By Dr. Gary L. Deel
Faculty Director, Wallace E. Boston School of Business
and Dr. Karin Ford-Torres
Faculty Member, Wallace E. Boston School of Business
This is the first article in an ongoing series that will provide sound, easy-to-understand tips for financial security and prosperity. Nothing in these articles is intended as formal legal or financial advice. Readers should consult with an attorney or licensed financial advisor before making any financial decisions.
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According to recent research, one-fifth of Americans do not save any of their regular income. Half of Americans live paycheck to paycheck, and collectively we carry more than a trillion dollars in credit card debt.
It’s clear from these statistics that our education system has failed to prepare American youth for the kinds of difficult and consequential financial decisions they are forced to make in adulthood. To begin righting this wrong, this article series will demystify some of the common pitfalls and misunderstandings around personal finance and guide readers on a better path toward financial prosperity.
Our promise to the readers: No fancy terminology or complex language. No heavy math or difficult conceptual frameworks. Just plain English. Simple ideas. And clear explanations to help you understand the “what” and “why” behind these important topics.
The Accounting Equation and How It Relates to Your Personal Finances
The Accounting Equation is a very easy way to assess your current financial situation so that you can make solid financial decisions. It is the foundation upon which everything else in the world of finance rests.
The Accounting Equation comes in many different forms, but here is the simplest version of the concept:
Assets – Liabilities = Equity
What are “assets”? Assets are something you own that has value — for example, a home, a car, cash or securities.
Liabilities are something you owe. For instance, liabilities can be in the form of long-term debt like a home mortgage or short-term debt like a credit card. Financial professionals have specific uses for the terms “liability” and “debt,” but for the purpose of this series, these terms will be used interchangeably.
Equity is what is left after you subtract your liabilities from your assets. Equity is a measure of your net worth.
How to Determine Your Equity
So how do you determine your equity? Here’s how it works in three easy steps.
First, add up the monetary value of everything you own — real estate, vehicles, bank accounts, cash on hand, jewelry and any other items with financial worth. Second, add up all the debt that you are carrying — mortgages, car payments, credit cards, student loans and any other form of debt. Third, subtract your total liabilities from your total assets.
Was your final equity number positive? If so, that’s good.
A positive equity essentially means you have a positive net worth. Although there are many other considerations when you’re assessing your financial health, solvency (i.e., the ability to satisfy debts in full) is a good start.
But if your final number was negative, this should serve as a wake-up call for you to take action to improve your financial situation. It means you owe more than you own…not a good position to be in, all things considered.
Using Ratios to Determine Your Financial Well-Being
One of the ways we use the Accounting Equation to assess financial well-being is through ratios. This is basically just a look at the proportionality of your debt compared with another factor — usually either your assets or your equity — to see how comfortable and secure your current financial situation is. The lower your debt is in comparison to assets or equity, the better off you are financially.
Suppose for example, that your assets are worth a total of $10,000. If your total debt is $5,000, we would say that your debt ratio (total debt/total assets) is ½ or .5. This ratio is fairly good because it means that if you liquidated all your assets, you could pay your debt twice over.
On the other hand, if you have $10,000 in assets and $20,000 in debt, that is a debt ratio of 2. That’s not good because it means that even if you liquidated everything you own and put all the proceeds toward paying off your debts, you could only ever hope to pay half of those debts.
Different financial advisors typically offer different advice regarding how leveraged an individual should be. In other words, financial advisors have various opinions on where your debt ratio should fall. Some advisors might argue that anything under 1 is good, while other, more conservative professionals might want to see ratios much lower.
However, one thing to keep in mind is that a ratio is just a relative frame of reference. It does not account for important differences in absolute values.
For example, suppose your assets are $10,000 and your debts are $8,000. A professional adviser might prudently caution you about carrying too much debt and not enough assets, because in this scenario your net worth (i.e., equity) would be just $2,000.
That’s obviously not a lot of money as a buffer between you and bankruptcy. Consider that one simple accident resulting in even a quick trip to the hospital could mean unanticipated medical expenses that would instantly put you “under water” financially.
But then consider a different person — let’s call him “Joe” — who has assets totaling $10 million and debts totaling $8 million. Now, technically, Joe has the exact same debt ratio — .8 — that you do.
But notice that while you only had $2,000 in net worth, Joe actually has $2 million in net worth. You are both equally debt leveraged. However, Joe obviously has a much larger financial cushion due to the fact that his asset total is so much higher than yours.
So Joe may be comfortable with his current ratio, but you would want to make urgent and drastic changes to improve the health of your situation. In essence, while ratios can be helpful, they are not the complete picture of your financial health.
The world of personal finance can be nuanced and complex. But don’t worry. Some simple and easy-to-understand tips make the maintenance of financial security a relatively easy and painless affair. In following articles, we’ll look at a number of strategies — for both debt and investment — to help maximize your financial prosperity. Stay tuned.
The university offers academic programs in accounting and finance, which cover important financial discussions in depth. Readers who are considering expanding their knowledge and credentials in this field are encouraged to visit our program pages for more information.
About the Authors
Dr. Gary Deel is a Faculty Director with the Wallace E. Boston School of Business at American Public University. He holds a J.D. in Law and a Ph.D. in Hospitality/Business Management. Gary teaches human resources and employment law classes for American Public University, the University of Central Florida, Colorado State University and others.
Dr. Karin Ford-Torres is an Associate Professor with the Wallace E. Boston School of Business at American Public University. She holds a Ph.D. in Business Administration with a concentration in Advanced Accounting and Financial Management. Karin teaches accounting and finance courses for American Public University, Purdue University Global and Colorado State University-Global. She has 24 years of prior banking experience with Bank of America.
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