Two Concepts [04/2024]

In personal finance, there are two important financial statements: your balance sheet and your cash flows.?

The Balance Sheet

The balance sheet adds up all your assets, less your liabilities, to produce your net worth. Most people track it as a barometer of their financial standing with the goal of increasing their net worth over time. When tracked yearly, you can see how your net worth has fluctuates over time.?

Net Worth = Assets - Liabilities

The major categories for assets are cash/cash equivalents, investments, and assets (e.g., your house and possessions). The major liability categories are credit card balances and loans.

Example: Bob has an outstanding $1,000,000 mortgage on his $2,000,000 house. He has investments of $3,000,000 between his brokerage and 401k. He also has rare house furnishings, cars, and a waterskiing boat, all worth $1,000,000. His net worth is:

Assets = $2,000,000 + $3,000,000 + $1,000,000 = $6,000,000

Liabilities = $1,000,000

Net Worth = $5,000,000

The balance sheet is simple to develop and track yearly.

The Statement of Cash Flows

The cash flow statement adds up all of your inflows and subtracts outflows. Think of it as income, less taxes and expenses.

Cash Flow = Inflows - Taxes - Outflows

Inflows =?Gross Income, which includes salary, interest and dividends, capital gains, rental income, Social Security, pensions, etc.

Taxes = federal, state, and local income taxes, FICA, self-employment taxes

Outflows?= fixed + other expenses such as mortgage payments, property tax, car payment, insurance premiums, food, utilities, clothing, vacation, charity, etc.

Why is the statement of cash flows so important??

1. At a minimum, it tells you whether your current cash flows are positive or negative.
2. It allows you to track over time (similar to how you track your net worth) and plan proactively.?

Example: Bob earns $200,000 per year, and his after-tax income is $135,000. He wants to save or invest at least 20% of his income to reach his retirement goals. He first tallies up what he considers to be his fixed expenses, expenses that he has to pay no matter what, and that don’t frequently change month to month.

Before looking at his cash flows, Bob had no idea where his income was going. He now understands that under 50% of his net income goes towards fixed expenses, which gives him much flexibility with the rest of his income. He can easily meet his savings goal by allotting 20% to his investments. For the remaining 32%, he can spend on whatever he likes or increase his savings to his retirement investments if he wants to retire sooner. Bob can look at these figures each year to see where his spending patterns are changing, especially as he nears retirement and his income and expense makeup changes.?

People hate budgeting. As a result, too many people use mental accounting for their cash flows and their bank account balances as lagging indicators. Not great.

Putting together a statement of cash flows achieves all the tracking that is necessary and allows you to spend without guilt. It also gives you the power to proactively change how much you save and where your desired spending occurs. Generally speaking, the lower your fixed costs, the greater your overall financial flexibility. A good rule of thumb is to keep your fixed expenses below 50%, invest/save 20%, and spend 30% on everything else. [1],[2]

The final reason to track your cash flows is to understand what levers you can pull when accumulating assets, including saving or spending more without guilt. When you enter retirement, you will understand your expenses in your ideal retirement (e.g., travel, charitable contributions) and your income sources (e.g., investments, pension, Social Security).

I’ve been astounded by the number of people who are nearing retirement (regardless of income level) who do not track their income/expenses yet simultaneously want to know if and how they can retire. Often, it is due to a lack of desire (e.g., “We're not broke!”) or a fear of seeing the actual figures. In either case, seeing the numbers often has a positive outcome, whether through the relief of unfounded thoughts or the ability to act towards your desired outcomes (e.g., retiring sooner, spending more, etc.). What gets measured gets managed.?

---

[1] Like most rules of thumb, there are specific considerations. For example, if you are trying to retire earlier, you would likely want to save more than 20%, or if you are ahead of your target goals, you could dial back your savings.

[2] Retirees can ignore the savings portion. It is more important to understand the balance of your fixed and variable costs, and the variability year-to-year as it relates to your income sources.