Month after month, many people go through their bank and credit card statements and are amazed that they spent more than they thought. To avoid this problem, a simple method of recording income and expenses is to have personal financial statements. Just like those used by businesses, financial statements provide you with an indication of your financial situation and can help you plan your budget. There are two types of personal financial statements:
Let’s explore them in more detail.
Key points to remember
- You can create your own personal financial statements to help you plan your budget and set goals for increasing your net worth.
- The two types of personal financial statements are the personal cash flow statement and the personal balance sheet.
- The personal cash flow statement measures your cash inflows (the money you earn) and your cash outflows (the money you spend) to determine whether you have a positive or negative net cash flow.
- A personal balance sheet summarizes your assets and liabilities in order to calculate your net worth.
Personal cash flow statement
A personal cash flow statement measures your cash inflows and outflows to show you your net cash flow for a specific period of time. Cash inflows generally include the following:
- Interest on savings accounts
- Dividends on investments
- Capital gains from the sale of financial securities such as stocks and bonds
Cash inflows can also include money received from the sale of assets such as houses or cars. Essentially, your cash flow is anything that makes money.
Cash outflows represent all expenses, regardless of their size. Cash outflows include the following types of costs:
- Rent or mortgage payments
- Utility bills
- Entertainment (books, cinema tickets, restaurant meals, etc.)
The purpose of determining your cash inflows and outflows is to find your net cash flow. Your net cash flow is simply the result of subtracting your outflows from your inflows. A positive net cash flow means that you earned more than what you spent and that you have money left over from that period. On the other hand, negative net cash flow shows that you spent more money than you brought in.
A balance sheet is the second type of personal financial statement. A personal report gives an overview of your assets at a given period. This is a summary of your assets (what you own), your liabilities (what you owe) and your net worth (assets minus liabilities).
Assets can be classified into three distinct categories:
- Liquid Assets: Liquid assets are things you own that can easily be sold or turned into cash without losing value. These include checking accounts, money market accounts, savings accounts and cash. Some people include certificates of deposit (CDs) in this category, but the problem with CDs is that most of them charge an early withdrawal fee, which causes your investment to lose some value.
- Large Assets: Large assets include things like houses, cars, boats, artwork, and furniture. When creating a personal balance sheet, be sure to use the market value of these items. If it is difficult to find a market value, use recent selling prices for similar items.
- Investments: Investments include bonds, stocks, CDs, mutual funds, and real estate. You should also record the investments at their current market value.
Liabilities are just what you owe. Liabilities include current bills, payments still owed on certain assets such as cars and homes, credit card balances and other loans.
âDebt avalancheâ and âdebt snowballâ are two popular methods of paying off debt, such as credit card debt.
Your net worth is the difference between what you own and what you owe. This number is your measure of wealth because it represents what you own after everything you owe has been paid off. If you have negative equity, it means you owe more than you own.
Two ways to increase your net worth are to increase your assets or decrease your liabilities. You can increase your assets by increasing your cash flow or increasing the value of any asset you own. One word of caution: make sure you don’t increase your debts along with your assets.
For example, your assets will increase if you buy a house, but if you take out a mortgage on that house, your debt will also increase. Increasing your net worth through an increase in assets will only work if the increase in assets is greater than the increase in liabilities. The same goes for trying to reduce liabilities. A decrease in what you owe must be greater than a reduction in assets.
Bring them together
Personal financial statements give you the tools to monitor your spending and increase your net worth. The problem with personal financial statements is that they are not just two separate pieces of information, but that they actually work together. Your net cash flow statement can actually help you in your quest to increase your net worth. If you have positive net cash flow over a period of time, you can use that money to acquire assets or pay off debt. Applying your free cash flow to your equity is a great way to increase assets without increasing liabilities or reducing liabilities without increasing assets.
The bottom line
If you currently have negative cash flow or want to increase your positive net cash flow, the only way to do that is to assess your spending habits and adjust them if necessary. By using your personal financials to learn more about your spending habits and your net worth, you’ll be on your way to greater financial security.