Ever wondered why organizations have financial statements? Companies take stock of all their sales, assets, expenses, and liabilities to determine their performance against set standards and then decide to either stick to their chosen strategic path or course-correct.
Organizations devote a whole department to financial planning, and CPAs are in short supply in the job market. Performance indicators such as profitability, liquidity, capital structure, and stock performance ratios are top of mind in boardrooms as crucial decisions are dependent on the results. If financial health is so important, why then is it not top of mind for us as individuals?
“Hold on Yeti are you asking me to create my financial statement and calculate my profitability ratio?”
Granted, I am asking you to take yourself very seriously at the moment. But just like companies, you will never be able to pin-point where your financial shortcomings are without a detailed analysis. Planning a financial strategy that is targeted at creating generational wealth is layered on a proper understanding of your current financial standing.
It seems daunting but I got you. Now let us simplify that marmot called a financial statement; there are four boxes.
- Liabilities and Equity
Revenue is a compilation of all your income, including your salary, commission, allowance, side-hustle, dividend, and other sources of income. Revenue never sits in the box, it moves immediately into the assets box, and it is considered cash or account receivable (AR). This is important as it shifts your way of thinking about income. When you think of it as an asset, then you know that assets are not spent but allocated. Allocation suggests budgeting; our chances for financial freedom is significantly slimmer without budgeting and forecasting (this is a topic for another day).
Expense is value consumed. Every asset that exits your pocket and never returns is an expense. If revenue equals incoming value, then expense equals outgoing value. The expense box is the box you have the most touchpoints with, hence the box that you need to be most strategic.
Your asset is the total value of your portfolio; Assets are a combination of cash at hand, future payment for services already rendered (account receivables), investment portfolios, education, rental properties, etc. In other posts, we will discuss how to multiply, invest, and secure cash from inflation, but in this article, we will keep it simple. As you itemize all your assets, also divvy them into current assets (an asset that is or can be converted to cash within a year – treasury bills, mutual funds, savings in fixed accounts, emergency funds) and long term assets.
NB: your inheritance is not an asset, until it has been given to you; “talking about my daddy has money” Is it your money.. lmao. I’m playing
Liabilities and equity speak about ownership; your liabilities are the parts of your assets that are owned by financial institutions (banks and money lenders) and account payable (money owed for service already consumed). Just like assets, divide your liabilities into current liabilities (liabilities that are due for payment within 12 months) and long-term debts
Equity, however, is the part of your assets that are owned by your shareholders. Your shareholders consist of you, friends, and family.
Build your Financial Statements.
Now that all the hard work is done let’s build your financial statement. The financial statements include three distinct but interwoven statements
- Income Statement: the income statement is constructed by taking away your expenses from your revenue, the variance is your net income (NI). Net income is an important indicator because it flows into the other two statements. If NI is positive, then good job my friend you did not spend more than you made within the set period. However, if it is negative, then you ran at a loss and your financial strategy needs to course-correct fast.
- Balance Sheet: the balance sheet shows the true picture of your total financial worth as it shows what you own and what you owe. The net income in the income statement shows up in the balance sheet as your retained earnings in the equity bucket.
Its that simple. We will discuss cashflow statement in subsequent posts so we can do it justice.
- This analysis shows the REAL you, it may be tough to look at but its the first step to financial freedom
- Your net income indicates to you if you need to increase revenue (income) or if you need to reduce expenses. Even when net income is positive, is it positive enough to increase your equity significantly and build generational wealth rapidly.
- Do not misconstrue assets for equity. Equity is your REAL worth, it is what belongs to you, while your asset is what is controlled by you. For instance, If you own a home that is valued at $350,000 and you have a $250,000 mortgage left to pay on it. Then your asset value is $350,000, and your equity is $100,000, so you are sharing ownership of that house with your lender. We would explore the importance of understanding the difference between assets and equity when we talk about investment strategies and leverage.
- I like to see retained earnings as the growth on my equity for the period, so if my retained earning is a negative (aka NI was a loss). Then there is a shrinkage in equity because that loss needs to be taken either from existing assets or new debt will be created as the piper always has to be paid. This is where people dig themselves into credit card debt holes as it is a debt that is easily accessible.
- Think about your liability to equity conversion; this is as I mentioned in my previous post paying your debts fast. The goal is to move your debt to equity ratio towards zero
- Take some time to create your financial statements to determine your financial health; I have a template that I can share with you that would help simplify this process if you subscribe. Are you surprised by what you see?
- Now that you have the data about your financial health, join me next week as I analyze the company called YOU and deep dive into all the performance ratios that will give you insights into your financial posture and what strategies are recommended to rectify your situation.
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