Month after month, many individuals look at their bank and credit card statements and are surprised that they spent more than they thought they did. To avoid this problem, one simple method of accounting for income and expenditures is to have personal financial statements. Just like the ones used by corporations, financial statements provide you with an indication of your financial condition and can help with budget planning. There are two types of personal financial statements:
Let's explore these in more detail.
- You can create your own personal financial statements to help with budget planning and to 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 (money you earn) and your cash outflows (money you spend) to determine if 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 in order to show you your net cash flow for a specific period of time. Cash inflows generally include the following:
- Interest from savings accounts
- Dividends from investments
- Capital gains from the sale of financial securities like stocks and bonds
Cash inflow can also include money received from the sale of assets like houses or cars. Essentially, your cash inflow consists of anything that brings in money.
Cash outflow represents all expenses, regardless of size. Cash outflows include the following types of costs:
- Rent or mortgage payments
- Utility bills
- Entertainment (books, movie 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 outflow from your inflow. A positive net cash flow means that you earned more than you spent and that you have some money left over from that period. On the other hand, a negative net cash flow shows that you spent more money than you brought in.
Personal Balance Sheet
A balance sheet is the second type of personal financial statement. A personal balance sheet provides an overall snapshot of your wealth at a specific period in time. It 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 those 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, causing your investment to lose a little value.
- Large Assets: Large assets include things like houses, cars, boats, artwork, and furniture. When creating a personal balance sheet, make sure to use the market value of these items. If it's difficult to find a market value, use recent sales prices of similar items.
- Investments: Investments include bonds, stocks, CDs, mutual funds, and real estate. You should record investments at their current market values as well.
The "debt avalanche" and the "debt snowball" are two popular methods for paying off liabilities, such as credit card debt.
Your net worth is the difference between what you own and what you owe. This figure is your measure of wealth because it represents what you own after everything you owe has been paid off. If you have a negative net worth, this means that 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 assets by increasing your cash or increasing the value of any asset you own. One note of caution: Make sure you don't increase your liabilities 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 liabilities will also increase. Increasing your net worth through an asset increase will only work if the increase in assets is greater than the increase in liabilities. The same goes for trying to decrease liabilities. A decrease in what you owe has to be greater than a reduction in assets.
Bringing Them Together
Personal financial statements give you the tools to monitor your spending and increase your net worth. The thing about personal financial statements is that they are not just two separate pieces of information, but they actually work together. Your net cash flow from the cash flow statement can actually help you in your quest to increase your net worth. If you have a positive net cash flow in a given period, you can apply that money to acquiring assets or paying off liabilities. Applying your net cash flow toward your net worth is a great way to increase assets without increasing liabilities or decrease liabilities without increasing assets.
The Bottom Line
If you currently have a negative cash flow or you want to increase positive net cash flow, the only way to do it is to assess your spending habits and adjust them as necessary. By using personal financial statements to become more aware of your spending habits and net worth, you'll be well on your way to greater financial security.