Personal financial statements, much like that X or finger pointing YOU ARE HERE on a map, let you know exactly where you currently stand financially. Why is this important? Well, because you can’t get to a destination and plan out your future without knowing your starting point.
Even amazing technology like Google Maps or Waze needs a current location to provide detailed directions on how to get to our desired endpoint. You may want to retire at 65 or pay for your kid’s education, but it is impossible to build plans to achieve those goals without proper financial statements. So what statements are important and what should they include?
An income statement covers a certain period of time, usually one year of income and expenses.
PRIOR YEAR INCOME: We start with including all of your income earned over the prior year, things like:
- Capital gains
- Business earnings
EXPENSES: Next, we calculate expenses. It’s always best to start with broad categories and work down to itemized expenses. Broad categories include:
- Living expenses
- Debt payments
- Insurance premiums
- Charitable contributions
- Children expenses
Once you have your categories, it’s easier to itemize individual entries.
HELPFUL TIP: It’s important that we attempt to be as accurate as possible when putting together our income statement. We don’t want to create too rosy or too dire a picture. I suggest tracking income and expenses over quarterly time periods first, then building them into annual amounts. The amounts can be verified through tax returns, bank statements, etc.
Once you have an income statement in place for the previous year, you can start to budget and build out a pro forma or projected income statement for upcoming years. Your income statement should show at least some discretionary or positive income.
If you are showing a negative number, that means you are spending more than you are earning and are likely doing so by using debt. At some point, you will have too much debt, creating too high a monthly interest expense that you can no longer afford, which will result in bankruptcy.
What is a Balance Sheet?
A balance sheet is a snapshot of your assets, liabilities and net worth. This statement can be summarized in two ways:
Assets – Liabilities = Net Worth
or Assets = Liabilities + Net Worth
Either way, each side of the equal sign must balance, hence the name.
ASSETS: Assets are going to include all of your cash or cash-like holdings including:
- Money markets
- Brokerage accounts
- 529 plans
- Real estate
- Personal use assets (such as primary residence/autos/jewelry).
There is an important distinction between investment and personal use assets. For something to be an investment asset, you need to be willing to sell the asset for profit to fund whatever financial goals you may have. So, if you have a wine collection that you drink throughout the year, that is a personal use asset, not an investment asset.
LIABILITIES: Liabilities are going to include all of your debts, both short-term and long-term – anything you are on the hook for paying back. Here we will find your:
- Home equity
- Credit cards
- Student loans
- Auto loans
Once we account for everything, we are hoping to have more assets than liabilities. This creates a positive net worth.
Personal Financial Statements Help You Set Goals
Your goal should be to increase this net worth over time so that when you retire you have accumulated a large enough nest egg that you no longer must work for your income. It is OK to have a negative net worth when you are younger, but it will prove very difficult to retire with one.
Creating personal financial statements is the first step toward taking ownership of your finances and learning where you currently stand. Without this vital information, it is impossible to build a roadmap (financial plan) and get to where we want to go. Succeeding (achieving our financial goals) becomes very unlikely.
If you haven’t recently reviewed your financial plan you should contact your CERTIFIED FINANCIAL PLANNER™ Practitioner.
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