Do You Really Know the State of Your Finances?
Every household, no matter how large or small, is its own business.
Like a business, a household has assets, liabilities, income, and expenses. And like a business, every household has various financial statements that explain the relationship among them.
Without a financial statement, you don’t really know where you are in life’s financial game. Like it or not, money tells the score of your “game,” and a financial statement is your scorecard.
I often hear, “I don’t want to learn about accounting. I’m not interested in keeping an updated financial statement.” When I hear comments such as these, I agree that it is a person’s individual choice to learn what they choose to learn.
At that point I often repeat a saying from rich dad, “Accounting leads to accountability.”
In other words, one of the benefits of studying accounting and continually striving to improve your financial statements is that the process improves your accountability to yourself. And being accountable to yourself is the price you need to pay if you really want to become rich.
After I lost my first business, my rich dad said to me, “When your car is broken, you take it to trained professional mechanics and they fix your car. The problem with your financial problems is that only one person can fix those problems, and that person is you.”
Explaining further, he said, “Your financial situation is much like your golf game. You can read books, attend seminars, hire a coach, and take lessons, but ultimately, only you can improve your golf game.”
One of the reasons so few people attain great wealth is because when people get into financial trouble, they don’t know how to get out of trouble. No one has ever taught them the basics of how to diagnose the particular financial problem they may be in. As a result, although people may know they are in financial trouble, they don’t know how to read a financial statement or how to keep accurate financial records, so they don’t know how serious their financial problems are or how to fix them.
Facing my ruined financial statement was a painful experience. Yet facing my problems was the best thing I could have done. Rather than wasting time pretending I had no problems, I faced my financial statement and my problems and found out exactly what I did not know, as well as what I needed to learn in order to fix my financial situation.
By taking a cold, hard look at the numbers and learning what they mean, you’ll be better positioned to assess your financial position and identify where changes can be made. Numbers are like words. Learn to read them, and you’ll grasp the story.
Learn to read and analyze them, and you’ll be able to change the plot to your liking…
Key Ingredients to Managing Your Money
If you really want to manage your money, you need three key ingredients:
- A financial statement to know where you are financially.
- Personal discipline.
- A game plan that’s going to take you where you want to go.
Is it difficult to change your habits? You bet it is. It depends on you, and how eager you are to take control of your financial life.
What Is a Personal Financial Statement?
A personal financial statement is a tool that provides a quick snapshot of your finances at a certain point in time.
Different people look for different things on a financial statement. A financial statement is like reading the story of a person’s life. It shows how financially smart or financially ignorant a person is with their money.
The document consists of three primary components:
- The income statement.
- Balance sheets
- The statement of cash flow.
The Income Statement
The income statement consists of two parts:
Income (money flowing in), and
Expenses (money flowing out).
All income that flows into your household flows through the income column of your income statement. When I look at an individual’s financial statement, I can usually tell if the person is going to be rich, poor, or middle class, just by looking at the income column.
This includes all three types of income:
Ordinary earned income is any money that you work for including your wages, tips, salaries, and commission from your job or business.
Portfolio income includes profits from any investment sales. These capital gains can come from the sale of stocks, businesses, and real estate.
Passive income is income from rental properties, limited partnerships in which you invest money but are not actively involved, and other similar enterprises. Passive income can also come from interest on savings accounts, bonds, certificates of deposit (CDs), stock dividends, patent royalties from inventions, and royalties from books, songs, and other original works.
When managing your money, it’s important to note that each of these types of income is taxed at a different rate. Ordinary income is taxed at the highest level. The government takes the biggest chunk from the money you work so hard for in your job or business.
Portfolio income is taxed at a lesser rate. Passive income is taxed at the lowest rate. When you invest for passive income, your money is working for you, plus you get to keep more of that money since it will be taxed at a lower rate.
Next, we have the expenses section of your personal financial income statement. This section consists of anything you pay out each month, including such things as your mortgage payment (or rent payment), car payment, student loans, food, car and gas, utilities, insurance, clothes, eating out, medical bills, and so forth.
When listing your monthly expenses, you might be tempted to leave off smaller expenses such as your Netflix or gym memberships. Remember, the purpose of completing a personal financial statement isn’t to compare yourself to your neighbors. The value is discovered by understanding the facts about how much you make and spend each month.
The Balance Sheet
Where the income statement lists how you make your money, the balance sheet gives you a snapshot of what you own and owe. The balance sheet consists of:
Assets (things that put money in your pocket), and
Liabilities (things that take money out of your pocket).
The Rich Dad definition of an asset is not the definition you’ll hear from your traditional accountant.
The conventional accountant will tell you that an asset is “something of monetary value that is owned by an individual or company.” By that definition, your vacuum cleaner and your everyday dishes could be considered assets!
Most accountants go crazy with this definition because they want to classify your shares of stock, your jewelry, your residence, your cars, and your mutual funds as assets. To me, none of these things have any value until the day you sell them.
Instead, here’s the Rich Dad definition: An asset is something that puts money in your pocket, whether you work or not.
Again, I go to battle with the traditional definition of a liability. Most accounting professionals will tell you that a liability is “an obligation to pay an amount you owe to creditors, be it an individual or an organization.”
My definition begs to differ: A liability is something that takes money out of your pocket.
One of the main reasons so many people are in financial trouble is because they refer to their liabilities as assets. In today’s financial crisis, millions of people are finding out their homes are not assets
The biggest fight I get into when I tell people your home is not an asset. We received a lot of flak for that, especially when times were booming and people were taking out loans against their homes, sometimes two or three times.
It wasn’t until the real estate market crashed back in 2008 and people found out that they owed more on their house than it was worth before they started to understand their home was not an asset. If you haven’t suffered through this experience personally, then please take my word for it — you don’t ever want to be in this position.
Why Your Financial Statement Is Important
As my rich dad said, your financial statement is your financial report card. It’s a reflection of your financial IQ.
The problem is that most people leave school not knowing what a financial statement is — so they are more likely to have an F on their financial report card. A person can go to great schools and get straight As on their academic report card but be a financial failure in terms of their financial statement.
You won’t know where you stand on your pathway to financial freedom until you face the facts…
Play it smart,
Editor, Rich Dad Poor Dad Daily