Equity
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I think that everyone should learn basic finance at school (along with learning about nutrition and food, but that is for another day……)
Why learn about finance, I hear you say?
Lets start with this. Here are some of the first things that young adults have to deal with when they finish their secondary education:
How to repay their debt whether it is their student loan, a loan to buy a car or furnish their flat
Understanding their cash flow now that they (hopefully) have a job
Working out what is Kiwisaver and what fund they should be in
Working out how they can afford to go flatting or not
Preparing a budget to see what they can and can’t afford
In most cases, they have had no training in any of these things so are relying on their parents or flying blind, hence my comment: learning about basic finance is vital for everyone.
Today I want to discuss Equity.
Equity
Your equity is how much of an asset you own compared to how much you owe to the bank or creditors. It is a key factor in working out if you can borrow more money, how risky you financial position is and if you can weather a financial crisis - just like we are facing now.
I will always remember my children coming home and the conversation would often go like this:
Kids: “Dad, the Browns’ are really rich.”
Me: "Why do you say that?”
Kids: “Because they have a really nice house and a flash car”
To which I would reply: “Do you know how much they owe the bank?”
My point is that there are two sides to every equation and the key thing is how much of any asset you own compared to how much you owe. There are many factors to take into account in determining what your equity should be, but consider this:
A bank will lend you about 80% for a residential property, expecting you to have 20% equity.
A bank will lend you 60% for a commercial property, expecting you to have 40% equity.
Banks will not lend you very much at all to buy shares in the share market.
A bank will lend you 40% against any inventory you have in a business and 50% against debtors.
So there is a wide range of percentages all based around the risk of the investment and asset you are looking at.
The other very important thing in determining what your equity should be is your cash flow. If your cash flow is strong (regular and has been for some time) then you can take on more debt and have less equity. If your cash flow is uncertain and subject to fluctuation then you should have more equity and less debt to ensure you can ride the tough times. If you are younger and starting out then you may have stronger cash flow (more debt) than someone moving into retirement (less debt). Equity and cash flow go hand in hand.
Golden Rules for Equity
You will never lose money if you decide when to sell an asset rather than the bank or creditor. Consequently, you must have sufficient equity to control your destiny.
Stress test your financial position regularly to see if you can withstand a downturn. Look ahead and ask yourself, "How long can I last with 50% of my current income?”.
Measure your equity. Six monthly at a minimum, but not too often.
Work out what your risk appetite is. This will help you decide how much debt you should have.
As a rough guide, your loan repayments should not be more than 40% of your gross income.
The goal is to increase your equity every 12 months - but don’t overvalue your assets!!!
A good business person is always in debt. If you want to grow your asset base, you need both equity and debt to do this.
Assets = Liabilities plus Equity (A = L + E - see here). They all work together and you must work on all three to develop your assets over time.
James