Blog | Personal Finance

Managing Your Money Begins With a Personal Financial Statement

Learn how to read and create a personal financial statement to properly budget your finances

Do your palms begin to sweat simply reading the title of this post? Honestly, it’s pretty common. We’ve been conditioned to think that you need to be an accountant or have a finance degree to make heads or tails of simple financial statements. But that’s simply not the case. In reality, you just need to start by understanding the basics of managing your money (income, expenses, assets, and liabilities) and which items get categorized under each (hint: forget everything you’ve ever been taught before).

Why do you need to bother learning this? Because, in the world of financial education, there are fundamental principles that are impossible to omit when we’re talking about money and investing. These conversations always begin with the personal financial statement.

What is a personal financial statement?

A personal financial statement is a tool that provides a quick snapshot of your finances at a certain point in time. The document consists of three primary components:

1. the income statement and balance sheets

2. the statement of cash flow.

For most people, those terms may be unfamiliar to you. That's fine, we'll explain them in greater detail below. However, if you are familiar with these documents, then you’ll quickly notice that the personal financial statement template shown below is not your traditional personal income statement. That’s because we like to keep things simple but complete.

How to read a personal financial statement

To properly fill out a personal financial statement, a small investment of time is required to understand the terminology. But don't worry, you'll be brimming with confidence in no time.

The Income Statement

The income statement consists of two parts:

1. Income (money flowing in), and
2. Expenses (money flowing out)

Income

All income that flows into your household flows through the income column of your income statement. This includes all three types of income:

1. Ordinary earned

   Any money that you work for including your wages, tips, salaries, and commission from your job or business.

2. Portfolio

   Portfolio income includes profits from any investment sales. These capital gains can come from the sale of stocks, businesses, and real estate.

3. Passive income

   This is income from rental properties (you know my mantra: cash flow is queen!), limited partnerships in which you invest money but are not actively involved, and other similar enterprises. Passive income can also come from interest on savings accounts, bonds, certificates of deposit (CDs), stock dividends, patent royalties from inventions, and royalties from books, songs, and other original works.

When managing your money, it’s important to note that each of these types of income is taxed at a different rate. Ordinary income is taxed at the highest level. The government takes the biggest chunk from the money you work so hard for in your job or business. Portfolio income is taxed at a lesser rate. Passive income is taxed at the lowest rate. When you invest for passive income, your money is working for you, plus you get to keep more of that money since it will be taxed at a lower rate.

Expenses

Next, we have the expenses section of the personal finance income statement. This section consists of anything you pay out each month, including such things as your mortgage payment (or rent payment), car payment, student loans, food, car and gas, utilities, insurance, clothes, eating out, medical bills, and so forth.

When listing your monthly expenses, you might be tempted to leave off smaller expenses such as your Netflix or gym memberships. Remember, the purpose of completing a personal financial statement isn't to compare yourself to your neighbors. The value is discovered by understanding the facts about how much you make and spend each month.

Live below your means... or expand them?

How many times have you heard, "I can't afford it." I would be willing to bet you've said it yourself. You're not alone. Robert heard his poor dad say that all the time. His rich dad, however, would turn that statement into the question, "How can I afford it?"

By making that subtle change in context, you put your brain to work. It kicks you out of the negative loop we easily fall into and replaces it with a positive problem solving mindset.

The Balance Sheet

Where the income statement lists how you make your money, the balance sheet gives you a snapshot of what you own and owe. The balance sheet consists of:

• Assets (things that put money in your pocket), and
• Liabilities (things that take money out of your pocket)

Assets

The Rich Dad definition of an asset is not the definition you’ll hear from your traditional accountant. The conventional accountant will tell you that an asset is “something of monetary value that is owned by an individual or company.” By that definition, your vacuum cleaner and your everyday dishes could be considered assets!

Most accountants go crazy with this definition because they want to classify your shares of stock, your jewelry, your personal residence, your cars, and your mutual funds as assets. To me, none of these things have any value until the day you sell them.

Instead, here’s the Rich Dad definition: An asset is something that puts money in your pocket, whether you work or not.

Why use such a definition? Because a vacuum and some plates and bowls will not get you closer to your financial dream, but something that is putting money in your pocket whether you work or not will.

Liabilities

Again, I go to battle with the traditional definition of a liability. Most accounting professionals will tell you that a liability is “an obligation to pay an amount you owe to creditors, be it an individual or an organization.”

My definition begs to differ: A liability is something that takes money out of your pocket.

You can see the dilemma. Most would list their Mercedes as an asset or something of value. However, I would list the Mercedes as a liability because every month it takes money out of your pocket. “But it’s paid for!” you argue. The car loan may be paid for, but what about gasoline, tune-ups and repairs, and insurance?

The biggest fight we get at The Rich Dad Company is when we tell people your home, your personal residence, is not an asset. We received a lot of flak for that, especially when times were booming and people were taking out loans against their home, sometimes two or three times. It wasn’t until the real estate market crashed back in 2008 and people found out that they owed more on their house than it was worth before they started to understand their home was not an asset. If you haven’t suffered through this experience personally, then please take my word for it — you don’t ever want to be in this position.

The bond between the financial statement and balance sheet

After you have completed your personal financial statement, you should start to see a correlation between the two components.

Robert’s rich dad felt that the connection between the two was the key to understanding how wealth is created. “How can you understand one without the other? How can you tell what an asset or liability really is without the income column or the expense column?“ he asked.

If you want to gain a deeper understanding of how the financial statement and balance sheet effect each other, you can discover more about it here.

Why understanding the personal financial statement is important

The problem with people calling their liabilities assets is that they believe they are financially better off than they really are. When the economy turned, many people were forced to face reality — realizing what they have and how long they actually can survive financially. This is why the concept of “net worth” means very little in the real world. When accountants calculate your net worth, they list everything but the kitchen sink. In most cases, to have the dollar amount your accountant attaches to your net worth, you would have to sell just about everything you own—at whatever the market will bear at the time.

This does not mean you shouldn’t buy a house or a BMW or a new Cartier watch. It just means that when you’re managing your money, you shouldn’t fool yourself into thinking that your liabilities, items that take money out of your pocket, are assets.

Once you understand the difference between assets and liabilities, and how to classify them on your personal financial statement, it becomes very easy to see where you actually are financially and how to build your own road map to financial freedom.