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Financial Statements: Wealth Starts With Your Personal Financial Statements

May 24, 2008
Financial Statements Introduction:

Financial statements generally take the form of records of the financial performance of a business. They provide information about the profitability and general financial health of the organisation. A company's financial records usually consist of:

* Income Statement
* Balance Sheet
* Cash Flow Statement

An income statement, also called a Profit and Loss Statement, shows how a company's sales or revenue translate into profit (net income) over a specific period (normally one year). It's a record of how much a company has earned, what expenses it has paid and the resulting profit or loss.

A balance sheet, also known as a statement of financial position, is a summary of what an entity is worth at a particular point in time. It summarizes what a business owns (its assets), what it owes (its liabilities) and its net worth (its equity or capital). While the income statement is a summary over a period of time (usually a year), the balance sheet is a summary at just one point in time. The balance sheet is a "snapshot" of a company's health

A cash flow statement is a summary of a company's ingoing and outgoing money over a specific period (normally one year). It is such a valuable report because it shows the cashflow strength of a business unlike the income statement which contain non-cash items.

The Importance of Financial Statements:

Financial statements are crucial instruments used by a company's management and investors for analysis and decision-making. They pore over the numbers and create every ratio imaginable in an effort to create the most accurate financial story possible. Without financial statements knowledgeable management and investment simply wouldn't be possible.

The Importance of Personal Financial Statements:

Everybody knows that company's product financial reports, but it is not as widely known that you can produce your own personal financial statements. Your own income statement and balance sheet which tells you your own financial performance, just like a company's financial statements.

Company management know that it would be impossible to run a company without financial reports giving them information about their financial strength, productivity, goal setting and so on. Is it any less logical that you need your own personal financial reports to know how well you are performing financially, just like a company's management?

Your financial statement will tell you your financial strength. They will tell you whether you fall into the poor, middle class or wealthy class. Current statements can be compared to prior statements to create a trend, a story, over time. You can also use your financial statements for scenario analysis, such as looking at he impact of an investment on your financial position or the impact of interest rates rising.

Your Personal Income Statement:

Income statements following the following structure: Income - expenses - taxes = net income (also called net profit).

Rather than simply listing your incomes and expenses by item it is useful to categorise them in a way that will help you know whether you have the income and expense profile of a poor, middle class or wealthy person. The Internal Revenue Service (IRS) in the U.S. classifies all income and loss items into three categories: active, passive and portfolio.

In brief, active income is income from your salary, wages, fees, commissions, and sole proprietorship business.

Passive income is income that's received, usually regularly, by an individual who doesn't materially participate such as rental from real estate, royalties from patents and license agreements, and businesses you own.

Portfolio income is investment income from paper investments such as stocks, bonds, mutual funds in the form of interest received or dividends or capital gains (or losses) from their sale.

Similarly, expenses that are associated with your active income are active expenses, and so forth for your passive and portfolio expenses against your passive and portfolio income. Your active income is generally not tax deductible while your passive and portfolio expenses are tax deductible. Thus we refer to active income as bad expenses and passive and portfolio expenses as good expenses.

Income Statement:

Income (Realised)

- Active
- Passive
- Portfolio

Deductible expenses

- Passive
- Portfolio

Non-deductible expenses
Net Income

Your Personal Balance Sheets:
Balance sheets follow the following structure: Assets = Liabilities + Equity or Equity (or net worth) = Assets - Liabilities.

Just like your personal income statement it is useful to categorise your personal balance sheet in a way that will help you know if you have the assets and debt profile of the poor, middle class or wealthy person. Assets and liabilities can be split into good and bad assets or liabilities.

Good assets are investments. In short, they put money in your bank account. Good liabilities refer to debt that is used to buy good assets, which makes the debt expense (interest payments) tax deductible.

Bad assets refer to anything else. They take money out of your bank account. They cost you money to own them. Bad liabilities, is debt that is used to buy bad assets, which makes the debt expense not tax deductible.

Just like your personal income statement, your good assets and good liabilities can be categorised as passive or portfolio based. There is no active assets or liabilities because the income is from your wage and thus there is no asset or liability.

Balance Sheet:

Good assets

- Passive
- Portfolio

Bad assets

Good assets

- Passive
- Portfolio

Bad assets
Net Worth

Poor, middle class and wealthy:

The makeup of your income, expenses, assets and liabilities and how they interact tells a story--your financial story. By filling in your financial statement, you can tell which class you're in and a great deal about where you are on your wealth journey.

The poor, middle class and wealthy each have a different story, a different financial makeup, which is reflected in their financial statements. Each class's financial statement is unique. You won't have a poor- or middle class-looking financial statement and be wealthy.

To become wealthy, you need to understand your financial statement and create a plan to change it so that it looks like that of a wealthy person.

The poor earn only limited active income and no passive or portfolio income. They have little or no good assets or bad assets.

The middle class earn primarily active income, and little in the way of passive or portfolio income. They have little in the way of good assets and loads of bad assets and thus have little good debt and loads of bad debt.

In contrast the wealthy earn primarily passive and portfolio income and little in the way if active income. They have loads of good assets which provide the passive and portfolio income and few bad assets (compared to their wealth). The wealthy have loads of good debt (at least while they're accumulating their wealth) and little or no bad debt (compared to their wealth).

So what does your personal financial statement looks like? The poor, middle class, the wealthy or a combination?
About the Author
Emlyn Scott is the founder of Rich1Percent , investor and wealth creation author. He is a wealth creation and finance expert with 4 post graduate qualifications and has amassed a multi-million dollar investment portfolio.
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