Month after month, many individuals look at their bank and credit statements and are surprised that they spent more than they thought they did. To avoid this problem, one simple method of accounting for income and expenditures is to have personal financial statements. Just like the ones used by corporations, financial statements provide you with an indication of your financial condition and can help with budget planning. There are two types of personal financial statements:
Let's explore these in more detail.
Personal Cash Flow Statement
A personal cash flow statement measures your cash inflows and outflows in order to show you your net cash flow for a specific period of time. Cash inflows generally include the following:
- Interest from savings accounts
- Dividends from investments
- Capital gains from the sale of financial securities like stocks and bonds
Cash inflow can also include money received from the sale of assets like houses or cars. Essentially, your cash inflow consists of anything that brings in money.
Cash outflow represents all expenses, regardless of size. Cash outflows include the following types of costs:
- Rent or mortgage payments
- Utility bills
- Entertainment (books, movie tickets, restaurant meals, etc.)
The purpose of determining your cash inflows and outflows is to find your net cash flow. Your net cash flow is simply the result of subtracting your outflow from your inflow. A positive net cash flow means that you earned more than you spent and that you have some money leftover from that period. On the other hand, a negative net cash flow shows that you spent more money than you brought in.
Personal Balance Sheet
A balance sheet is the second type of personal financial statement. A personal balance sheet provides an overall snapshot of your wealth at a specific period in time. It is a summary of your assets (what you own), your liabilities (what you owe) and your net worth (assets minus liabilities).
Assets can be classified into three distinct categories:
- Liquid Assets: Liquid assets are those things you own that can easily be sold or turned into cash without losing value. These include checking accounts, money market accounts, savings accounts and cash. Some people include certificates of deposit (CDs) in this category, but the problem with CDs is that most of them charge an early withdrawal fee, causing your investment to lose a little value.
- Large Assets: Large assets include things like houses, cars, boats, artwork and furniture. When creating a personal balance sheet, make sure to use the market value of these items. If it's difficult to find a market value, use recent sales prices of similar items.
- Investments: Investments include bonds, stocks, CDs, mutual funds and real estate. You should record investments at their current market values as well.
Liabilities are merely what you owe. Liabilities include current bills, payments still owed on some assets like cars and houses, credit card balances and other loans.
Your net worth is the difference between what you own and what you owe. This figure is your measure of wealth because it represents what you own after everything you owe has been paid off. If you have a negative net worth, this means that you owe more than you own.
Two ways to increase your net worth are to increase your assets or decrease your liabilities. You can increase assets by increasing your cash or increasing the value of any asset you own. One note of caution: make sure you don't increase your liabilities along with your assets. For example, your assets will increase if you buy a house, but if you take out a mortgage on that house your liabilities will also increase. Increasing your net worth through an asset increase will only work if the increase in assets is greater than the increase in liabilities. The same goes for trying to decrease liabilities. A decrease in what you owe has to be greater than a reduction in assets.
Bringing Them Together
Personal financial statements give you the tools to monitor your spending and increase your net worth. The thing about personal financial statements is that they are not just two separate pieces of information, but they actually work together. Your net cash flow from the cash flow statement can actually help you in your quest to increase net worth. If you have a positive net cash flow in a given period, you can apply that money to acquiring assets or paying off liabilities. Applying your net cash flow toward your net worth is a great way to increase assets without increasing liabilities or decrease liabilities without increasing assets.
The Bottom Line
If you currently have a negative cash flow or you want to increase positive net cash flow, the only way to do it is to assess your spending habits and adjust them as necessary. By using personal financial statements to become more aware of your spending habits and net worth, you'll be well on your way to greater financial security.
There are many ways to measure your financial health. The measurement that probably gets the most attention from personal finance books and news outlets is the personal balance sheet, or net worth statement. Knowing your net worth can be important, but keep in mind that it is a snapshot in time and not necessarily a true indicator of financial health. There are many other factors that affect your financial health, one of which is your cash flow statement, which is a representation of your net monthly cash flow.
You can use your cash flow statement in conjunction with your net worth statement to get a better idea of your overall financial health. Later we will show you how to combine your net worth statement and cash flow statement with a financial risk test and debt analysis which will help you get a more clear picture of your financial health.
Positive Cash Flow is the Building Block of Wealth
One of the fundamental building blocks of becoming wealthy is spending less than you earn. It is one of the core concepts of achieving wealth. Your cash flow statement won’t tell you if you will become a millionaire or not, but it can tell you if you are on the right path – hint: you can’t build wealth if you are running on a deficit.
This is why it’s essential to know where your money is coming from, and where it is going. You should also know when all of this is happening. Cash flow management in your personal finances is important, since it keeps you from overdrawing your account and helps you plan ahead for larger expenses. When you know how money flows through your personal economy, you are in control.
How to Create a Personal Cash Flow Statement
Creating a cash flow statement may remind you of creating a budget. You will need to record all sources of income and all your expenses. Then you will add the final amounts for income and expenses. Just like your net worth statement, a positive number is positive cash flow (good!) and a negative number is negative cash flow (bad!).
Understanding Your Cash Flow – the When, Where, and Why
If you want to get an idea of how money is moving in your personal finances, the first thing you need to do is keep track of everything:
- Note your income. Find out when you are paid. This is about more than just recognizing your monthly income. You should know when each pay day is (the first of the month, or every other Friday, etc.), and how much you will receive each time you are paid.
- Track your expenses. Next, you should know where your money is going, and when it needs to get there. Figure out how much is going into your retirement account, emergency savings and for bills. Check to see when your regular bills are due, so you know when that money will be needed.
Knowing where your money is coming from, how much of it is spoken for, and when it needs to be taken care of, is very important. If you do not have an idea of how your money is moving through your personal economy, it is much easier to make mistakes—and you could find yourself overdrawing your account and perhaps not having the money you need to meet your obligations.
Factors to Consider in Personal Cash Flow Statement
Account for regular and irregular income. A cash flow statement is designed to list all sources of income that affect your cash flow, not just your salary from your day job. Below this section is a list of income streams to consider adding to your cash flow statement. However, you should only add the income sources that are available for spending. For example, investment income and dividends are listed as forms of income, but you wouldn’t list those on your cash flow statement if they are in retirement accounts or are automatically reinvested. Dividends are also unique, in that many pay out quarterly or semi-annually. So you will want to note that on your projections if you rely upon dividend investments for cash flow.
Track both regular and irregular expenses. On the same token, you need to record all expenses, including regular and irregular expenses. For example, some of your expenses, such as insurance, may come quarterly, semi-annually, or annually. You may wish to break those down into a monthly approximation (examples could include insurance premiums, taxes, homeowner’s association fees, investment contributions, etc.). Groceries and utilities are also expenses that can be approximated to smooth out your cash flow statement.
The following is a list of income sources and expenses that you may wish to include in your personal cash flow statement. You will need to tailor it to your needs.
Common Types of Income
- Salary 1
- Salary 2
- Self-employment income
- Freelance/consulting income
- Government benefits (unemployment, Social Security Disability benefits, VA disability benefits, welfare, etc.).
- Child support/alimony
- Investment Income
- Interest income
- Capital gains
- Medical care
- Dining out
- Maintenance/home or auto
- Spending money
Calculate the Net Cash Flow and Adjust Your Budget
Add total income and expenses and you have a personal cash flow statement. If your cash flow statement is positive, then you have some additional cash each month that you can use to help you reach your financial goals (build emergency fund, pay down debt, invest, etc.). If your cash flow statement is negative, then it is time to look for ways to right the ship and turn things around. Look for areas you can trim back on expenses, and ways to increase income.
You may be able to project your income and expenses for several months. Take care to notice any upcoming big ticket items or irregular expenses, and plan accordingly.
Once you understand how your money is moving through your personal finances, you can begin to make changes to the way things are done. For example, you may find that most of your income is irregular. This is common when first starting a career in freelancing, starting a small business, and in certain types of jobs.
It’s important to pay your bills when they are due, and not try to get too far ahead of yourself if things are tight. That way you don’t spend all the money you need for living expenses for the next couple weeks on a bill that isn’t due for another month. It can take a balancing act, but it’s worth going through this exercise to avoid overdraft fees, bounced checks, late payment penalties, or cutting back in other areas.
Creating a cash flow statement, and using it, can do wonders for your financial health.