Sid Roy
I had intended to write this article a while back during the tax season and then some personal events derailed that plan. Now, it is the end of the financial year for many companies in US. And I again got inspired to write about this topic. As the earnings from the companies roll in, I got reminded of an important lesson to be drawn here.
Every well-run company sets some goals and measures its progress throughout the year with quarterly statements of its financial health and future prospects. Based on Wikipedia, the main and relevant parts of the statement are below:
- A balance sheet or statement of financial position, reports on a company’s assets, liabilities, and owner equity at a given point in time.
- An income statement—or profit and loss report (P&L report), or statement of comprehensive income, or statement of revenue & expense—reports on a company’s income, expenses, and profits over a stated period.
- A cash flow statement reports on a company’s cash flow activities, particularly its operating, investing and financing activities over a stated period.
Just like the companies, it makes a good deal of sense to report to ourselves on a regular basis how we are doing. Ok, every quarter might be a bit too much for everyone but may be once a year it is very achievable.
Now, I know some of you might be thinking what I thought first. The companies have an army of people to pull all of that together. We do not have people, nor do we have time. The tax season was on us at that time, and I realized one thing. In many ways, we do all the work every year for Uncle Sam when we file taxes. With a few additional tweaks, we can make our tax returns into our very own financial statement. I wanted to share how I did it with a few of my friends this year and hope you might find this useful too.
First, let us identify what are the key elements of your personal financial statement. Just like the companies, those are:
- Gross Income
- Net Income
- Expenses
- Cash flow
- Net worth
- Unrealized Investment Gains (Losses)
There are many other things that make up a financial statement, but we can focus on the main essentials. Now let us get into how you arrive at each of the above easily and what to make of the figures.
Gross Income – this is your gross income throughout the year. The easiest way to get to this gross income is from your tax return. This includes income from every source – wages, capital gains, dividends, CDs, etc.
Net Income – this is your gross income less taxes. This is really the amount that you have in hand to pay for any expenses or investments.
Expenses – this includes all the expenses you had throughout the year. Most of us have a bank account or two from which we pay all our yearly bills. Every bank provides a yearly statement of accounts. All that you have to do is to get the total of all debits from all of these bank accounts for the year.
Cash flow – you can assess your cashflow on an average at a monthly level. This is how much cash was available after subtracting all income from all expenses in any given month. It is enough to sample for the lows over the year. This one needs a bit more work beyond your taxes to calculate at monthly level. If you have found yourself short of cash a few times in the last few years, it is absolutely worth doing.
Net Worth – this is the sum total of all your current assets minus debts.
Unrealized Investment Gains (Losses) – this is the sum total of all your investment gains and losses for the year.
It is helpful to do this exercise for at least the last three years to get a more complete picture.
Now that you have gathered the basic elements of the financial statement, there are some questions to ask. Before you begin this whole exercise, take a guess on each of these below. It is always interesting to see how off-base we are sometimes on this.
- How has your income grown over the same period?
- How has your expenses grown over the same period?
- How has your cashflow changed over this period? Uneven cash flow creates risks.
- What percentage of your net income is being saved over this period?
- What is the growth rate of your net worth?
- Do your expenses over the last 3-5 years surprise you? If so, where did the surprise come from?
Finally, to get an even better handle on where things stand, compare yourself with others in the same situation. The US government publishes a wealth of data outlining income, expenses across various demographics.
So, what are the key takeaways? Assess with a few simple calculations where you are and consider if there is a problem to fix. Are my expenses are too high? Am I earning too little? Am I growing my net worth according to my expectations?
Since we come from the world of software, a software analogy seems appropriate. In software, there is concept of scrum – where you visibly inspect the progress you have made in your deliverables on a regular basis. It is the same concept as public companies reporting their income every quarter. And guess what? It is remarkably effective and practiced everywhere in the world. You should also try this out and get to better outcomes.