Saturday, March 15, 2014

Personal Financial Statements

This is part 7 of 14 of my series on the 14 ways I am changing my financial life in 2014.

I love the topic of personal financial statements for two reasons. First, I don't think we look at them often enough. And, second, they are the best way to get a regular snapshot of our progress. And, if I were to add a third, it probably has something to do with the fact that I am a corporate finance geek and have prepared financial statements for hundreds of businesses. Shoot, I've even written and entire book on how to use business financial statements to improve performance and outcomes, Impact Your Business. So I promise in this post to keep it basic and focused on personal situations, not complex businesses.

The best way to start is by creating a balance sheet. Here is the easiest way to think of it. Everything that has a balance of money in it should be accounted for here. You start with all of your assets, then your debts/liabilities. The you subtract your debts from you assets to determine your net worth.

These are the most common categories for listing your assets:

  • Checking Accounts
  • Savings Accounts
  • CD Accounts
  • Stock, Bond, Mutual Fund Accounts (Non-Retirement)
  • Notes and Contracts Receivable (a fancy way to say that someone owes you money)
  • Cash Value of Life Insurance policies (for whole or universal life, hopefully you have term life insurance and this a zero balance! I'll write on that topic another time.)
  • Personal Property (jewelry, cars, RV, boat, toys, household items.
  • Retirement Accounts (IRAs, 401(k), 403(b), etc.)
  • Personal Residence
  • Other Real Estate Holdings
  • Other Assets
Add all of these up, and you will have the balance of all of your assets. Here is an example of what it might look like.

Sample Assets - Personal Financial Statement
When listing the value of your assets (and liabilities for that matter), it is important to note the value as of the date you are preparing the statement. Some of these values can change daily, like your checking account, while others are likely estimated values, like your home, that may stay static for a while.

These are the most common categories for listing your debts:
  • Credit Cards
  • Accounts Owed (like medical and other bills, especially any accounts that have slipped past their dues date)
  • Notes Payable (a fancy way for saying that you owe money to someone else)
  • Taxes Payable (any taxes that you owe but have not yet paid)
  • Real Estate mortgages
  • Other liabilities
Add all of these up, and you will have the total amount that you owe, also referred to as liabilities. Here is what it might look like:

Sample Liabilities - Personal Financial Statement
Personal finance is simple math, and calculating net worth is no different. Simply subtract your liabilities from your assets, and the remainder is your net worth. Here is what it looks like:

Sample Personal Financial Statement - Net Worth
It is important to look at your net worth every month to see which direction it is trending and to understand why it is going in that direction. Over time, we want our net worth to increase, and you really only have two levers you can pull to make that happen - increase assets, decrease debt. The more you do of both, the more your net worth will increase over time. The second part of the personal financial statement will help you determine how to best accomplish that.

Please don't let this title scare you. All we want to accomplish with this second part of your personal financial statement is determine how much extra cash you have at the end of every month/year to pay off debt (reduce liabilities) and/or save or invest (increase assets). As a rule of thumb, we want to try to have at least 20% of our income available for increasing our net worth. For purposes of this blog post, everything will be stated on a monthly basis.

These are the most common categories for listing your income:
  • Net paycheck or W-2 income
  • Earnings from self employment or businesses
  • Interest and investment income
  • Rent income (if you own rentals)
  • Other Income
Here is what this might look like:

Sample Income - Personal Financial Statement
Outflow refers to all of the money that leaves your accounts. Generally, a household has three types of outflows: needs, wants/luxuries, increase net worth with free cash flow. We delineate the needs and wants, then the remaining is what we can use to either pay down debt or save/invest. These are the most common categories for needs and wants:
  • Needs
    • Tithing/charitable donations
    • Rent/mortagage
    • Utilities
    • Groceries
    • Clothing
    • Transportation (necessary for work, etc.)
    • Insurance
    • Other needs
  • Wants/Luxuries
    • Shopping
    • Travel
    • Dining Out
    • Vacation
    • Gifts and presents
    • Other wants/luxuries
Here is what the accounting of needs and wants might look like:

Sample Outflow - Personal Financial Statement
Notice a couple of things in this example. First, the percentages listed to the right of the totals calculate the percentage of the inflow that is going to that category. From my perspective, the most desirable situation for this is 60% to needs, 20% to wants and luxuries, leaving 20% remaining. For people in dire financial situations with a lot of debt to pay off or other serious financial problems, a great deal of discipline is used to reduce the wants outflow to almost zero, leaving almost 40% of income per month to clean up whatever financial mess they are in. This is very hard to do and requires great sacrifice, but it can and has been done.

With money left after all of the main expenses, we need to decide what to do with it. Here is an example of the entire free cash flow statement indicating that the free cash is used to pay down debt. 

Free Cash Flow - Personal Financial Statement
Hopefully you can see that the purpose of the free cash flow statement is to help clarify how much money is available each month or year to make progress on your net worth, in the form of accelerating debt repayments or saving/investing.

It is imperative that we all make growing our net worth a significant priority in our lives. Why? Because no one else is taking responsibility for our financial future, and our net worth will determine how well we are prepared for the future, including all of our retirement years. Debt is stopping us from growing our net worth, so we need to focus intently on knocking that out. Then we need to put away as much money as possible for the future. We control the growth of our net worth by reducing debt and increasing assets. 

If free cash flow is how we grow our net worth, then we want as much of it as possible! We increase our free cash flow two ways: increase income and decrease our needs and wants outflows. It is very simple math, but very hard to exercise self-restraint and deferred gratification to slowly eliminate our debts and slowly watch our savings and retirement accounts grow. 

If you would like a copy of the template I used for this blog to use to calculate your net worth and free cash flow, just leave me a comment or message me and I can send it to you. It is in Microsoft Excel format, but I could also drop it into Google Docs if needed.

AFTERWORD: Two additional thoughts came since I posted this. First, the best way to view net worth is with several years worth of data so you can see the trends. When you are making it trend up, that's the satisfaction that you are working hard! Second, this post, when applied to business, actually is the foundation for a well-run and financially strong company.

Saturday, March 8, 2014

New Budgeting Software

This is part 6 of 14 of my series on the 14 ways I am changing my financial life in 2014.

My budget and my budgeting software weren't working. Well, technically they worked, but they left something to be desired in terms of helping me build and maintain the right habits to optimize how I used my money.

I have used for for the last several years. It is great for looking at historical expenses, and I love that it will connect to all my accounts, download their balances and transactions, and even allow me to categorize the expenses and build monthly budgets for each category. However, it lacked in a few areas.

If I ever spent more than I budgeted, the software gave me no consequence for my indiscretion. It didn't require me to make it up in the next month or pay it back in any other way. When the next month came, the system just rolled all the balances to zero and I started over with a clean slate. I realize I should be responsible to hold myself accountable, but it would have been nice if the software forced me to pay it back.

Another frustration with most budgeting software is how to handle expenses that come up less frequently than monthly. For example. I pay for my life insurance annually. The annual premium doesn't fit into my monthly budget, but it would if I could accrue 1/12th of it every month until it was due a year later. The most common alternative is to set up a separate savings account for each of these types of expenses, but that can add up to more than 10 different accounts. That's cumbersome.

Have you ever come to the end of the month, blown through your spending budget, and made excuses for all of the things you needed to buy just that month, just once? The challenge is that many of us make the same excuses pretty frequently, sometimes even monthly. That is not one-time, and it says that you either need to increase your expense budget or get your spending under control. Either way, most budgeting software struggles to help you target and improve in this area.

So my three pain points mentioned above had me convinced I needed a new solution. So I started looking for a new budgeting software and came across a company that I heard of before. In fact, I had met the company founder at a business event and remembered him telling me about his company. Most importantly, his software solved all the problems I mentioned and more. It is called You Need A Budget (use this link for a 10% discount on the software: You Need a Budget 10% discount).

I started using this software in January and I am hooked. It allows for zero-sum budget, where every dollar that comes in is allocated for a specific purpose. The You Need A Budget site calls it giving every dollar a job, which is the first of four rules the site uses to explain the methodology behind the software design. It is a digital format of the envelope budget, the old-school way of using cash for all purchases.

Here's how the envelope budget works with cash. You place each dollar you receive into one of several envelopes. You then need to carry those envelopes with you everywhere. When you spend money on groceries, then you remove money from the grocery envelope. When the envelope is empty, you know you can't spend any more. The same applies for each of your envelopes representing how you have categorized your spending.

Carrying around envelopes with cash is just not practical anymore, especially for those like me who would much rather live a paper-free life. "There's got to be an app for that" is how I approach old, archaic ways of doing things. You Need a Budget makes it easy to create digital envelopes with money that is in your bank account. Using your computer or smartphone you can quickly see how how much is in each envelope whenever needed. I always check the budget before I spend to make sure I have enough in the envelope. If I have enough, then I swipe my debit card. This is the modern way of applying the envelope budget principles, and it solves many of my aforementioned problems.

Unlike my old budgeting software, You Need A Budget makes me pay the price if I overspend on my monthly budget. It carries the deficit into the next month! And, if I under-spend, it carries the surplus into the next month. The makers of the budgeting software call this rolling with the punches.

I love how You Need A Budget handles the expenses that are highly variable each month, like my annual life insurance premium. I pay zero dollars for life insurance for 11 months, then in the 12 month I pay the entire amount. Called saving for a rainy day, I just put the monthly amount needed into the life insurance digital envelope. If I don't use the amount during the month, the balance rolls simply over to the next month (treated like a surplus in a budget), and sits there until I need it. I repeat this process each month during the year, saving 1/12th of the annual premium each month. Then, when the premium is due, I spend all of the accrued balance without a major gyration in that month's budget. Here is a list of what I use this for: Christmas, life insurance, summer vacation, winter vacation, medical, home repairs, home furnishings, school clothes, auto repairs, gym membership, and athletic contest fees (triathlons). This allows me to have a planned budget for all of these expenses even though the actual need to pay for them varies significantly from month-to-month. All the while, the cash is sitting in my checking account earning a small amount of interest.

Although not a complaint I mentioned above, the software solves another pet-peeve I have with other budgeting software - focusing only on expenses, neglecting the management of income. Rather than living paycheck to paycheck and hoping to cover your expenses, the software is designed to help you live on last month's income.

As money comes into your account, you can assign it to be used for next month's expenses. It may take a little time to build up the reserves to do it, but it I highly recommend you implement this discipline into you life. This process is amazingly helpful for knowing how much money you have to work with at the beginning of the month (especially helpful for those with variable incomes). You start every month knowing exactly how much you have to spend, and you can easily give every one of those dollars a job. It makes "nailing" your zero-sum budget pretty easy.

So think this through. That means that during the month of March, each time you get paid or money comes into your account you are ear-marking it for use in April. You are stockpiling cash all month, then using it the next month. That sounds like one month's worth of an emergency fund to me.

You Need A Budget has been a great fit for the way I want to manage my money. It even gives me an easy option for tracking money for the kids and the tithing they owe. It is offered as downloadable software with a great iPhone and Android app. It is very easy to use and designed to help you see and understand what you need to do with your money. If you want to check it out, use this link for a 10% discount: You Need A Budget 10% Off.