Whether you’re just starting out and have a minimal net worth or are further along the path toward achieving your goals, your balance sheet and income and expense statement provide insight into your current financial status. You now have the information you need to examine your financial position, monitor your financial activities, and track the progress you’re making toward your financial goals. Let’s now look at ways to help you create better personal financial statements and analyze them to better understand your financial situation.
Keeping Good Records
Although record keeping doesn’t rank high on most “to do” lists, a good recordkeeping system helps you manage and control your personal financial affairs. With organized, up-to-date financial records, you’ll prepare more accurate personal financial statements and budgets, pay less to your tax preparer, not miss any tax deductions, and save on taxes when you sell a house or securities or withdraw retirement funds. Also, good records make it easier for a spouse or relative to manage your financial affairs in an emergency. To that end, you should prepare a comprehensive list of these records, their locations, and your key advisors (financial planner, banker, accountant, attorney, doctors) for family members.
Prepare your personal financial statements at least once each year, ideally when drawing up your budget. Many people update their financial statements every 3 or 6 months. You may want to keep a ledger, or financial record book, to summarize all your financial transactions. The ledger has sections for assets, liabilities, sources of income, and expenses; these sections contain separate accounts for each item. Whenever any accounts change, make an appropriate ledger entry. For example, if you bought an iPod for $250 in cash, you’d show the iPod on your balance sheet as an asset (at its fair market value) and as a $250 expenditure on your income and expense statement. If you borrowed to pay for the iPod, the loan amount would be a liability on the balance sheet, and any loan payments made during the period would be shown on the income and expense statement. You’d keep similar records for asset sales, loan repayments, income sources, and so on.
Keeping Good Records
Although record keeping doesn’t rank high on most “to do” lists, a good recordkeeping system helps you manage and control your personal financial affairs. With organized, up-to-date financial records, you’ll prepare more accurate personal financial statements and budgets, pay less to your tax preparer, not miss any tax deductions, and save on taxes when you sell a house or securities or withdraw retirement funds. Also, good records make it easier for a spouse or relative to manage your financial affairs in an emergency. To that end, you should prepare a comprehensive list of these records, their locations, and your key advisors (financial planner, banker, accountant, attorney, doctors) for family members.
Prepare your personal financial statements at least once each year, ideally when drawing up your budget. Many people update their financial statements every 3 or 6 months. You may want to keep a ledger, or financial record book, to summarize all your financial transactions. The ledger has sections for assets, liabilities, sources of income, and expenses; these sections contain separate accounts for each item. Whenever any accounts change, make an appropriate ledger entry. For example, if you bought an iPod for $250 in cash, you’d show the iPod on your balance sheet as an asset (at its fair market value) and as a $250 expenditure on your income and expense statement. If you borrowed to pay for the iPod, the loan amount would be a liability on the balance sheet, and any loan payments made during the period would be shown on the income and expense statement. You’d keep similar records for asset sales, loan repayments, income sources, and so on.
Organizing Your Records
Your system doesn’t have to be fancy to be effective. You’ll need the ledger book just described and a set of files with general categories such as banking and credit cards, taxes, home, insurance, investments, and retirement accounts. An expandable file, with a dozen or so compartments for incoming bills, receipts, paycheck stubs, or anything you might need later, works well. You can easily keep a lot of this kind of information in a computer spreadsheet—but if so, be sure to back it up from time to time. Also, keep in mind that a bank safe-deposit box is a great place to store important documents and files. Start by taking an inventory. Make a list of everything you own and owe. Check it at least once a year to make sure it’s up-to-date and to review your financial progress. Then, record transactions manually in your ledger or with financial planning software. Exhibit 2.5 offers general guidelines for keeping and organizing your personalfinancial records.
Tracking Financial Progress: Ratio Analysis
Each time you prepare your financial statements, you should analyze them to see how well you’re doing on your financial goals. For example, with an income and expense statement, you can compare actual financial results with budgeted figures to make sure that your spending is under control. Likewise, comparing a set of financial plans with a balance sheet will reveal whether you’re meeting your savings and investment goals, reducing your debt, or building up a retirement reserve. You can compare current performance with historical performance to find out if your financial situation is improving or getting worse. Calculating certain financial ratios can help you evaluate your financial performance over time. What’s more, if you apply for a loan, the lender probably will look at these ratios to judge your ability to carry additional debt. Four important money management ratios are (1) solvency ratio, (2) liquidity ratio, (3) savings ratio, and (4) debt service ratio. The first two are associated primarily with the balance sheet, the last two with the income and expense statement. Exhibit 2.6 defines these ratios and illustrates their calculation for Bob and Cathy Case.
Income and Expense Statement Ratios
When evaluating your income and expense statement, you should be concerned with the bottom line, which shows the cash surplus (or deficit) resulting from the period’s activities. You can relate the cash surplus (or deficit) to income by calculating a savings ratio, which is done most effectively with after-tax income. Bob and Cathy saved about 20% of their after-tax income, which is on the high side (American families, on average, save about 5% to 8%). How much to save is a personal choice. Some families would plan much higher levels, particularly if they’re saving to achieve an important goal,such as buying a home.Although maintaining an adequate level of savings is obviously important to personal financial planning, so is the ability to pay debts promptly. In fact, debt payments have a higher priority. The debt service ratio allows you to make sure you can comfortably meet your debt obligations. This ratio excludes current liabilities and considers only mortgage, installment, and personal loan obligations. Monthly loan payments account for about 20% of Bob and Cathy’s monthly gross income. This relatively low debt service ratio indicates that the Cases should have little difficulty in meeting their monthly loan payments. In yourfinancial planning, try to keep your debt service ratio somewhere under 35% or so, because that’s generally viewed as a manageable level of debt. Of course, the lower the debt service ratio, the easier it is to meet loan payments as they come due.
Your system doesn’t have to be fancy to be effective. You’ll need the ledger book just described and a set of files with general categories such as banking and credit cards, taxes, home, insurance, investments, and retirement accounts. An expandable file, with a dozen or so compartments for incoming bills, receipts, paycheck stubs, or anything you might need later, works well. You can easily keep a lot of this kind of information in a computer spreadsheet—but if so, be sure to back it up from time to time. Also, keep in mind that a bank safe-deposit box is a great place to store important documents and files. Start by taking an inventory. Make a list of everything you own and owe. Check it at least once a year to make sure it’s up-to-date and to review your financial progress. Then, record transactions manually in your ledger or with financial planning software. Exhibit 2.5 offers general guidelines for keeping and organizing your personalfinancial records.
Tracking Financial Progress: Ratio Analysis
Each time you prepare your financial statements, you should analyze them to see how well you’re doing on your financial goals. For example, with an income and expense statement, you can compare actual financial results with budgeted figures to make sure that your spending is under control. Likewise, comparing a set of financial plans with a balance sheet will reveal whether you’re meeting your savings and investment goals, reducing your debt, or building up a retirement reserve. You can compare current performance with historical performance to find out if your financial situation is improving or getting worse. Calculating certain financial ratios can help you evaluate your financial performance over time. What’s more, if you apply for a loan, the lender probably will look at these ratios to judge your ability to carry additional debt. Four important money management ratios are (1) solvency ratio, (2) liquidity ratio, (3) savings ratio, and (4) debt service ratio. The first two are associated primarily with the balance sheet, the last two with the income and expense statement. Exhibit 2.6 defines these ratios and illustrates their calculation for Bob and Cathy Case.
Income and Expense Statement Ratios
When evaluating your income and expense statement, you should be concerned with the bottom line, which shows the cash surplus (or deficit) resulting from the period’s activities. You can relate the cash surplus (or deficit) to income by calculating a savings ratio, which is done most effectively with after-tax income. Bob and Cathy saved about 20% of their after-tax income, which is on the high side (American families, on average, save about 5% to 8%). How much to save is a personal choice. Some families would plan much higher levels, particularly if they’re saving to achieve an important goal,such as buying a home.Although maintaining an adequate level of savings is obviously important to personal financial planning, so is the ability to pay debts promptly. In fact, debt payments have a higher priority. The debt service ratio allows you to make sure you can comfortably meet your debt obligations. This ratio excludes current liabilities and considers only mortgage, installment, and personal loan obligations. Monthly loan payments account for about 20% of Bob and Cathy’s monthly gross income. This relatively low debt service ratio indicates that the Cases should have little difficulty in meeting their monthly loan payments. In yourfinancial planning, try to keep your debt service ratio somewhere under 35% or so, because that’s generally viewed as a manageable level of debt. Of course, the lower the debt service ratio, the easier it is to meet loan payments as they come due.
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