Before You Make A Budget
It’s commonly accepted that you shouldn’t build your home on anything less than a solid foundation. Similarly, it’s almost impossible to build wealth and financial independence without first having sound foundational principles to build upon. When developing a plan for your finances, the toughest question often is: “Where do I begin?” Before delving headfirst into investment literature, before buying life insurance, even before making your budget, 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 personal balance sheet is a snapshot of your financial position on a given date, usually the end of a month or year. It lists the dollar amounts of your liabilities (what you owe to others) and your assets (what you own of monetary value). Your net worth (also referred to as equity) is the difference between your assets and your liabilities.
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.
Whether your net worth is negative or positive, it doesn’t mean anything if you have no idea where it’s going, and that’s where your cash flow statement comes in handy.
Cash Flow Statement
After your balance sheet reality check, you now need to determine your goals and decide how to fund them. 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, like a financial motion picture of your cash inflows and outflows. 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.
Revenue includes things such as salary and wages, tips, self-employment earnings, dividends, royalties, interest, and other investment income. Revenue is the amount you earn, which is not necessarily equal to the amount you receive. This is because some expenses, such as taxes, health care costs, 401(k) contributions, and so on, are deducted from your check before you receive it.
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. There are two main types of expenses, fixed and variable. Fixed expenses are expenses that you don’t directly control and that you usually pay monthly or semiannually, such as a mortgage payment, rent, tuition, and books. On the other hand, variable expenses are expenses that you have control over, such as food, fuel, entertainment, clothing, utilities bills (to a degree), and cable TV.
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.
“Finish Rich” Insights
Your balance sheet and income statement are joined at the hip. In a way, I’m tempted to say that a negative cash flow is a bigger cause for concern than a negative net worth. For example if you funded your college education through student loans, it’s more than likely you will have a negative net worth at graduation. A trip to the hospital or a lawsuit can also dramatically increase your liabilities, thus causing your net worth to turn negative. To paint the whole picture, it will also impact your cash flow because you’ll have to pay for those liabilities. The extent of the damage, though, depends on the size of the debt.
On the other hand, a negative cash flow has to potential to drive even the largest positive net worth into the ground, simply because you’re spending more than you’re bringing in. It will eventually catch up to you (unless you can tap into a limitless trust fund – in which case you would NOT be reading this). Eventually the source will dry up and if the habit continues uncorrected, then your lifestyle will be financed by debt, which in turn will increase your expenses, and it’s a never-ending cycle. That’s not where you want to be.
Before you can attain your goals, you must first understand where you are financially. Your personal balance sheet and income statement will give you the best possible picture of your current situation and will also show you where you’re headed. And instead of a budget that squarely focuses on making ends meet, you’ll be able to make a budget that incorporates your goals, dreams, and the occasional (financial) pat on the back.
As we all know, making a budget isn’t the hard part, sticking to it is. Here’s hoping this method will make yours way easier to stick to!
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