When developing a plan for your finances, the toughest question often is: “Where do I begin?” Before investing in stocks and bonds or buying life insurance, before implementing any change or making any decisions, you first need to analyze and understand your entire financial picture. Two documents allow you to do just that. A Balance Sheet and a Cash Flow Statement enable you to take an in-depth look at your current financial situation and make better decisions about the future. With a little work, you can develop these two tools and be on your way to a solid plan for your finances.
Balance Sheet
A balance sheet is a snapshot of your personal finances at one point in time. It contains two main elements: what you own (assets), and what you owe (liabilities). Your net worth is expressed as: Net Worth = Assets – Liabilities. That is, what you own minus what you owe.
A balance sheet clearly lists all assets and liabilities. Examples of assets include: house, investments such as stocks and bonds, savings and checking accounts, 401(k), IRAs, business interests, artwork, and jewelry, among others. Liabilities include mortgage balances, credit cards, education loans, and any other debt. Once you have created a list of everything you own and everything you owe, simply subtract the sum of the assets from the sum of the liabilities- this is your net worth.
The ultimate goal of most investors is to increase their net worth. The balance sheet is a very useful tool to identify strengths and weaknesses in your current finances, as well as to determine your goals for the future. Someone with a disproportionate amount of liabilities might set a goal to eliminate this debt. On the other hand, someone with a positive net worth (more assets than liabilities) might plan to save and invest towards retirement, college, or another goal.
Cash Flow Statement
After analyzing your balance sheet and determining your goals, you need to decide how to fund these goals. A well formulated plan is one not only with realistic goals, but also a sensible means of achieving them. That is, having goals is good, but you must be able to pay for them. Using a cash flow statement will enable you to determine how to pay for your goals.
A cash flow statement is a detailed look at all money coming in and going out over a period of time. It illustrates what you earn (revenue) and what you spend (expenses). Your net cash flow is expressed as: Net Cash Flow = Revenue – Expenses. That is, what you earn minus what you spend.
Some examples of revenue include: salary and wages, self-employment earnings, dividends, interest, and other investment income. Expenses may include: mortgage payments, rent payments, insurance costs, utilities, clothing, food, child care, alimony or child support, travel, entertainment, loan payments, education costs, taxes, charitable contributions, gifts, and gasoline. After listing all you earn and everything you spend, you can calculate your net cash flow by simply subtracting expenses from revenue.
By analyzing your cash flow statement, you can more easily cut expenses and identify excess net cash to use towards your goals. Generally, someone with negative net cash flow should first concentrate on cutting expenses to achieve positive cash flow before attempting to save or invest towards any future goals. Once positive net cash flow is achieved, excess money can be used directly for funding and achieving your goals.
In developing a balance sheet and a cash flow statement, it is important to remember one general rule-of-thumb- Quality in – Quality out. The more detail and care you put into your planning documents, the more effective they will be. A plan is only as good as the effort you put forth when creating it.
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