The Power of Personal Financial Statements

Imagine going into the financial department of a large company like Apple and finding that all the financial records, accounting, etc., were kept with Post-it Notes, bills and statements scattered around, and scraps of paper in piles! It would be a complete disaster. Sadly, this is how too many people run their own financial lives. They don’t know how much money is coming in, where it goes and what they own. If a business ran this way, it would be out of business in less than a year.

I have met people that don’t even balance their checking account each month. If you don’t keep good financial records, your ability to manage your finances, business, or wealth-building efforts will be nearly impossible. The tool that companies use is financial statements developed by modern accounting. If this works for a business, why wouldn’t it work for an individual?

Three Financial Statements

Modern accounting has developed three financial statements that every business uses to manage their operations, or at least those that stay in business. Those three statements are:

1. Income Statement
2. Balance Sheet
3. Statement of Cashflows

Income Statement

The income statement is one of the most critical statements for a business; it documents income and expenses for a period. That could be a month, quarter, or year. The simplest version lists income followed by expenses and at the bottom shows if there was a profit or loss for the period in question. Individual transactions are summarized into categories on the statement. For example, sales to individual customers are grouped under sales. Expenses for marketing which might include payment to specific vendors will be grouped under marketing. This keeps the statement neat and easy to read.

A business that consistently shows more expenses than income will not be long for this world. This principle applies equally to individuals. If you always spend more money than you bring in, i.e., your expenses exceed your income, you are headed towards bankruptcy. This fundamental truth applies to both businesses and individuals.

Balance Sheet

A business’s balance sheet shows all a company’s assets and liabilities. Assets are items like a building, bank account, cash on hand, and investments. Liabilities include bank loans, credit cards, invoices from vendors, and taxes due. Like an income statement, the balance sheet shows all your assets followed by your liabilities. At the bottom of the balance sheet is (hopefully) a positive number, i.e., they have more assets than liabilities which a business calls this owners’ equity.

A business that consistently shows negative owners’ equity will not survive in the long run. This also applies to individuals. You have a positive net worth if you have more assets than liabilities. If your net worth is negative, just like a business, you must bring in a constant source of income to live, and you have nothing to sustain yourself if your income stops.

Statement of Cashflows

The Cash Flow Statement (CFS) shows the sources and uses of income that comes into a business. All income and expenses are categorized into one of three areas:

1. Operations
2. Investments
3. Financing

For example, if a business has income from the sale of products and deducts payroll and expenses for materials, these monies would all be grouped under operations. If some of that income is diverted to purchase new computers or machines, that would be considered investments. Finally, any monies diverted to pay off debt and interest would be grouped under financing.

A business that plows all its income into the wrong areas will eventually go out of business. A healthy business must divert funds into all three areas to stay healthy and grow. Investors use this information to evaluate if a company’s management is doing its job and taking the proper actions to increase the value of a company.

The principles from a statement of cash flow also apply to individuals. A person with a healthy financial life diverts income to all three categories. They will have income from “operations,” such as a small business or employer. That income is used to pay expenses such as day-to-day living expenses, food, rent, etc. Income going to investments could be contributions to a retirement plan, purchasing investment real estate, or buying cryptocurrency. Finally, most people don’t generate enough income to pay for everything at once and will have debt for a house, car, and other things. While debt isn’t what you should strive for, it is a necessary part of life and can have strategic value during times of inflation.

Personal Financial Statements

The reason a business uses financial statements is to track progress and make sure they are growing. This same principle applies to individuals, so why would you not want to use financial statements in your own financial life?

I started using personal financial statements a few years ago, which was quite an eye opener. I started with a personal balance sheet to evaluate my net worth. I had a loose idea of how many assets I had before I did this but didn’t have a firm grip on it until I did this exercise. Later I added an income statement to show all my income and what my expenses looked like each month. Finally, I added a cash flow statement to see which areas my cash was diverted, i.e., was it mostly going to operations (living expenses) and how much was allocated to my investments vs. debts. It was interesting to see as it showed me where I prioritized my finances and where I wasn’t.

You Inc.

Think of yourself as a small business because you aren’t that different. Just like a business, you have income coming in from operations. Those operations can be the income you earn from freelancing or a small business or income coming in from outside employment. It can also be income from a side hustle or investments like rental properties.

Just like a business, you also have expenses from your (operations), which include rent, car payments, mortgage, utility bills, food, clothing, etc. these expenses are not unlike business expenses. Like business expenses, you must spend something to continue to earn income.

Finally, if a business has income that exceeds expenses, it generates a profit, and that profit must be allocated to future investments to grow the business. Again, this is just like an individual. If your income exceeds your expenses, your “profit” should also be allocated to future investments to grow your net worth.

A personal version of the same financial statements that businesses use can give you a lot of the same guidance it provides the management of a business. It will allow you to see if expenses are too high or income is too low (income statement). It shows your assets minus your liabilities and your net worth (balance sheet). Finally, you can see where your cash (income) is diverted via a version of a cash flow statement. Is your income used on operations (expenses), liabilities (debt), or investments? Which is the same thing as saying assets that will grow your future net worth or debt. You will get a lot of insight and tools to improve.

Step1: Financial Software

As I mentioned earlier, far too many people won’t even reconcile their checking account each month. If this is you, you already have serious problems before you even get to personal financial statements.

I recommend you implement some personal financial management software such as Mint, Quicken, or Personal Capital. These programs will allow you to set up a checkbook and track bill payments, investments, and other financial activities.

I use Quicken, but that is simply because when I started doing this 25 years ago, Quicken was the only tool available. The other companies came along later, and I was already used to and established with Quicken and haven’t changed. Most of these programs all work along similar lines, and I recommend you spend a little time evaluating each one and decide on the best fit for you.

If you have never used personal finance software, you will be amazed at how helpful it can be. It will make monthly activities such as reconciling your checkbook and giving you access to spending records a breeze. I am not sure I would be where I am today had I not started using it as soon as I was out of college.

Step 2: Balance Sheet

While all the personal financial management software mentioned above will allow you to track your net worth, I have found it is in a format that isn’t really conducive to how I wanted to see the information. I developed my balance sheet as my first step in personal financial statements and created my own based on how I wanted to see the information.

I started by tracking it every single month. I would go through and update all the balances for my investment accounts, the value of notes and properties, personal property, debts, etc. Every month, this became a massive chore that I didn’t look forward to and took a few hours. I decided the numbers didn’t change enough in a month to warrant this extra work, so I have since switched to doing this quarterly and find it easier and more useful. A lot can change in a quarter, so it makes sense. Everyone may find they need to do it more or less often. I would suggest that if this is the first time you have heard of this concept, that once per quarter is more than adequate. You might be good with doing it twice a year. No matter what choice you make, pick a schedule, and stick to it.

Step 3: Use the Information

This is the final and possibly most important step, use the information. If you go through all this work and don’t utilize the information you are getting, you did it for nothing. Spend time each month in your financial management software reviewing income and expenses. Spend some time each month asking yourself the following questions:

Monthly Income

How much money did you make for the month? If you are a freelancer, small business owner, or work on commission this number could fluctuate every month. If you have a side hustle or outside investments that earn passive income like rental properties this could also fluctuate from month to month. Assuming you work a full-time job while freelancing on the side, did you earn more income from freelancing than your job? If you have passive income from rental properties or notes how much of your monthly income came from those investments? If you have multiple streams of income how much did you earn from each one. Finally, the important question to always ask is how do I make this number larger? What specific steps should I take next month to make these numbers larger?

Monthly Expenses

What were your total expenses for the month? Hopefully, you spent less money than you earned, but if you didn’t this information becomes even more critical. Where did your money go? What specific items did you spend money on? Where those items fixed expenses such as a mortgage, car payment, or student loan or were they variable expenses such as dining out, entertainment, or new clothes? If you find most of your expenses are fixed you need to start looking at ways to lower your debt and expenses or raising your income before you can start moving the needle. If your expenses are variable, you need to decide if those expenses are in alignment with your overall long term financial goals. Finally, ask what specific steps you need to take to reduce or eliminate these expenses to increase your wealth gap.  

If you implement a personal balance sheet, study it and ask yourself the critical question, what do I need to do to grow my net worth? Keep asking yourself this question over and over until you start to take action on methods and strategies that you can take TODAY to increase your net worth for tomorrow.

Take Baby Steps

While I started, in the beginning, talking about all three financial statements, I recommend that if this entire concept is new to you, stick to the baby steps I outlined above. Implement the financial management software and personal balance sheet.

This was my approach. I implemented the financial management software right out of college and didn’t start using the personal financial statements until just a few years ago. I wish I had done it earlier, but I am glad I started it. Until just this year, I stuck to just a personal balance sheet. This year I started using a personal income statement and playing around with a version of the statement of cash flow called a source and use of funds statement, which I learned in college that businesses use. The source and use of funds statement simply categorized my income into the three buckets I mentioned before, expenses, investments, and financing or debt payments. At a glance I was able to see where most of my income was being diverted to and it allowed me to make some changes.

Don’t overdo this, or you will become frustrated and stop doing it. That is why I recommend doing it in baby steps. In future posts, I will outline each statement in more detail. The point of this article was to introduce you to the concept and get you moving in the right direction.

Conclusion

Businesses use financial statements to track income, expenses, and investments. This information is used to guide management and help them make decisions that will grow the company and create wealth.

Every individual is like a small business; you have income, expenses, and hopefully, investments. Therefore, it makes sense to implement a personal version of the same tools that companies use to grow. If you take the time to set up financial management software and a personal balance sheet, you will be ahead of most people.

The information you can glean from these tools, if you keep them updated, use them, and ask yourself critical questions about the information it is telling you and base future decisions on the answers to those questions, you can grow your wealth.