Understand Your Finances With These 2 Statements

To get what you want out of life, you need to set some goals. But that can be hard to do when you're not sure where all your money goes or how much you even have. Getting financially organized can bring clarity to your money situation so you can develop achievable goals that make sense for your life.

But where do you start? From good old pencil and paper to cloud-based platforms that keep track of all your accounts, there's no shortage of options for anyone who wants to get his or her financial house in order. The good news is that you don't have to spend a penny to start organizing.

That's because what it all comes down to understanding two simple reports, and you don’t need to be an accountant to understand them either! Once you have these under your belt, you'll be better prepared to leverage whatever financial tools you like. Soon you'll be on your way to setting realistic goals, pursuing them and eventually reaching them.

Knowing where you stand financially is as simple as understanding these two personal financial statements:

1. Your Balance Sheet

A personal balance sheet provides a snapshot of your net worth. It provides a simple framework for you to understand what your net worth is and the difference between your assets and liabilities.

Assets – Liabilities = Net Worth

Assets are items you own, such as your home, investments and cash you have in your bank account.  Everything you own is totaled up into one number.

Your liabilities represent everything you owe, like your mortgage, credit card balances and student loans. These are totaled up and subtracted from your assets to give you your net worth.

Now, if you are a young doctor just out of school, chances are your net worth will be negative. This is ok because you have only been building up liabilities in school for the past 10+ years and haven’t had a chance to grow your assets. However, if you are a doctor (or anyone for that matter) in their late 50s with a negative net worth, I would be very concerned. (For more from this author, see: 3 Crucial Tips for Living Within Your Means.)

Knowing your balance sheet is important, but it’s only half of the equation and can’t be looked at alone. Time to start examining your cash flow.

2. Your Cash Flow

Cash flow represents the difference between your income and your expenses, usually measured on a monthly basis.

Income – Expenses = Cash Flow

You either have positive or negative cash flow (or very rarely break-even). Cash flow can only be improved by making more money or spending less, that’s it. Simple to understand, hard to execute on.

Cash flow measures how we are doing over a distinct period of time, whereas a balance sheet is a one-time snapshot that shows the accumulation of a lifetime of saving, investing and spending.

The easiest way to track your money is to sign up for a free online service that takes information from all of your accounts and automatically categorizes them for you. It takes a little setup time, but you will soon have a clear understanding of where your money goes and, more importantly, if your spending is aligned with your values. (For related reading, see: 6 Best Personal Finance Apps.) 

Arguably, the most effective thing you can do to ensure your financial success is to live within your means and spend less than what you earn.  This makes total sense, but in today’s world it’s often difficult to do.

Putting the Two Financial Statements Together

The balance sheet and the cash flow statement are two different pictures of your financial health. They work in synergy: one affects the other.

All things being equal, if your cash flow is positive, your net worth should go up. If you made $1,000 more than you spent last month, that money would go into your bank account and increase your assets, thus increasing your net worth.

Likewise, if you spend more than you make in one month and rack up credit card debt, your liabilities (credit card debt) on your balance sheet will increase. This will result in your net worth dropping. (For related reading, see: Evaluating Your Personal Financial Statement.)

Why Is This Important?

Unless you're a genius at creating wealth like Richard Branson or Warren Buffet, you have limited financial resources available to you for achieving your goals. Like the dieter who doesn't know what weight he started at, you won't know how much you are gaining or losing unless you get a clear picture of where you stand. You will have no way to know if what you are doing is working.

Start today with a clear understanding of your resources to help you improve your finances. Once you know where you are, you can make the best financial decisions to help you move in the direction you want to go and reach your goals. 

(For more from this author, see: 4 Steps to Help You Build Wealth Right Now.)