Personal financial Statements for Financial Progress
Every journey starts somewhere. You need to know where you are before you can go somewhere else. Personal financial statements tell you the starting point of your financial journey.
Most of the financial documents come from financial institutions. other business organizations. or the government. Two documents that you create yourself, the personal balance sheet and the cash flow statement. are called personal financial statements. These reports provide information about your current financial position and present a summary of your income and spending. The main purposes of personal financial statements are to
- Report your current financial position in relation to the value of the items you own and the amounts you owe.
- Measure your progress toward your financial goals.
- Maintain information about your financial activities.
- Provide data you can use when preparing tax forms or applying for credit.
The Personal Balance Sheet: Where Are You Now?
The cunent financial position of an indi\'idual or a family is a common starting point for fmancial planning. A balance sheet, also called a net Worth statement or statement of financial position. reports what you own and what you owe. You prepare a personal balance sheet to determine your current financial position using the following process:
Step 1: Listing Items of Value Available cash and money in bank accounts combined with other items of value are the foundation of your current financial position. Assets are cash and other tangible property with a monetary value. The balance sheet for Rose and Edgar Gomez lists their assets under four categories:
Liquid assets are cash and items of value that can easily be converted to cash.
Money in checking and savings accounts is liquid and is available to the Gomez family for current spending. The cash value of their life insurance may be borrowed if needed. While assets other than liquid assets can also be converted into cash. the process is not quite as easy.
Real estate includes a home. a condominium. vacation property, or other land that a person or famjly owns.
Personal possessions are a major portion of assets for most people.
Included in this category are automobiles and other personal belongings. While these items have value. they may be difficult to convert to cash. You may decide to list your possessions on the balance sheet at their original cost. However. these values probably need to be revised over time. since a five-year-old television set, for example, is worthless now than when it was new. Thus, you may wish to list your possessions at their current value (also refen'ed to as market value). This method takes into account the fact that such things as a home or rare jewelry may increase in value over time.
You can estimate current value by looking at ads for the selling price of comparable automobiles. homes. or other possessions. Or you may use the services of an appraiser.
Investment assets are funds set aside for long-term financial needs.
The Gomez family will use their im'estments for such things as financing their children's education, purchasing a vacation home, and planning for retirement. Since investment assets usually fluctuate in value. the amounts listed should reflect their value at the time the balance sheet is prepared.
Step 2: Determining Amounts Owed Looking at the total assets of the Gomez family, you might conclude that they have a strong financial position. However, their debts must also be considered. Liabilities are amounts owed to others but do not include items not yet due, such as next month's rent. A liability is a debt you owe now, not something you may owe in the future. Liabilities fall into two categories:
Current liabilities are debts you must pay within a short time. usually less than a year. These liabilities include such things as medical bills, tax payments, insurance premiums, cash loans, and charge accounts.
Long-term liabilities are debts you do not have to pay in full until more than
a year from now. Common long-term liabilities include auto loans. educational loans, and mortgages. A mortgage is an amount borrowed to buy a house or other real estate that will be repaid over a period of IS. 20. or 30 years. Similarly, a home improvement loan may be repaid to the lender over the next 5 to 10 years.
The debts listed in the liability section of a balance sheet represent the amount owe at the moment; they do not include future interest payments. However. each de payment is likely to include a portion of interest
Step 3. Computing Net Worth Your net worth is the difference between
your total assets and your total liabilities. This relationship can be stated as
Assets - Liabilities = Net worth
Net worth is the amount you would have if all assets were sold for the listed values and all debts were paid in full. Also, total assets equal total liabilities plus net worth. The balance sheet of a business is commonly expressed as
Assets = Liabilities + Net worth
Since very few people, if any, liquidate all assets. the amount of net worth has a more practical purpose: It provides a measurement of your current financial position.
A person may have a high net worth but still have financial difficulties. Having many assets with low liquidity means not haying the cash available to pay current expenses. Insolvency is the inability to pay debts when they are due; it occurs when a person's liabilities far exceed available assets. Bankruptcy may be an alternative for a person in this position.
You can increase your net worth in various ways. including
Increasing your savings.
Reducing spending.
Increasing the value of investments and other possessions. Reducing the amounts you owe.
Remember. your net worth is not money available for use but an indication of your financial position on a given date.
Evaluating Your Financial Position
A personal balance sheet helps you measure progress toward financial goals. Your financial situation improves if your net worth increases each time you prepare a balance sheet. It will improve more rapidly if you are able to set aside money each month for savings and investments.
As with net worth, the relationship among various balance sheet items can give an indication of your financial position. The Financial Planning Calculations box on the next page explains several commonly used financial ratios.
The Cash Flow Statement:
Where Did Your Money Go?
Each day, financial events can affect your net worth. When you receive a paycheck or pay living expenses, your total assets and liabilities change. Cash flow is the actual inflow and outflow of cash during a given time period. Income from employment will probably represent your most important cash inflow; however, other income, such as interest earned on a savings account, should also be considered. In contrast, payments for items such as rent, food. and loans are cash outflows.
A cash flow statement, also called a personal income and expenditure statement, is a summary of cash receipts and payments for a given period, uch as a month or a year. This report provides data on your income and spending patterns, which will be helpful when preparing a budget. A checking account can provide information for your cash flow statement. Deposits to the account are your inflows; checks written are your outflows. Of course, in using this system, when you do not deposit the entire amounts received. you must also note the spending of undeposited amounts in your cash flow statement.
The process for preparing a cash flow statement is
Total cash received during the time period
Cash outflows during the time period
Cash surplus or deficit
Step 1: Record Income Creating a cash flow statement starts with identifying the cash received during the time peliod involved. Income is the inflows of cash for an individual or a household. For most people, the main source of income is money received from a job. Other common income sources include
- Wages, salaries, and commissions. Self-employment business income.
- Saving and investment income (interest, dividends, rent}
- Gifts, grants, scholarships, and educational loans.
- Government payments, such as Social Security, public assistance, and unemployment benefits.
- Amounts received from pension and retirement programs.
- Alimony and child support payments.
Take-home pay, also called net pay is a person's earnings after deductions for taxes and other items. Lin's deductions for federal, state, and Social Security taxes are $1,250. Her take-home pay is $3,196. This amount, plus earnings from savings an investments, is the income she has available for use during the current month.
Take-home pay is also called disposable income, the amount a person or househo.~ has available to spend. Discretionary income is money left over after paying for housing, food, and other necessities. Studies report that discretionary income ranges fro less than 5 percent for people under age 25 to more than 40 percent for older people.
Step 2: Record Cash Outflows Cash payments for living expenses another items make up the second component of a cash flow statement. Lin Ye divides h cash outflows into two major categories: fixed expenses and variable expenses. While every individual and household has different cash outflows, these main categories along with the subgroupings Lin uses, can be adapted to most situations.
1. Fixed expenses are payments that do not vary from month to month. Rent or mongage payments, installment loan payments, cable television service fees, and a month]. train ticket for commuting to work are examples of constant or fixed cash outflows.
For Lin, another type of fixed expense is the amount she sets aside each month f, payments due once or twice a year. For example, Lin pays $384 every March for lit insurance. Each month, she records a fixed outflow of $32 for deposit in a special sa\ings account so that the money will be available when her insurance payment is due.
2. Variable expenses are flexible payments that change from month to month. Common examples of variable cash outflows are food, clothing, utilities (such as electricity and telephone), recreation, medical expenses, gifts, and donations. The use of a checkbook or some other recordkeeping system is necessary for an accurate total of cast outflows.
Step 3: Determine Net Cash Flow The difference betweer: income and outflows can be either a positive (surplus) or a negative (deficit) cash flow. A deficit exists if more cash goes out than comes in during a giver: month. This amount must be made up by withdrawals from savings or by borrowing.
When you have a cash surplus, as Lin did, this amount is available for saving, investing, or paying off debts. Each month, Lin sets aside money for her emergency fund in a savings account that she would use for unexpected expenses or to pay living costs if she did not receive her salary. She deposits the rest of the surplus in savings and investment plans that have two purposes. The first is the achievement of short-term and intermediate financial goals, such as a new car, a vacation, or reenrollment in school; the second is long-term financial security-her retirement.
