Chapter 5 – Financial Statements

Financial statements and ratios are tools that are used to monitor and assess your progress towards reaching the goals specified in your financial plan. They play a key role in the implementation of your financial plan.

There are three reports that are essential to monitoring your financial condition. These reports are called financial statements. These three statements each measure different aspects of your financial condition. We will examine them one by one.

Balance sheet

The balance sheet is sometimes also called the net worth statement. It is snapshot of your financial condition at a specific point in time. It shows what you own, what you owe, and what you are worth.

Assets

The first item reported on the balance sheet are assets. Assets are things that you own. The key to determining if something is an asset is to ask yourself if it could be sold or exchanged for money. Everything that can be exchanged for cash is an asset. Assets are listed on the balance sheet at their fair market value, or the amount that you could get if you were to sell it. Any analysis you conduct on your financial statements should use the market value of the assets.

There are three main types of assets.

1. Liquid assets are cash and things that can be converted to cash quickly and easily, such as checking and savings accounts. Liquid assets are great for paying for things. You want to keep liquid assets on hand so that you can pay for your day-to-day expenses. If you have no money in your checking account, then you can't buy things! It's also a good idea to keep some liquid assets available in case of an emergency. Such a reserve is called an emergency fund.

Liquid assets are very bad at earning money. Checking and savings accounts typically pay very little interest. You don't want to keep too much money in liquid assets because you will lose out on the ability to grow your wealth!

2. Investment assets are assets whose primary purpose is to grow and increase in value, such as stocks, bonds, and real estate. These are not very good for buying things with because their value changes all the time. This means that investment assets are not a good place to hold your emergency fund. They are good to hold on to for a long time to save up for big goals. Most investments assets are held for many years to help pay for retirement. Their ability to grow over time makes them wonderful for accumulating wealth.

3. Tangible assets are assets that you use, such as cars, furniture, clothing, etc. These are good for improving your lifestyle now. In other words, they create utility now. You want some tangible assets because they are what provides a lot of our quality of life. Tangible assets have a major problem. They almost always lose value over time. Having too much money in tangible assets is bad because you are losing money simply by owning them.

You want to make sure that you have a good mix of assets. You needs some liquid assets to buy things and protect yourself in case of an emergency. You need investment assets to grow your wealth over time and meet long-term goals. You need tangible assets to improve your lifestyle right now.

Liabilities

Your liabilities are the next item on the balance sheet. Liabilities are debts that you owe to others. Mortgages, car loans, student loans, and credit card balances are all liabilities. If you owe money to someone, then you have a liability. The amount that you owe is reported as a liability on your balance sheet.

Liabilities are categorized by how long they will take to repay. Short-term liabilities are debts that you will repay within one year. Long-term liabilities are debts that you will repay for more than one year.

Net Worth

Your net worth represents the total financial value of everything your own. This is a calculated number. It is equal to your total assets minus your total liabilities.

The best way to understand net worth is to imagine if you died tomorrow. If everything you owned were sold and used to pay off your debts, how much would be money left over? The amount of money left over after you repay your debts is your net worth. If your net worth is positive, then you are considered solvent, and you have enough money to cover all of your financial obligations. If your net worth is negative, then you are considered insolvent.

The relationship between assets, liabilities, and net worth is exact. Any increase in assets must be matched by an equal increase in either liabilities or net worth. This relationship shows us how to increase your net worth. There are only two ways to increase your net worth:

Method 1) Increase your assets without increasing your liabilities. You can do this by earning money and placing it into an asset that holds value, such as a checking account or brokerage account.

Method 2) Decrease your liabilities without decreasing your assets. You can do this by paying off loans using your paycheck. Each payment you make towards a loan reduces your balance, and therefore increases your net worth. You do not increase your net worth by using existing assets to repay the loan. This is because you lose net worth when you lose assets, and that loss balances exactly with gain from paying off the loan.

Cash Flow Statement

The cash flow statement is also called an income and expense statement. This statement shows changes in your financial position over a period of time, usually a month or a year. The reason it is called a cash flow statement is because it shows how your money is moving (or flowing) from one place to another.

Income

The places your money comes from are called income. Income can be wages, salaries, bonuses, interest, stock dividends, support payments, tax refunds, gifts, and government payments. These all count as income on the cash flow statement. Income is where money flows into your financial statements.

Income is classified at three levels.

1. Gross income is all income you receive from any source. It is the first line of your cash flow statement. If you’ve ever received a paycheck, gross income is the first number on the check.

2. Net income is the income that you have left after involuntary expenses are taken out of your gross income. These involuntary expenses include taxes and health insurance premiums that are automatically deducted by your employer. Net income is also called disposable income because it is income that you can choose how to dispose of.

3. Discretionary income is the income that you have left after you have paid for all of your essentials, such as food and shelter. This is income that you have in excess of your most basic needs. You have a lot of choice, or discretion, in how this money is spent. It's not needed to survive so you can spend it on whatever you like.

Expenses

The places your money flows out of your financial statements are called expenses. You incur an expense any pay for something. If money is leaving your hands, then you have an expense.

Expenses are either fixed or variable.

1. Fixed expenses are fairly stable and change very little over time. Rent, insurance, and cable bills are good examples of fixed expenses. An expense doesn't have to be 100% unchangeable to be considered fixed. It just needs to be more difficult than choosing to spend less or more on this expense.

2. Variable expenses are expenses over which you have a large degree of control. You can increase or decrease your spending on variable expenses relatively easily. Your spending on dry cleaning, recreational activities, and eating out at restaurants are excellent examples of variable expenses. Variable expenses should be the first expenses that you should try to reduce if you are looking to reduce your spending because they are easier to change than fixed expenses.

The main piece of information you are looking to find from your cash flow statement is whether or not you were able to afford all of your spending. If your income exceeds your expenses, then you have a surplus. A surplus can be saved for the future or used to repay loans. If your expenses are greater than your income, then you have a deficit. Running a deficit can be a problem. Deficits can only be fixed by withdrawing from an emergency fund or by taking out a loan. You should consider either increasing your income or decreasing your expenses if you find yourself regularly having a deficit in your cashflow statement.

Ratios

We use a number of financial ratios to analyze these two statements to determine your financial health and your progress towards your goals. These ratios can show if your finances are out-of-balance. Any problems hiding in your finances can also be revealed using these ratios. Descriptions of these ratios and the methods for calculating them are described in math skill 2.

What do a diet, a blueprint, a trip map, and a budget all have in common? They are all plans!

Budget

The cash flow statement measures the activities of your money in the past. The balance sheet is a snapshot of of where you stand now. But what about the future? How do we reach our financial goals?

A budget is a cash flow statement for your future. It's a plan for your income and expenses. A plan is defined as a procedure used to achieve an action. This means that a budget is a tool we use to allocate funds to reach various goals. It is an essential part of a comprehensive strategy to reach your goals.

Budgets have a terrible reputation. People hate them as much as they hate diets. The reason people hate budgets is because they use them incorrectly. A budget is often viewed as a source of unhappiness in our lives.

This view is wrong.

A budget is simply a means of empowering you to take control of your money. It lets you use your money to get the things that are most valuable to you. A budget helps you control your spending so that you only spend money on the most valuable things. You can use a budget to gain control over what you will own, how you will live, and how you will protect yourself and your family.

The key to a successful budget is to make sure you can be comfortable with it. If it is too confining in some aspect, then you must reconsider whether or not the goals you have set are realistic, given your resources. Always remember that it is your budget, and you are in control of it, not the other way around.

Budgets look much like cash flow statements because they show income and expenses. However, a budget is concerned with controlling future outcomes. A cash flow statement is only concerned with reporting on the past.

Lecture:

This is an excellent time to watch Lecture 4 from the course pack.

Definitions:

Balance sheet: a snapshot of your financial condition at a specific point of time, net worth statement

Asset: any item that you own

Liquid assets: cash or anything you own that can quickly be converted to cash like checkings and savings accounts

Investment assets: assets whose primary purpose is to grow and increase in value, such as stocks, bonds and real estate

Tangible assets: assets that you use, such as cars, furniture, clothing, etc.

Liabilities: debts that you owe

Net worth: your total assets minus your total liabilities

Cash flow statement: a summary that shows every dollar coming in the door and every dollar going out over a period of time, considered the most important financial statement

Income: money coming in the door from a wide variety of activities, such as wages, salaries, bonuses, interest, stock dividends, support payments, tax refunds, gifts, and government payments

Gross income: all income you receive from a source

Net income: the income retained after involuntary expenses are deducted from your gross income, such as taxes from a paycheck

Discretionary income: income that you have left after you have paid for all of your essentials, such as food and shelter

Expense: Any cash going out the door

Fixed expense: expenses that stay stagnant over time, such as rent, insurance and cable bills

Variable expense: expenses that you have a large degree of control over, such as dry cleaning, recreational activities and going out to eat

Debt ratio: total debt divided by total assets, determining solvency

Investment assets to total assets ratio: investment assets divided by total assets, degree which you are building wealth

Basic liquidity ratio: liquid assets divided by monthly expense, degree to which you can withstand shock to your income

Debt service to income ratio: annual debt payments divided by gross annual income, determining if you have too much debt for your income

Disposable income ratio: monthly non-mortgage debt divided by disposable income, the amount of your money being consumed by debts