It’s hard to know how to get to where you want to go if you don’t know where you are in the first place. Financial statements help you in that regard. Both individuals and businesses benefit from creating and studying their financial statements. Individuals can learn a lot from the information provided by their balance sheet and cash flow statements, as can businesses. Businesses also have an additional financial statement that supplies them with other information: an income statement.
A personal balance sheet provides a picture of an individual’s current financial position. It lists the assets owned and the debts owed. It is the person’s financial position as of a specific date. It is analogous to taking a still photo shot. The object of your picture may have moved right after you clicked the button.
On the balance sheet, assets are divided into three separate categories: liquid, or current, assets; household assets and possessions; and investment assets. Similarly, liabilities are listed as either current liabilities or long-term liabilities.
Current, or liquid, assets are those assets that can be quickly converted into cash with little or no loss in value. Checking, savings, and money market account/fund balances fall into this category, as does the cash value of a whole life insurance policy. Current liabilities are those debts that are due within a short period of time, such as revolving charge account and credit card payments and other loan balances coming due. Good money managers will strive to ensure that their current assets exceed their current liabilities by a comfortable amount so that they never are caught short.
Household assets and possessions and investment assets are longer-term assets that aren’t as easily convertible to cash upon demand. The market value of one’s home, vehicles, furniture, jewelry, and special purpose assets, such as musical instruments, fall into the former category. While these items can typically be sold—perhaps even for a profit—it is hard to do so at a moment’s notice if cash is needed for an emergency. Investment assets include U.S. government bonds and stocks and bonds of large corporations, whether invested in individually or via a mutual fund or exchange-traded fund (ETF). Any monies in an individual retirement account, 401k, or 403b plan also fall into this category, as does a bank certificate of deposit (CD). Like household assets and possessions, these assets can also be sold to generate cash, but often not with “little or no loss in value.” For example, there is a penalty involved when money is pulled out of a 401k or 403b plan, with some exceptions. And cashing in a 3-year CD prior to its maturity also comes with a penalty.
Long-term liabilities, as the name implies, are those debts that have some time before they are due, such as the balance on a mortgage or a business loan.
An individual’s net worth at any given point in time can be calculated by adding up the total value of the assets and subtracting the total amount of liabilities:
Net worth = Total assets – Total liabilities
= (liquid assets + household assets & possessions + investment assets) – (current liabilities + long-term liabilities)
Your net worth tells you how much you would have left if you liquidated all your assets and paid off all your debt.
While the balance sheet provides a snapshot of an individual’s financial position at a specific point in time, a cash flow statement is a statement of cash inflows and outflows over a period of time, such as a month, a quarter, or a year. It will indicate whether the person was operating at a surplus or a deficit during that time frame. It is analogous to shooting a video of a person for some time period. You can observe that person’s movements.
A personal cash flow statement lists all the cash inflows, such as the person’s salary (net paycheck) and any other income he or she had during the time period, such as dividend or interest income from investments. Cash outflows are generally separated into fixed expenses and variable expenses. Fixed expenses are those expenses that are the same every period–rent payments, payments on mortgages and other loans, and insurance payments. Variable expenses, on the other hand, are not constant from one period to the next. These include expenses such as food, clothing, utilities (electricity, cable, phone, water, gas), personal care (barbers, personal grooming items), transportation (gasoline and/or train or bus fares), medical, entertainment, gifts, and donations.
Any surplus or deficit is found by subtracting the total of the fixed and variable cash flows from the cash inflows for the period:
Surplus (Deficit) = cash inflows – (fixed expenses + variable expenses)
If you discover you were operating at a deficit, the cash flow statement enables you to review your cash outflows and determine the areas in which you can cut back. If you have a surplus, you should determine where you will allocate it. You may decide to add it to your rainy-day savings account, use it to purchase an investment asset that will help you advance toward a financial goal, or add it to a special purpose savings account, e.g. one that you created to save up for that new boat.
In addition to providing you with a clearer picture of your financial position, preparing your personal balance sheets and cash flow statements on a regular basis will benefit you if you ever decide to open your own business. Businesses, too, generate balance sheets and cash flow statements. They also prepare one additional financial statement—an income statement, which, for small businesses, is often called a profit and loss (P&L) statement. Should you ever want to apply for a business loan, you will need to present these to your banker, and you’ll be one step ahead of the game since you’ll be familiar with two of the required statements, at least.
Like the personal balance sheet, the assets on the balance sheet of a business are divided into categories: current, or liquid, assets; fixed assets; and investment assets. The accounts are only slightly different from those found on the balance sheet of an individual. The current assets of a business include not only checking, savings, and money market account/fund balances (typically listed as “cash and equivalents”), but also inventory (if any) and accounts receivable, which are those amounts that their customers owe them for goods and/or services that have been provided, since all of these are considered readily convertible into cash within a short time frame. The plant, property, and equipment that the business owns falls under fixed assets, so it is similar to the “household assets and possessions” account on the personal balance sheet, and the investment assets are fairly similar to those found on the balance sheet of an individual.
As on a personal balance sheet, the liabilities are divided into current and long-term, and subtracting the total liabilities from the total assets of a business provides us with the firm’s net worth, which is also referred to as its “equity.”
The cash flow statement of a business serves the same purpose as the personal cash flow statement. It is used to determine whether the firm operated at a cash surplus or deficit over the specified time period. This provides different information than the income (or P&L) statement of a firm because most firms operate on what is called an “accrual” basis, rather than a cash basis. The income statement of a company subtracts expenses from revenues to determine the firm’s “net profit.” However, under accrual-basis accounting, revenues are recognized when a sale is made, regardless of whether or not the customer has paid cash for the good or service. Thus, a firm’s revenues do not equate to its cash inflows. Similarly, a firm may include a bill that it has yet to pay as an expense, even though it has not yet paid out the cash. And there are other expenses that involve no cash outflows at all. They are merely accounting entries.
But regardless of whether you ever plan on opening your own business, periodically generating your own personal balance sheet and cash flow statement will enable you to discover where you are financially and help you move forward to meet your financial goals.