Everyone remembers back when they were in school, and they had to bring their report card home to their parents. All the adults in your life, or at least your teachers, told you that it was of upmost importance that you kept at least A’s and B’s. Even as I am finishing up my college degree, I am noticing how little the real world actually cares about your grades. As I talk to my academic advisors about possibly going to grad school, I am told how graduate admissions will look at my research experience before they look at my transcripts. Yes, you need to keep your grades up to keep scholarships, but even academics place experience over grades. Also, with the majority of people not in academia, a person’s financial statement is the most important “grading” scheme you can have because it is shows a “bad grade”, your life will probably be very stressful and suck.
The Financial Statement
This is where the financial statement comes in. Your financial statement is like your report card on life, but it actually matters. This is the main thing banks will look at if you want to take a mortgage out on a house. A financial statement shows how stable a person or entity is financially.
Individuals, companies, and even sovereign nations, all have financial statements. Granted, they will have different terms to describe things. I would be extremely surprised if you had Gross Domestic Product on your personal income statement. Nevertheless, the concepts are essentially identical.
Income
The income section of the financial statement is self-explanatory. This is the part that everyone is familiar with as this is where your paycheck shows up. This is the section that is filled with the money that goes into your pocket or bank account. It could come from a job as with most people, dividends from stocks, rent collected from rental real-estate you own, amongst other things. It is rather difficult to come up with a reason why increasing the amount of income sources you have would be a bad thing.
Expenses
Expenses are all the bills that you pay and the things you pay for to survive. This is where your groceries, phone bill, as well as car payment and mortgage payments will show up. Having a high amount of expenses is not necessarily a bad thing, as long as you have the income to pay for it.
The Income Statement of the Financial Statement
The income and expenses sections together comprise of the Income statement. The income statement shows you how your money is coming in and going out every month. When you subtract your expenses from your income you can see your cashflow.
Cashflow is king. It is cashflow that exhibits whether a person is financially stable. If it is a positive number, then you have more money flowing into your pocket then out. On the other hand, if it is a negative number, then you have more money flowing out of your pocket. It does not take a rocket scientist to see which is the more beneficial scenario.
Now, what you do with this cashflow is what determines your lifestyle. This discussion will be saved for a later post where I will show you how all this ties into your lifestyle and why some people become rich over time and others become poor, even with identical situations.
Assets
The assets section is where there are a lot of misconceptions. This is really one section and the subsection labeled “fake assets” is not an actual section, I just put it there to make a point. A true asset is something that puts money in your pocket. It is really that simple. A must-read book for this is Rich Dad Poor Dad by Robert Kiyosaki. This book will lay the foundation on which you will grow your financial education. It would be extremely hard for me to believe that a person who is truly financially educated has not read this book, or at least heard of it. It is that important.
By knowing that assets put money in your pocket, this section will hopefully make more sense. Your personal residence is not YOUR asset. It is the banks because you are paying the bank. Your personal residence is taking money out of your pocket and therefore it is not an asset. The vehicles you own are also not your asset. In this case they are the banks asset because if you do not pay them back, they can take them and sell them.
However, it is possible to make them an asset. You may have to get creative. For example, you can put advertising decals on your car , and if that pays you more than you spend on your car, then you have made your car an asset. On the other hand, if you start delivering pizza or driving for uber, your car is still a liability. You are having to work for the money, the car is not generating it on its own. At least with the advertising decals you are receiving income without adding extra driving on top of what you normally would.
Why is it fake?
Probably the biggest confusion with this is with real-estate. As stated above, your personal residence is not an asset, but rental properties that you own are. Now you hopefully will have mortgages on those rental properties, as it does not make sense from an investing standpoint to not. So, if you own both of them and have a mortgage on both why are they different?
They are different because you are being paid from the rental property and it is with the money the tenet gives you that you pay the mortgage as well as all the expenses and hopefully have some left over. When I brough up this concept with someone that I am close to, she argued that her equity in her house was an asset.
The equity in your personal home is not an asset of yours because that is money that you have already paid the bank. It does not add any money to your pocket that was not already there in the first place. However, equity on your rental property is your asset because it is the money that the tenet essentially paid the bank, but if you sell or refinance the house, YOU get to keep it. That is why rental property is an asset and your personal residence is not.
Liabilities
Now that we know what a true asset is, it should not be difficult to see that liabilities are the opposite. Liabilities take money out of your pocket. This is where your personal residence and vehicles should show up on your balance sheet. This is for the financial statement that is only for you to see how you are personally fairing financially.
If a bank or some other entity requests your financial statement, put your personal residence and cars in the asset’s columns. This is because we are looking at your financial statement in a different context. The bank wants to see that they will be paid back in some way. So, for all intents and purposes, have two separate financial statements, one for only you to gauge your personal situation, and an official one that you show the bank.
The Balance Sheet of the Financial Statement
The assets and liabilities sections together make up the balance sheet. By subtracting the value of all your liabilities from the value of all your assets, you can see your net worth. For successful people, this is generally the longer part of their financial statements. Life-long financial success is maintained by creating income producing assets that will pay you whether you work or not. Those who are successful become successful because this is where they focus their efforts.
Everyone wants the buy the nice cars and the huge houses with lots of land. That requires a lot of income. If you must work at a job for all that income, you will not have the time to spend at that huge house or driving that nice car. You need to build up the asset column so that your assets will pay for the liabilities. As long as the asset produces more than the liabilities take away, you will see a positive impact on your income statement.
Conclusions
For some reason everyone is obsessed with net worth. Net worth is important, but not nearly as important as cashflow. If you own a Ferrari but you cannot pay your bills, you have a high net worth but a negative cashflow. You will probably lose your Ferrari very quickly. However, if you focus on creating positive cashflow that covers all your expenses, then you are stepping closer to being financially free.
Financial freedom is when you can pay all your expenses from the cashflow received from your income producing assets alone. This means that you do not need to have a job to pay all your expenses, and you are free to do as you please. At least for me, that is a major goal. It is not my end goal, but it is a major milestone because once you are financially free, you have complete access to the most valuable asset that you could ever own, you time.
To your wealth and future,
James Forsythe
Below is a preview of Rich Dad Poor Dad from Amazon. You can get the mass market paperback for less then $10. It is definitely worth it for all of the information that is inside.
https://www.amazon.com/Rich-Dad-Poor-Teach-Middle/dp/1612680194
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