Every publicly listed company prepares financial statements for shareholders to evaluate how the company is performing. Similarly, we should prepare financial statements for ourselves and analyze them to determine how we are performing financially.
Most people consider net worth, the equivalent of a company's book value, the sole indicator of wealth. I believe, however, net worth is an incomplete measure of wealth. Does any reputable financial analyst determine a company's financial performance by its book value alone? No! Book value is a starting point, but it does not tell the whole story.
Here, I propose how you can prepare and structure your financial statements similar to the way a company does it. I am not sure whether others have suggested this before, but because of my interest in finance and investing, I am thinking of better ways to structure and analyze my personal financial statements.
Income statement
Your income statement states all your incomes and expenses, split into 5 lines: revenue, operating expenses, operating income, income and expenses from non-operating activities, and net income.
1. Revenue: Gross incomes from your job (salary and bonus) and your business.
2. Operating expenses: Expenses that you need to operate your day-to-day life. They can be split into several of subcategories:
- Non-discretionary expenses: Expenses that you cannot live without, such as food, groceries, medical care, transportation, utilities, etc.
- Discretionary expenses: Expenses that you can live without, such as books & subscriptions, clothes, entertainment, social, vacation, etc.
- Insurance expenses: Life insurance, health insurance, home insurance, car insurance, etc.
- Interest expenses*: Mortgages, car loans, student loans, credit card debts, etc.
- Income taxes: Federal income tax, state income tax, Medicare, social security, etc.
- Residential property taxes: Property tax, land tax, etc.
- Tax adjustments for operating activities: Tax deductions, tax credits, etc.
3. Operating income: This is the income you have left after deducting all your day-to-day expenses, calculated by subtracting operating expenses from revenue. If this figure is negative, you are in deep trouble! You need to start making changes now! Maximize your operating income by maximizing your (revenue) incomes and minimizing your (operating) expenses and taxes.
4. Non-operating income (expenses): Non-operating activities may produce incomes and expenses that do not related to your day-to-day life, such as those relating to your investments or extraordinary transactions.
- Investment incomes: Cash distributions from your investments, such as savings and bond interests, stock dividends, mutual fund distributions, and rental/lease income from real estates.
- Realized investment gains (losses): Gains or losses on the sale of investments, net of accrued unrealized gains and losses and accrued deferred taxes.
- Unrealized investment gains (losses): Paper gains or losses on investments you still hold, net of deferred taxes.
- Investment taxes: Capital gains tax, dividend tax, property tax, land tax, etc.
- Tax adjustments for non-operating activities: Tax deductions, tax credits, etc.
- Extraordinary incomes (expenses): Everything that you do not expect to happen in your day-to-day life, such as inheritance, lottery, robbery, or fraud. Please don't put "vacation" or other day-to-day expenses here - you have no one to fool but yourself.
5. Net income (earnings): Calculate your net income (earnings) by adding non-operating income to and deducting non-operating expenses from your operating income.
Please remember that this income statement is for you to keep track of your financial progress and analyze your financial situation. Your budget should be structured more traditionally to resemble cash flow, with income at the top, followed by employer deductions, then all the expenses that you pay out-of-pocket at the bottom.
Balance sheet
Your balance sheet will state all your assets and liabilities, split into 8 lines: current assets, non-current assets, total assets, current liabilities, non-current liabilities, total liabilities, equity, and total liabilities & equity.
1. Current assets: Assets than can be liquidated and used within a short period of time.
- Cash: Cash that you can easily access, including money in your wallet, car, and bank accounts (savings, checking, and money market accounts).
- US Treasury bonds: Bonds (I bonds and EE bonds) you have owned for more than 5 years; they can be redeemed without penalty.
- Accounts receivable: Money that you lend to family, relatives, and friends that you expect to be repaid within 12 months. It is your call whether to call the loans assets or expenses.
2. Non-current assets: Assets that are more difficult, or take more time, to liquidate.
- Home equity: Equity in your primary residence (not investment properties). Unless you are broke, it's unlikely that you will sell your home to use the equity.
- Business equity: Equity in your privately-held business. You probably won't sell or liquidate your business unless you receive a very good offer or unless it becomes absolutely necessary to do so.
- US Treasury bonds: Bonds within 5 years of purchase. You cannot redeem bonds within 12 months or purchase. Within 5 years of purchase, you may redeem the bonds but will be charged a penalty for early redemption.
- Marketable securities: Bonds, stocks, and mutual funds. While marketable securities can be liquidated easily and rapidly in case of an emergency, you should treat them as long-term investments.
- Retirement accounts: Your 401(k), IRA, Roth IRA, RRSP, Superannuation, KiwiSaver, etc. You cannot withdraw your retirement funds until retirement age. Exceptions may be made for some accounts, but I do not recommend using your retirement fund unless you are retired.
- Real estate investments: Real estate investments are more difficult and time consuming to liquidate.
3. Total assets: Sum of your current assets and non-current assets.
4. Current liabilities: Liabilities that you should pay off within 12 months.
- Credit card debt: All your credit card debts are due at the end of each month. The minimum payment is a form of financing. If you manage your money well, you should not be required to finance with credit card debt.
- Consumer loans: Eliminate these if possible. They are expensive and you don't need them.
- Current portion of long-term debts: The portion of long-term debts due within 12 months.
- Accounts payable: Money that you borrow from family, relatives, and friends. Be sure to repay them. Don't ruin your relationships for money.
5. Non-current liabilities (long-term debts): Liabilities that you will hold for more than one year.
- Mortgages.
- Student loans.
- Car loans.
6. Total liabilities: Sum of your current liabilities and non-current liabilities.
7. Equity (Net worth): Deduct total liabilities from total assets.
8. Total liabilities & equity: Sum of your total liabilities and your equity. This will equal to your total assets (thus the "balance" in "balance sheet").
Statement of cash flow
Your statement of cash flow shows you how cash flows through your life. It is used reconcile your income statement and balance sheet, and you can use it as a check for inconsistencies and errors.
1. Cash flow from operating activities: This is your net income. No adjustments should be necessary, unless you have non-cash operating income or expenses.
2. Cash flow from investments activities: Adjust your cash flow for:
- Accrued deferred taxes for realized gains and losses on investments.
- Unrealized gains and losses on investments, net of deferred taxes.
3. Cash flow from financing activities: Remember that "interest expenses" in your income statement do not include principal repayments. You need to adjust your cash flow for the borrowing and principal repayments of debts.
4. Net change in cash: The net change in cash should equal the change in your cash from the previous year.
Notes to financial statements
You need to make all kinds of decisions, assumptions, and estimations when you do accounting. Be sure to note all the decisions, assumptions, and estimations made for each line in your financial statement - you will forget why you made them by the time you review your financial statements next year.
I hope this "new" method of preparing and structuring your financial statements will help you get a better picture of how you are performing financially. The way I classify accounts is by no means definitive - you can modify things to the way you think will represent your financial situation most accurately (that's what financial accounting is supposed to do). Comments and suggestions on my proposed method are welcomed. I am not an accountant, so if you spot a problem, please let me know.
I will discuss how to analyze and interpret on your financial statements in the next post. Stay tuned!
Update: I tried to prepare my financial statements using the structured I proposed above. I found the Quicken reports are poorly structured to help me prepare my financial statements. I have not begun trialling GnuCash because it uses double-entry accounting, as normally used by businesses.
Related posts:
- Analyzing your financial statements.
- How are you performing financially?
- Keep track of your financial progress.
- Maximize income.
- Minimize expenses.
- Minimize expenses (revisited).
- The principles of wealth accumulation.
References:
- US SEC - Beginners' Guide to Financial Statements.
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