Monthly Archives: May 2013

Practical Finance and Accounting

One does not need to have a degree in finance and/or accounting to make it worthwhile to spend some time to learn more about issues involving those subjects in order to potentially ensure more efficient decision making with one’s excess cash (used synonymously with “capital” for purposes of this discussion).

In fact, it is important that folks consider enhancing their knowledge about some practical implications of these subjects, as it touches most people’s lives.  This discussion is far from comprehensive but, relative to merely considering short-term cash flow, it may help open folks’ minds to some issues that may be worth contemplating depending on their personal situation.

As always, I highly recommend discussing these important issues with whichever professionals one utilizes for making these vital decisions. 

From an accounting perspective, there are a few different issues that individuals may want to consider when assessing their personal finances.  Many folks often discuss the idea of budgeting to help plot out whether one has a positive cash flow after expenses are paid for the month.

However, budgeting alone may not be enough.  People may want to also consider focusing upon what most corporations do, creating the three different financial statements utilized in assessing financial health for both the short and long run.

By not only looking at one’s short-term cash-flow situation (the “cash flow statement” in accounting jargon), one can also take a broader look at one’s assets and liabilities (the “balance sheet“), as well as one’s true income and expenses on more than just a mere cash flow basis (the “income statement“).

For instance, if you have an upcoming planned expense that you may not have paid for yet, there are ways to address this probable expense on one’s balance sheet and/or income statement, even if it would not show up on the traditional cash flow budget that many folks solely utilize in assessing one’s financial health for short-term consumption decisions.

Regarding that issue of consumption, when deciding whether to consume or invest extra cash from one’s paycheck, it is helpful to balance the benefits of the consumed item relative to the benefits one might get by not consuming the capital immediately (i.e. investing).

On this issue of practical finance, in a recent post on the value of capital, I acknowledged that capital holders who invest that capital should receive some real return in order to be compensated for foregoing consumption of that scarce (i.e. not infinite) capital today.

However, that does not mean that all capital holders should invest their capital in the traditional sense of allocating that money into an investment vehicle aimed at earning returns.  Before I move onto some evaluations of traditional situations, I want to point out that I am not referring to retirement savings in this discussion.

As a brief aside, a recent issue I’ve been reading about is whether people with excess cash should choose to allocate funds earmarked for investing into hedge funds.  In doing so, the issue of whether folks, in general, should be investing in traditional investments (e.g. stocks) also arose.

This latter question led me to consider whether some people may want to re-evaluate whether they use excess cash for paying down their debts, rather than investing their excess short-term cash.

Since I have spoken with some individuals who have assumed that invested capital will usually earn a higher rate of return than the cost of debt, it seemed worthwhile to address that important issue.  Folks often look at returns, but do they always fully assess the risks involved when trying to achieve those returns?

For example, let’s take a look at people whose short-term cash flow analysis would indicate positive cash flow, but are net debtors if they also took their balance sheet into consideration.

Some people may be cash-flow positive when considering their paychecks and have solid earnings power moving forward, but if their personal/family balance sheet currently shows net debt, then they might want to consider paying down that debt before investing any excess cash that results from their paycheck.

One key issue here is the type of debt involved.  For folks with credit card debt, the interest rates on that debt are likely in double digits.  Do you think you can earn more than that on your investments?  If you do, then you may want to re-evaluate the risks involved with those investments.

On the other hand, for folks with mortgage debt, the analysis is a bit more challenging.  With mortgage rates quite low (hope you locked them in!), the rate of return people need to achieve with their investments is much lower than those with credit card debt in order to justify investing their money, rather than paying down their debts.

FRED Graph

For these folks, I am still personally skeptical that they can earn more (net of fees, etc.) than their debt costs, but it is obviously a much closer call.  That being said, if you can pay off your debts, should you?

It is obviously a very personal decision.  What happens if you invest your excess cash, the investment results in a loss, and you still have those debts? Still gonna be sleeping well at night?  Some folks would be fine, as their earnings power would still provide enough positive cash flow to service the mortgage debt.

Accordingly, this highlights an important conclusion.  Folks should do what they prefer, but they should also consider how they will feel regardless of how their investments play out (e.g. scenario analysis).  Because if there’s one thing people probably realize after seeing how the stock market has played out so far this century – it is far from an easy thing to predict asset price movements in the short run

FRED Graph