

You'll need to enter in two types of data: your assets and your liabilities. Assets are your "stuff", including all your bank accounts, retirement accounts (401k, IRA, 403b, etc.), stocks, bonds, mutual funds, cars, market value of your home if you own, value of your real estate holdings, and other personal property. "Other personal property" includes things like the diamond ring that grandma gave you, the Monet hanging over your fireplace and the Mickey Mantle rookie baseball card that your mom almost threw away when she was cleaning your room. On the liability side, you have items such as the principal amount of your mortgage, auto loans, student loans, and any other loans, along with your credit card debt and any other debts that you may have. Add up all your assets. Add up all your liabilities. Subtract the total liabilities from total assets, and you've got your net worth number.

2) Monthly Cash Flow

While net worth gives you an overall financial picture, you'll also want to take a snapshot of your monthly cash flow. That is, in a month, how much money do you bring in, and how much money goes out? Unfortunately, unless you have a photographic memory of all the Starbucks and McDonalds purchases, this is where entering in receipts comes into play if you want a completely accurate picture. If a month seems too long, try keeping track of cash flow for a week. After keeping track of your cash flow, you should be able to answer the following questions: What are my total fixed monthly costs ( e.g. rent, mortgage, utility bills, groceries) and, consequently, how much money do I need to bring in in order to meet those fixed costs? What does my discretionary spending look like? Am I saving money? If so, how can I save more?

And perhaps most important, figuring out your monthly cash flow will let you know what amount of emergency reserves you should have handy in order to meet your living expenses. A lot of experts will generally suggest having 3 to 6 months of living expenses as a rule of thumb. Those numbers sound about right, but again it depends on one's personal situation. If you're a DINK (double-income, no kids), one partner losing their job might not be as disastrous as a family with a single breadwinner who loses his or her job. If you're in an occupation where other comparable jobs are not readily available, it may make sense to have a bigger cushion of emergency reserves.

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