Let’s start by reviewing a few fundamental accounting documents. There are two accounting statements that you should become very familiar with. The first accounting statement you should know is the Income Statement and the second is the Balance Sheet.
The Income Statement is where we keep track of our monthly income and expenses. Among other things this document helps us understand how well we are “living within our means.” Our monthly Income is usually the easiest item for us to keep track of because receiving money is not painful and there are only a few of these transactions to deal with each month. It feels good when others value our efforts enough to fairly compensate us.
Depending on our personal financial position our monthly expenses may look very different when compared our neighbors. Monthly expenses are usually more difficult to keep track of than incomes. For instance, my family may have 200 expenses per month but only 2 income transactions. The amount of money remaining at the end of the month after all expenses are accounted for is Net Income or Cash Flow. Income, expenses and cash flow are managed together using a budget.
A budget is nothing more than a target for our monthly income and expenses and is usually broken into categories. A target amount is allocated to each category. These targets should be flexible and adjust as your needs change, preferably before the month begins. Budgets are a vehicle to help us reach our long term goals. The majority of people I speak with have a budget. However, many of these folks miss the point when they try to execute it. Ultimately they should be using their budget to reach their long term financial goals. This brings us to our second financial statement.
The Balance Sheet contains the cumulative effect of our financial decisions. All financial decisions that we have made throughout the course of our lives are funneled into this record. The balance sheet is broken into two categories Assets and Liabilities. Assets are items we own that are of worth to others. My home, cars, furniture and other possessions fall into this category. Some of these items such as furniture I have purchased with available net income. Other items such as my home and cars I’ve borrowed from a bank in order to obtain them.
Our long-term financial obligations are Liabilities. Everyone dollar that we’ve borrowed that we have not paid back yet, debt, is a Liability. A mortgage, car loans, student loans, credit card balances, overdraft balances all fall into this category.
The difference between the value of our Assets and Liabilities is Equity or Net Wealth. Our goal should be to avoid, minimize and eliminate Liabilities and increase our Assets in order to maximize Equity or Net Wealth.
Now, the Balance Sheet and Income Statement are inseparably connected.
Income Statement drives the Balance Sheet
Our monthly Income Statement shows us the change in our Balance Sheet. For example if my monthly income is $1,000 and expense is $800 I have $200 in Cash Flow. Unless I blow the $200 on a party for my son’s football team, this Cash Flow is the change to my Balance Sheet for the month. My assets go up by $200 which increases my Net Wealth by $200. My Liabilities are unaffected unless I choose to take the cash and pay off some debt. In this case my Liabilities go down by $200 which also increases my Net Wealth by $200.
Balance Sheet drives Income Statement
Liabilities or Debt usually come with strings attached. I might take a mortgage out for $100,000 with an interest rate of 5%. Each month I will pay a portion of the annual $5,000 interest expense. This interest expense will be recorded as an expense on my Income Statement. Also, I may have a rental property as an Asset on my Balance Sheet. If I’ve played my cards right this rental will provide a monthly income. The conclusion that can be drawn here is that Liabilities -> Expenses and Assets -> Income
No comments:
Post a Comment