There are three financial statements that you should look at each month to “take the pulse” of your finances, and make sure there are no irregular heartbeats that indicate your finances may soon be on life support. For personal fiance, and for the purpose of this site, these statements are simplified. Do your research to read about these in more details; especially if you have, or plan to have a business.
The first of these is your income statement, also referred to as a profit and loss statement, or simply the P & L. Income statements show your income, your expenses, and what is left after the expenses are paid (incomes minus expenses, or your net profit).
Even with high profits, your financial health can still be at risk. The balance sheet shows your assets and liabilities, from which you can calculate your net worth. Assets include the money in bank accounts, investments, computers, motor vehicles, etc. Liabilities on the balance sheet would be mortgages, other debts, etc. The value of your assets minus the value of your liabilities will give you your net worth.
Cash Flow Statements
The cash flow statement takes the net profit from income statement and accounts for changes in the amount of equity shown on the balance sheet. This lets you know what cash you have available for paying bills, debt, etc. For examples, if your income statement shows you made a $30,000 net profit last month, you would have to check the cash flow statement to know that your partner spent $50,000 on a lavish party, and that’s why you don’t have enough money to cover expenses this month. Cash flow statements track profits, but also how the money was used. It also shows cash draws and expenses, and lets you know what should be in the bank to cover future needs as they arise.
How Your Money Should Flow
This diagram below is an example of two income statements and two balance sheets.
The left side is the income statement and balance sheet for a person in the struggling middle class. This person’s only source of income comes from a job in the form of salary. This person has many liabilities but no assets, so the income will constantly go out as expenses to cover the liabilities. This person has a negative net worth.
The right side is the income statement and the balance sheet for someone who is on the path to financial freedom. This person has many assets and few liabilities, so there will always be more passive income than is paid out in expenses. This person has a positive net worth and is on the way to financial freedom.
While you may not need to know every nit-picking number at the drop of a hat, it would be nice to know your net profits, your net worth, and the cash available each month to truly know if your finance is healthy or sick.