Do you get an inexplicable headache when you hear the word Personal Finance? Does the very thought of getting financially organized make you feel inadequate regarding your financial knowledge? Well, the good news is, you are not alone. Even better news is that you do not need the help of an accountant to make sense of your investing and your finances. In order to understand where you stand financially, you just need to understand two personal financial statements. They are the balance sheet and the cash flow. Read on to know more!
#1 Balance Sheet: This gives you a snapshot of your net worth. Net worth is defined as your liabilities subtracted from your assets.
- Assets are defined as the things that you own. Examples include your cash in the bank account, home, and other investments.
- Liabilities are basically things that you owe. Examples include your student loans, credit card bills, and mortgage.
Net Worth = Assets – Liabilities
In case you newly graduated from your college, your net worth may be lesser than your liabilities. This is perfectly okay, as you are yet to grow your assets while you raked in a lot of liabilities during the past decade of school.
Now, the balance sheet is just one half of the picture. The other half of the picture is the cash flow.
#2 Cash Flow: Cash flow is basically measured on a monthly basis. It is defined as the difference between your expenses and your income. Your cash flow can be negative or positive based on how much you spend. This is because
Cash Flow = Income – Expenses
In case you spend more than your income, the cash flow would be negative. In case your income exceeds your expenses for the month, your cash flow is said to be positive.
Reading them together: As you can see, cash flow basically measures how you are doing financially over a specific time period (like a month). On the other hand, your balance sheet gives you an overview of your life’s savings, spending, and investing.
Even though both cash flow and balance sheet give you two different views of your financial health, they are connected to one another.
- Whenever your cash flow becomes positive, it causes your net worth to go up.
- Whenever your cash flow becomes negative, it causes your net worth to decrease.
This can be explained using an example.
- Assume that your cash flow for last month was $500. This means that your income exceeded your expenses by $500. This money would be included in your bank account. Since bank account is an asset, it increases your Net worth.
- On the other hand, assume that you overspent on the previous month and charged $1000 on your credit card. This would cause your cash flow to be negative. It also increases your liabilities, leading to a lower Net worth.
As you can see, you can improve your personal finance only once you have a clear understanding of how each decision about spending or investing impacts your overall net worth and cash flow.