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.