“It is better to have a permanent income than to be
fascinating.”
Oscar Wilde
I. Introduction
Most people’s biggest financial
problem is their lack of financial education. In this blog, my intention is to
share all the knowledge I’ve acquired in the last five years through personal
experience and the study of financial books so you don’t have that problem. In
fact, I can guarantee that if you read this blog you won’t have that problem
although you might have other ones since knowledge alone does not lead to
wealth. What we do with the knowledge we acquire is what really makes the
difference between failure and success.
This will be the most important
post so far because I will deal with financial statements which are the base of
financial knowledge and success. In fact, until you can write and read
financial statements, you don’t really understand how money works. Fortunately,
this will no longer be a problem for you, since this post, if I do my job
right, will teach you how to read and write financial statements.
II. Income Statement
A basic personal financial
statement has two main parts, and each part is divided into two columns. The
first part is the income statement, which is something most people are somewhat
familiar with. An income statement has two different columns: the income column
and the expenses column.
Your income column is composed of
all the money you make every month. For the average poor or middle class
person, this column will only have one item: his or her salary. This is
because, for the vast majority of people, their income is equal to their salary
or some other form of active income. For liberal professionals such as lawyers
or doctors, their income might actually be a sum of fees paid directly to them
by their clients. For sales people, their income will usually be the sum of a
base salary and the commissions they were able to earn that month. All these
types of income are active income, which makes up the totality of most people’s
income altogether.
However, if you read the last
post, you know that there are two essential types of income: active income and
passive income. Most rich people will have both types of income in their income
column and some will only have sources of passive income and no active income
at all. There are several possible sources of passive income: rental properties
will produce income in the form of rent. Stocks and bonds will provide you with
dividends, usually on a quarterly basis. Business owners receive income
generated by their businesses. Both active and passive forms of income are good
since they put money in your pocket, the difference is that you don’t need to
work for passive income.
The second column in an income
statement is a lot less pleasant. Everyone is familiar with this column to some
extent, they just aren’t accustomed to put it into writing. I’m talking, as you
might have already guessed, about the expenses column. Everyone has expenses.
Usually, those expenses come in the form of accommodation, clothing, food,
leisure, transportation, utility bills, communication and other life expenses.
Each of these different expenses should constitute an item in your expenses
column and the sum of all of them will constitute your total expenses figure.
After you have exact figures for
your total income and your total expenses, you can see how well you’re doing
financially by determining your cashflow. Your cashflow is essentially how much
money comes in or out of your pocket each month. You’ll always want to have
positive cashflow, that is, more money coming in than going out. Cashflow is the most
important word in personal finance, so always keep it in mind.
People generally associate
a large income with great financial success but this is incorrect since what really
matters is not how much you earn, but how much you keep at the end of the
month. If you only look at someone’s income column you’re only getting half of
the picture. If you want to draw any meaningful conclusions about a person’s or
a company’s finances, you really need to look at the whole picture. Remember, an
income statement is composed of two columns: income and expenses. It is only
when you compare the two that you understand if someone is financially successful
or not.
If you want to be financially independent you have to stop thinking as most people
do. Most people tend to react to an increase in their income by increasing their
expenses proportionally. As a result, their net income (total income – total expenses)
tends to remain always dangerously close to zero. As a matter of fact, in some cases, people’s net income decreases even if their income increases. That’s
because the more money they make the more willing they are to spend a lot of
money in unnecessary things like big houses, expensive cars and luxurious
consumer goods.
A financially savvy person, on
the other hand, knows that cashflow is king. That person is always looking
straight at the net income figure (total income – total expenses). Almost no one
becomes truly wealthy by just producing a great income. In order to become
wealthy one needs to produce a considerable positive gap between income and
expenses. Make a lot of money and spend a lot less money than you make. Save
and invest the difference. That’s the formula for success and that’s how you
have to shape your income statement if you’re serious about becoming
financially independent. You don’t want to look rich by having a Porsche and
living in a huge house. You want to be financially free and never have to work
on something you hate ever again in your life.
III. Balance Sheet
As important as the income
statement is, however, it is certainly not the whole picture. Actually, it is
only half of the picture. The other half is called a balance sheet and, just
like the income statement, it is divided into two columns: the asset column and
the liabilities column.
Let’s begin with the asset
column. In last week’s post I already talked about assets and explained why
they are so important. In fact, assets are essentially like money-making machines
since they create passive income for you. As Robert Kiyosaki would say, assets
put money in your pocket. Examples of productive assets are: real estate,
stocks, bonds or private businesses. Hopefully, those assets will be producing
money for you on a monthly or quarterly basis.
Assets, however, can also be of a
non-productive variety. That type of asset won’t necessarily put money in your
pocket, but they possess a certain market value. In other words, you can
still sell non-productive assets if you wish to do so and receive a
considerable amount of money in exchange for them. Examples of non-productive
assets are: precious metals and stones, commodities such as oil or natural gas,
raw land or even currencies such as dollars, euros or British pounds. These
assets, even though they don’t put money in your pocket on a regular basis, can
be sold at any time in exchange for money. As a result, they contribute to increase
your total assets value, which is the sum of the value of all your assets
(productive and non-productive) combined.
Your liabilities column, on the
other hand, is an inventory of all of the things you owe. It’s a picture of your debt to others. Examples of liabilities
are: private debts, credit card debts, mortgages, consumer debts, car loans or
tuition fee loans. As a general rule, you want to have as few debts as possible
because debts usually have to be paid sooner or later, and that means money
coming out of your pocket. In other words, whereas assets tend to increase your
income, debts (liabilities) tend to increase your expenses. There are, of
course, some exceptions to this rule, since some types of debt are good.
However, most debts are bad, and those are generally the debts most people
have. Generally, all the following types of liabilities are bad and should be
avoided: credit card debts, consumer debts, car loans, boat loans and private
debts such as asking money to friends and relatives. There are debts that might
be desirable at times, debts that actually put money in your pocket, but that
will be the subject of another post.
For now, let us establish that,
as a general rule, one must accumulate as many assets as possible and contract
as few debts as one can. The objective is to achieve a great total assets value
and have a small or inexistent total liabilities value. The final and most
important number in a balance sheet is what we call net worth, which the total assets value minus the total liabilities value.
Essentially, the higher that number is, the richer you are.
IV. Conclusion
So now that we’ve covered the
different sections of a personal financial statement, I believe we are in a
good position to track the essential elements that lead to durable wealth
building and financial independence. At first sight, one may conclude that the
most important part of a financial statement is the income statement. After
all, everyone’s primary concern is to pay for one’s key monthly expenses, such
as accommodation and food, and the way to do that is to generate enough monthly
income. However, things get a bit more complicated, and a bit more interesting
I might add, when we start looking deeper into the nature of income.
Even though active
income is mostly unrelated to one’s balance sheet, this is definitely not the
case of passive income. In fact, there is a very intimate connection between
one’s passive income and one’s asset column, since one’s passive income is
entirely generated by one’s productive assets. Therefore, we must conclude that
the more and better productive assets one can accumulate, the higher passive
income one will be able to generate. This establishes, to a considerable
extent, a relation of cause-effect between balance sheet and income statement.
Thus, if one wishes to achieve financial independence, one must acquire enough
productive assets in order to generate a sufficient passive income. This, I
believe, is the path to financial freedom and it requires at least some
knowledge of personal finances as you can see.
As a way of concluding this
essay, I want to direct you to some easily accessible resources that will help
you understand these concepts more clearly and in more depth. Firstly, I want
to recommend that you read Robert Kiyosaki’s seminal book
Rich Dad, Poor Dad. I’ve
already recommended that book before but if you still haven’t
read it you absolutely must if you’re serious about becoming financially
independent or even just financially literate. If you like this essay, you will
like that book even more! Secondly, and perhaps most importantly, I want you to
play Robert Kiyosaki’s board game, which is called
Cashflow. You can
easily play it online and you can do so completely free of charge. I’ve played that game dozens of times and I
emphatically suggest you do the same. The game is a simulation of real life and
it’s a great opportunity for you to learn and use the concepts outlined in this
essay in a fun and intuitive way. Trust me, after playing the game a dozen
times you will become very familiar with essential concepts such as income
statement, assets, liabilities, passive income, cashflow and so on. The goal of
the game is to generate enough passive income to cover all your monthly
expenses. In other words, you win the game by becoming financially independent.
As we have seen, you achieve that by building your assets column.
I think you now have
a roadmap to financial freedom, it is your job to use it to get there!
Online Resources:
- Cashflow game:
www.richdad.com/apps-games/cashflow-classic
- Podcast on Balance Sheet:
www.getricheducation.com/project/52-building-you-how-much-are-you-worth/
- Podcast on Income Statement:
www.getricheducation.com/project/53-building-you-whats-your-income-and-cash-flow/
