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Business owners and professional practices know that they cannot effectively manage their business without understanding their financial situation. In the same way, when it comes to making a comprehensive estate plan, they also need a framework for evaluating their overall financial health.
A “life balance”[1] provides a comprehensive view of the owner’s assets, liabilities, and equity. Although similar to the more traditional balance sheet used to monitor your business, the life balance includes both real and implicit assets and liabilities.
The left side of the sheet lists the owner’s assets and includes traditional financial assets (cash, stocks, bonds, alternative assets, etc.) and other tangible assets (real estate, precious metals, art collections, etc.). It also includes implicit but expected assets.
Implied assets are illiquid assets that are often non-marketable but have value. In a previous article, this was called “Human Capital”. Although often overlooked, human capital represents the present value of the owner’s expected earnings.
The liabilities, on the right side of the sheet, should look the same. Mortgages, business loans, and other debt secured by property are explicit liabilities. Additionally, business and practice owners should include their succession goals as an embedded liability, and career professionals and non-business owners should include their estimated retirement costs.
For example, if you want to maintain a certain standard of living after leaving your business or retiring from your career, you are creating an implicit liability that must be funded from the assets on the left side of the Life Balance. Aspirations to buy a vacation home, start another business, or fulfill a charitable commitment also represent implicit responsibilities.
Think of a balance sheet with assets listed on the left side and liabilities on the right. Assets combined include a home, retirement plans, and the family business. Together these are worth $ 2,000,000. To this we are going to add $ 800,000, the amount of money the owner expects to earn as income from the business. This increases the value of total assets to $ 2,800,000 /
Under Liabilities, we will list three common assets that include a mortgage, college expenses, and estimated retirement costs. These total $ 1,800,000. This leaves $ 1,000,000 as discretionary wealth; an amount that the person can use as they wish, but that will have a significant impact on their net worth, retirement, and even legacy.
Using the life balance sheet helps owners, professionals, and others put a value (present value) on their embedded assets (their projected earnings), as well as their embedded liabilities (retirement and other costs). This information should cause owners to review all of their tangible and real assets, including their business value, to make sure they are on track to meet their long-term goals.
[1] Wilcox, Jarrod, Jeffrey E. Horvitz, and Dan diBartolomeo, 2006. Investment management for taxable private investors, Charlottsville, VA: CFA Institute Research Foundation.