Every well run business is expected to prepare its Accounts (Financial Statements) periodically. These accounts are essential for appraising its performance and guiding its management on how to move the business forward. In business accounting, there are internationally accepted accounts preparing and reporting standards called (IFRS) that ensure that all businesses use the same principles and assumptions to prepare their financial statements. This uniformity allows for accurate comparison between businesses and economic sectors. The three most common ones are Income Statement (now known as Statement of Comprehensive Income; it used to be known as Profit and Loss Statement or P & L); Balance Sheet (now known as Statement of Financial Position) and Cash Flow Statement (now known as Statement of Cash Flows). These statements, because they are produced periodically, enable the comparison of different periods in the history of a business so that its managers can determine if there is sufficient growth or not.
Any person serious about wealth creation must apply these accounting processes to her personal finances. For instance, periodic preparation of the statement of financial position would help us to compare our positions across those periods – has there been growth? Was the growth sufficient? What were the sources of growth? Could the growth be replicated? Let us see how we can personalize at least two of these statements.
Statement of Cash Flows – as the name suggests, this statement shows the actual amounts of cash (money – bank transfers, cheques or cash) that passed through one’s hands during a period. It helps one to realize how prudently or otherwise one is spending one’s income. Is it in line with your personal budget? The statement has two sections – at the top, Cash Inflows and at the bottom, Cash Outflows. Items to put in the inflow section include salary/ personal income from business, commissions/ bonuses, pension income, investment income (e.g. rent, dividend and interest), gifts etc. Outflows include taxes, tithes, housing expenses, transportation expenses, utilities, food, medical expenses, personal care, clothing, recreation, equipment and appliances etc. In a good statement of cash flows, the outflows are less than the inflows. The best way to appraise a statement of cash flows is by comparing it to our personal budgets. Did the expected inflows come in? If not, why not? If for instance, it is dividend income that fell below expectation, we have a decision to make – do we sell the under-performing shares or not? If it is outflows that grew unacceptably, we are able to isolate which particular outflow item grew. If it is medical expenses, should we buy health insurance to reduce our expenses? If it is recreation, do we need a change in priorities and lifestyle?
Statement of Financial Position (aka Balance Sheet) – it is the measure of personal wealth. It has two sections – Assets and Liabilities. For it to balance like the old name implies, our assets must equal our liabilities. A personal balance sheet has 4 main assets subsections – liquid assets (e.g. bank balances, money market balances, and treasury bills); investment assets (e.g. bonds, public company shares, real estate, mutual funds, private equity etc.); retirement assets (e.g. RSA balance, insurance annuities, employer gratuities etc.) and personal use assets (e.g. jewelry, personal residences, residences in the hometown, vehicles, furniture, appliances, artwork etc.). The liabilities section would include current liabilities (falling due within a short time e.g. rent, insurance, school fees, utilities, loan repayments, medical expenses, insurance premium, repair bills etc.) and long term liabilities (falling due after one year e.g. mortgages, car loans etc.). Both sides of the balance sheet are equal because the asset side is expected to fund the liabilities side. This implies that though we have liabilities falling due like school fees and rent, assets such as bank balances are able to fund those liabilities and cancel them out. The balance sheet size is expected to grow periodically. A shrinkage in the balance sheet size means a reduction in personal wealth.
Preparing these financial statements is critical for effective personal finance management (PFM) but extremely tedious and time-consuming, besides many people find accounting principles confusing. Thankfully, we do not have to prepare these financial statements ourselves.The PFM apps we buy from our phone’s app stores can prepare these statements, make comparisons and chart trends across periods, help us to determine how well we are doing and how/ where we should improve our PFM.So, let us use the apps for financial statements preparation and interpretations too.
Happy Investing.
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