Understanding your financial situation

Part 2

In Part 1 of Undertanding your financial situation you will have downloaded our budget planner and assessed your financial performance.

FIDO suggests you now check your financial position and financial capacity. When you've done this you'll understand your financial situation and be able to work out how much you can afford to invest.

Your financial position

Are you a borrower or a lender?
Do you own more than you owe?
Are your assets worth more than your liabilities?

Your 'financial position' answers these questions. It's a snapshot of your finances taken at a particular date. FIDO suggests 30 June, which ties in with most superannuation member statements.

Look at your assets

See FIDO's Statement of financial position.

The statement has been designed especially for listing and comparing your personal assets and liabilities.

What makes up your assets?
For many of you, your home and superannuation will make up your largest assets.

Your home will probably grow in value, and is usually excellent security for loans. However if you need cash, you have to sell all of it, not just some of it, and then buy or rent somewhere else to live.
Your super will also grow, but can only be touched when you retire permanently from the workforce and reach the minimum age set by law (see Essential facts about superannuation).

Look out for a few asset traps:

Will most of your assets lose value over time, for example cars and household effects?
Is your cash earning low, fully taxed interest while you are paying high interest rates on credit card debts? If so, would it be a better idea to pay off some or all of the debts with some of the spare cash?

Trends
Have your assets increased or fallen in value compared with a year ago?

If you own your home, have you kept it in good condition?
Superannuation and shares are affected by rising and falling markets, but how have they performed compared with market trends?

Do you expect any changes to your assets in the new few years? For example, you may plan to sell your home and buy a more expensive or cheaper place.

Unusual features
Because your statement of financial position takes a snapshot of your finances at a particular date, check for anything about that date that's really unusual. For example, if you had just sold your house, but were planning to buy another one very soon, you may have a lot of cash.

Look at your liabilities

See FIDO's Statement of financial position.

The statement has been designed especially for listing and comparing your personal assets and liabilities.

What makes up your liabilities?
If you have borrowed to buy a house, your mortgage may be your largest liability. Large debts, even for assets that may grow in value, can cut back your financial flexibility.

Debts for assets that lose value, like cars, usually weaken your financial position, even if they may sometimes be unavoidable.

Look out for these liability traps:

Are you financing your life through credit cards or personal loans? These usually charge the highest rates of interest.
Do you owe money for purchases on 'interest free' terms? If so will you be able to pay it back on time? Otherwise you may be hit with hefty interest charges backdated to the time of purchase.
Do you rely on an overdraft, line of credit or another loan that allows your bank to issue a letter of demand that makes them due and payable at short notice? If so, make sure you comply strictly with the terms and conditions.

Trends
Have your liabilities increased or fallen compared with a year ago?

If you are buying your home, have you reduced your mortgage compared with a year ago?
Do you have a home equity loan? Have you used it to increase your overall wealth or for day to day or lifestyle spending?
Have your current liabilities (those due within the next 12 months) increased? If so, can you meet them comfortably?
Have you got increasing amounts outstanding on 'interest free' terms?

Do you expect any changes in the new few years that are likely to increase your debts and borrowings?

Unusual features
Because your statement of financial position takes a snapshot of your finances at a particular date, check for anything about that date that's really unusual. For example, if you had just bought your house, you may have lots of debt.

Potential or uncertain liabilities
Also called 'contingent' liabilities. For example, suppose someone sues you for damaging their car and you're not insured. You may win or lose the case, you may have to pay nothing or the full amount claimed. These liabilities may weaken your financial position.

Your financial position and investing

Before you work out how much you can invest, see how your finances look against three important tests. Your answer to these tests is calculated from the information you put into FIDO's DIY Statement of financial position.

Test 1: Are your current assets adequate to meet your current liabilities, with access to extra money in an emergency?

Warning 1: Does your FIDO DIY Statement shows a negative number for your current assets? Perhaps you cannot meet your immediate financial commitments? For example, if you have many bills and credit card debts, other money locked away in long term assets like superannuation may not help you.

If you cannot finance your immediate needs, you may need financial counselling.

Test 2: Do your total assets exceed your total liabilities?

Assets minus liabilities equals your wealth or 'equity'.

Positive equity means you own more than you owe (assets greater than liabilities).
Negative equity means you owe more than you own (liabilities greater than assets).

The greater your positive equity, the better your financial position, and safer it may be to set money aside to invest. If your position is strong, you may be able to take greater risks in choosing investments.

Warning 2: Low or negative equity suggests too few savings and too much debt. Reduce your debts fast, starting with those that charge you the highest rates of interest. Resist the temptation to borrow more. Your loan applications will often get refused or you may have to pay high rates of interest on oppressive terms.

Test 3: What is your equity's share of total assets?

FIDO's DIY Statement shows your equity as a percentage of your total assets, called an 'equity ratio'. It helps indicate your financial freedom to invest.

This percentage is a more useful indicator of your financial feedom to invest than dollar amounts. For example, someone with $100,000 in assets and $90,000 in debt has an equity ratio of only 10%. They probably have less freedom to invest than someone with $500,000 in assets and $90,000 in debt whose equity ratio is 82%.

Your financial capacity

Now you have looked at your financial position and your financial performance, you can better answer the question:

How much can you afford to invest?

A strong financial performance builds a strong financial position. If both are strong, you may decide to invest more or even handle such risks as borrowing money to invest.

Stress tests to build confidence

Your own financial capacity and strength depends on all sorts of personal factors such as:

your income
your job security
your spending and saving habits
your future needs, and
your how much you have saved already.

When you invest, you must still maintain a sound financial situation despite unexpected financial demands or poor market conditions.

At this stage, FIDO suggests you stress test your finances. Look at various unpleasant possibilities to see if you can handle them financially. You want to invest knowing that even if something bad happens, your finances are not going to topple over. Here are a few nasty ideas to get you started.

Income stress: Suppose you get retrenched. Will you get any redundancy or unemployment benefits? How long do you expect it would take to get another job at the same pay? Do you have enough to last that time? Suppose you get really sick. How much paid and unpaid sick leave can you take?
Expenses stress: Imagine interest rates double. Can you afford to keep up your repayments? You suddenly have to buy a new car just when you are involved in major home repairs or renovations. Can you call on emergency funds?
Stress on equity: What if housing prices stop going up and then fall by 15%, making a $300,000 home worth only $255,000? Then, say extra expenses force you to borrow $30,000 in a hurry. Will you move into a weak financial position, or even into negative equity?

Your financial situation

If you've already downloaded our budget planner and assessed your financial performance, you've now covered three ideas to help you look at whether you may be able to start investing:

1. Your financial performance
2. Your financial position
3. Your financial capacity

Together, these three things describe your overall financial situation.

Make sure your financial situation can carry you from where you are today to your personal objectives. Keep it in good repair, inspect it closely for weaknesses and take decisions that allow for the stresses and strains that life will impose.

More about investing

FIDO Website: Printed 07/31/2010