This is part of a weekly series on personal finance and wealth building. If you care to read the first one, click here.
The first step of the trip from where you are now to where you want to be is understanding how to tell where you are. For wealth, that’s a Balance Sheet. You also need to know how that’s changing over time, which is where you need the Income Statement.
Many financial ‘experts’ poorly or incorrectly explain the balance sheet, assets, liabilities, income, and expenses. I’ve seen one go as far as to suggest your house isn’t an asset (and then suggest a good way to get rich is to invest in real estate). While I’m not presenting a lesson in Finance, these are pretty much the same tools you would learn to use in a Finance 101 class.
Wealth: Simply put, wealth is the stuff you own. Assets less liabilities. Usually measured in dollars, but could be measured in baseballs or butterflies if you like.
Asset: Stuff you have. (Having and owning are not the same thing)
Liability: Stuff you owe to other people.
Income: Stuff you get in return for selling your stuff or your labor, usually dollars
Expense: Stuff you have to give to other people in return for stuff you got or are getting from them, usually measured in dollars
The Balance Sheet
A Balance Sheet is simply a means to compare your assets against your liabilities. If you’ve taken a finance class, you know that Assets = Liabilities + Owners’ Equity. In our case, “Owners’ Equity” is wealth, and we’ll use this formula:
Assets – Liabilities = Wealth
(Here seems as good a place as any to mention that ‘wealth’ need not be measured in dollars, and there are many things with values that can not be measured in dollars. In a future article, I’ll go into more detail on what value means, and how it means different things to different people.)
A Balance Sheet is a picture at a moment in time of your financial situation. To build your Balance Sheet, take a piece of paper or spreadsheet, and divide it into two sections. In one section, list your assets and their current value. On the liability side, list what you owe other people.
Note that recurring expenses, like utilities, aren’t on the balance sheet. The gym membership is, as it represents an item that is a recurring payment for a fixed period of time – it’s really a loan (a gym membership is for a year, you pay monthly, but you owe it all). Likewise, the income from work isn’t included. You could count earned income that wasn’t paid yet, but that’s getting a bit more detailed than we need to be.
This example person has a pretty healthy net worth. He’s got a nice Lexus and nice house, and it looks like he’s doing OK. How could you make it better? How could you make it grow?
The Income Statement
The Income Statement is also pretty straightforward, but instead of a snapshot of a specific moment, it is a record for a period of time. Most people use a month. Using the same process, on one side of your sheet, put your income (money moving into your pockets), on the other, put expenses (money moving out).
For our purposes, I’m ignoring non-cash expenses, namely depreciation. If I ever get to writing something about why car loans are almost always a bad idea if your goal is to increase your net worth, I will include depreciation in the income statement. What you get when you compare the two is typically going to be the impact of that period of time on your asset “Cash”, something a lot like Cash Flow. (To the Finance professors out there, again, I know I’m oversimplifying). In fact, this isn’t really an Income Statement, but a hybrid Income Statement and Statement of Cash Flow.
How’s our example look now?
Assignment for this week: Build your Balance Sheet and your Income (Cash Flow) Statement. Want me to look at it? Hit me in the comments. Also, if you have any suggestions, please leave them. My feelings won’t be hurt if you think I’m doing this wrong, or you have a suggestion on how to do this that’s more effective.
Next week, budgeting and debt repayment strategies.