A red flag is an indicator of potential problems. It means danger, stop or caution because of something ahead of you. In personal finance there are a number of things to watch for or avoid to be successful. They are things that we all go through, but should pay attention to and avoid the big problems. I am going to use new terms, but I will explain them in simple terms. Take notes because this is important!
Income Statement
An income statement (profit & loss statement) is a company’s financial statement that indicates how the revenue (gross income) is transformed into net income (net profit). It may be your pay check or your business, but you want your income to increase every year. Why? Inflation and it is a strong indication your employer values you. You are your own Chief Financial Officer (CFO) and you want to see increases in income or profitability individually or as a business. The other part of being a good CFO is lowering your expenses to increase profitability. A decline in profitability is a red flag!
Balance Sheet
A balance sheet is a summary of the financial balances for a company or individual. Assets, liabilities and equity are listed as of a specific date such end of the month, quarter or year. There are a number of red flags if your current assets do not cover your current liabilities. It is a red flag if your current ratio is less than 100%. Current assets represent the value of all assets that can be reasonably expected to convert to cash within one year. They are usually cash, marketable securities and other liquid assets. Current liabilities are debt due within one year. They are usually short term debt and the portion of long term debt due within one year.
Assets equal liabilities and equity. They call it a balance sheet because the two sides must equal. A red flag would be if liabilities exceed your assets or a negative net worth. A typical asset is your personal residence! Depending when you bought it should have built up some equity (market value less mortgage balance). If you are upside down on your home, it is a red flag. That is you owe more than what your home is worth. This is one way of saying you debt to equity ratio is bad, when it is over 100%. Another would be taking on too much debt. This may be a mortgage, car loan or credit card debt. Your payments cannot exceed your operating earnings. It is what is left after your operating expenses.
How are your investments? You can measure or evaluate your investment by calculating your return on investment (ROI). Take the market value at a particular time less the cost divided by the cost of the investment. It is expressed as a percentage. What is a reasonable return on investment? You can compare your return with indices or alternative investments. A red flag would be a negative return or too low of a return over time compared to alternative investments. In simple terms, if your investment return is similar to US Treasuries and you have much more risk.
How many red flags can you handle? I believe you should avoid red flags because they only cause you pain! Additional red flags can be adding to inventory. Inventory is thought of as an asset, but you should not take on debt to buy it. Did you ever think of the things you own as inventory? If your inventory can turn into cash, it may be a good thing. Recently, Leroy Nieman died, I own a Nieman, but I won’t sell. Is it worth more now? You betcha! Assets like inventory can go down in value and you should not finance your inventory. A red flag would be if you add to debt when you add an asset.
Final Thoughts
Have you ever thought of your finances in this way? Robert Kyosaki says you should only buy assets that produce revenue. That may too extreme or is it? Do you buy investments to lose money? Of course not! I tried to alert you to some of the red flags in your finances in order to make changes. It is up to you! I started buying income producing assets (rental property) before Robert Kyosaki wrote his first book. Real estate is a great way to leverage your investment and create wealth, but it is not the only way. If you control your finances, you can avoid a red flag.
Photo by: Luke Hoagland
You covered a lot of key concepts here that would also tell you of a business is healthy or not. It wad basically my intro to finance class converted to personal finance. I don’t have any red flags right now so I am happy about that!
No red flags are good! Thanks to my background in finance, I use my business skills in personal finance.
Wouldn’t it be great if someone really waved a red flag when you were screwing up? …so much easier…..
If you are aware of it, there is a red flag going off in your head. If you are listening!
When I perform my monthly net worth calculations, I have a tab in my spreadsheet for Balance Sheet. I think it’s important to see this angle even from a personal finance perspective.
A balance sheet and net worth calculation are excellent markers to measure your progress.
Red flags are definitely something to avoid, but even when we do our very best to avoid them, the unavoidable happens. For example, look at the housing market in the US, especially in places like LV. I travel to Vegas once a year, and got to know some of the locals who have rental properties. Some have a mortgage for $300k, but the value of the home is $120k. They can’t get another renter, because nobody is willing to pay more.
I love real-estate investing, but leveraging too much into one type of investment (rental properties), can be a scary situation if shit hits the fan.
No question, this was and is a bad situation. At the height of the real estate bubble, the numbers did not make sense. As the market bubbled, some people were sucked in with the constantly increasing prices. Although I sold my mother’s condo during that time, I was not interested in buying. It scared me off.
Interesting! Thinking about it as ‘red flags’. You are right that we need a relatively straight forward system os signalling problems; the reasons and remedies are a different matter entirely, though.
I thought I would offer a different approach to warning signals or what to be aware of when you look at personal finance.
Isn’t it ironic that the people who need to know that they have red flags with their finances are too blind to see them? and the people who are actively looking for red flags have very few? maybe that’s not irony.
Isn’t that always true! Banks are willing to loan money to people who don’t need it too.
Nice public service announcement to be aware of red flags. I agree, the ones with the biggest problems don’t even know it. Knowing is half the battle? Kiyosaki has a winning formula (buy assets that generate revenue). On a side note about inventory, imagine all those poor NY stores with Jeremy Lin jerseys! Red flag?
That is why they have sales! They reduce the price enough that someone will buy it. I realize I am preaching to the choir, but it applies a different approach to personal finance.
Great post. The breakdown really simplifies it for people. We watch our stuff quite closely and we use Quicken to keep track of everything. It actually has red flags built into it which is a great feature. I am happy to say though that we don’t see them much.
Being aware of red flags is more important that actually seeing them. It is sort of like slowing down for curves, if you didn’t you would have an accident.
Interesting approach. I’ve never looked at our personal assets that way. Although we’ve owned many homes and used them as personal residences, it’s not always clear cut that they will provide a strong ROI.
It is an accountant or financial person’s point of view. Some may even say it is looking at personal finance from a business perspective. I think it is an objective point of view. You take some, if not all the emotion out of your personal finances.
Right now, we don’t have any red flags…but we are buying our first home very soon. I have gotten better at spotting the red flags before it’s too late, but not always.
Great post. I like how you merge business terms with personal finance. 🙂
I am drawing on my many years as an entrepreneur and CFO. I think it views personal finance objectively. Congratulations on the new home.