Personal Financial Statements

It is common practice for businesses to prepare financial statements. This is because they need to get these financial statements audited. Once these statements are audited and found to be correct, they become an official record that can be used in loan applications as well as for tax purposes. However, since individuals do not need such statements for either obtaining a loan or for tax purposes, most people do not prepare personal financial statements.

However, preparing such statements can be of extremely helpful. This is because these statements convey important information about the financial health of a person. This is the reason why preparing personal financial statements is one of the habits which is inculcated during personal finance training sessions.

Corporate financial statements are composed of three statements, i.e., the income statement, the balance sheet, and the cash flow statement. On the other hand, personal financial statements are also composed of three statements. Here too, the income statement and balance sheet are prepared. However, the cash flow statement is replaced by the budget. In this article, we will have a closer look at all three types of financial statements as well as how they aid in making the right decisions.

Statement #1: The Income Statement

The income statement, as the name states, is a statement where the incomes and expenses of a person are listed down for a given period of time. The different sources from which a person earns income have to be mentioned in this statement. The common expenses are then to be listed out. The expenses which remain fixed from month to month should be mentioned separately. On the other hand, the expenses which vary from month to month should be segregated. This is because, from a control perspective, there is not much that can be done about fixed expenses. However, variable expenses can be monitored and managed each month. The manner in which repayment of loans has to be accounted for often creates some confusion. This is because some people believe that they should be removed from liabilities. However, adding them as an expense is a simpler approach. This is because the end result of the income statement is a surplus or deficit (not profit or loss). The surplus or deficit is then further carried forward to the balance sheet. It is important to note that the income statement represents activity only in a given month. At the end of the month, the balance resets to zero!

Statement #2: The Balance Sheet

The balance sheet is also quite similar to corporate balance sheets. However, the logic needs to be explained to individuals. On the asset side is the list of everything that a person owns. The valuation of the assets should be done on cost or market valuation, whichever is lower, keeping in mind the principle of conservatism. Similarly, on the liability side, a list of everything that is owed needs to be made. The same principle of valuation needs to be followed here. The end result after the list of assets and liabilities is called net worth. The surplus from each month gets added to the assets, and if it is a deficit, it gets added to the liabilities. The balance sheet should be analyzed for solvency issues. For instance, if a person has too many current liabilities, i.e., credit card bills, mortgage payments, etc., and not enough current assets, i.e., cash on hand, a person may be falling into a debt trap.

Statement #3: The Budget

Corporations also prepare budgets. However, their budgets do not form a part of the primary statements. Budgets are very important from an individual point of view since they can be used as a tool of control. When a budget is made, the format used is the same, i.e., income statement and balance sheet. However, instead of actual numbers being filled there, projections are filled in. The budget statement is forward-looking. Hence, if a person finds that their expenses for the month are going very high, then they can reduce some of their expenses in order to meet their savings goal.

Budgets can also be used as backward-looking statements for analysis purposes. The actual numbers incurred and the budgeted numbers can be displayed side by side. The variance between these numbers can then be calculated. The cause of this variance can then be zeroed down upon. This helps improve planning. If there is too much variance, then obviously, the planner did not take many things into account.

Why Create Personal Financial Statements?

Personal financial statements are important because of the age-old saying i.e. “what gets measured, gets managed.” When a person creates their own personal financial statement, they become aware of what their net worth is. They then set future goals and try to achieve the same. The exercise of preparing personal financial statements may be mathematical in nature. However, the intent behind the same is philosophical in nature. It is a tool which if correctly used, will motivate the investors to continuously bring their finances in better shape.

Also, the three financial statements form a feedback loop. Shortcomings in planning can be seen in the budget, and shortcomings in budgeting can be seen in the income statement and balance sheet. If the statements are not prepared and monitored, investors are likely to create plans which may not be grounded in reality and hence will be difficult to implement.