Measuring the Past

Measuring the Past

In January 2002, Luke Landes realized he needed to make some changes in his life.

In a span of weeks, his girlfriend left him, he lost his job, his car was impounded, and he was evicted from his apartment. Seeing no other option, Landes moved in with his father while he hunted for a new job. As he looked for work, he did some soul-searching.

Landes realized that for too long, he’d been letting life happen to him. He’d been allowing external forces to control his destiny. He’d been placing the blame for his failure or success on the economy, on his boss, on his girlfriend, on luck – on everything but his own actions. But blaming others only left him feeling helpless.

Slowly at first, Landes shifted his mindset. He decided that it was up to him whether he failed or succeeded. He decided to live the way he wanted instead of simply reacting to events around him. He decided to remove the negative influences from his life and replace them with positives.

Landes made it his mission to improve his life and his finances.

He moved to a new apartment, which he shared with three roommates. His rent was less than $350 per month, and other expenses were split four ways.
He found a new, higher-paying job as an assistant to the Chief Operating Officer of a large financial firm.
He began actively managing his money. He tracked every penny he spent. He opened a savings account and began to save for retirement with a company 401(k) plan.

In short, Landes began to believe that he was in control of his life. He chose whether to get out of bed in the morning. He decided how well he performed the tasks his boss assigned him. He chose whether to be happy or not – every second of the day. Landes realized that he was calling the shots – all of them.

As part of his new job, Landes learned how large public corporations operate, and he began to apply some of these lessons at home. For instance, because he’d been producing financial reports for one division of his company, he tried doing the same for himself. At about the same time I chose to become the Chief Financial Officer of JD, Inc, Landes started seeing himself as the CFO of Luke, Inc.

In 2003, Landes founded one of the world’s first financial blogs, Consumerism Commentary (ConsumerismCommentary.com). Like a public company, he began publishing regular reports of his financial progress online. At first, these reports were embarrassing because they revealed just how poorly he’d been managing his money. But Landes found that sharing monthly financial statements held him accountable and motivated him to improve his habits.

For nearly a decade – even after he quit his corporate job to become his own boss – Landes published his personal financial reports at Consumerism Commentary.

When I seized control of my money, I took a similar approach. I’d been using Quicken to track my income and expenses, and I noticed the software could generate the same financial reports I already used to analyze the performance of both the family box factory and my computer consulting business. I starting using these in my personal life, and they changed the way I managed my money. I became obsessed with generating a “profit” – earning more than I spent.

At nearly the same time, on opposite sides of the country, Landes and discovered that financial statements were a great way to “keep score” of our results.

Keeping Score

Large corporations have a variety of financial statements at their disposal. The CFO uses these reports to show where the company’s money came from, where it went, and where it is now. To master your personal finances, you only need to bother with two: the balance sheet and the income statement. Although these reports might seem mysterious at first, it’s quite easy to use them to get a grip on your past financial performance.

The Balance Sheet

The first report we’ll generate is the balance sheet, which shows what you own and what you owe at a particular instant. This report is simple to create. In fact, because the balance sheet is a snapshot of your finances at one moment in time, you can produce it without examining individual transactions. All you need are the current balances of your accounts.

Some software programs will generate a balance sheet for you. (For instance, Quicken automatically creates a balance sheet based on my recorded transactions.) But it’s not difficult to produce one by hand. You can do it in three steps: List your assets, list your liabilities, and calculate your net worth.

Start by calculating the value of your assets, the things you own. List the current balance of each bank account. Tally your cash on hand. Track down the total of each investment account, including retirement accounts. List the value of other major assets, such as your home, you car, and personal property. (You can approximate the value of your home using Zillow.com and you can find out how much your car’s worth at KBB.com.) Your total assets is calculated by adding your account balances to the value of your possessions.
Next, determine the value of your liabilities (the money you owe). List how much you owe on your mortgage, car, student loans, and personal loans. Note the balance of each credit card. The sum of everything you owe represents your total liabilities.
A corporate CFO would next compute the company’s “equity” (or “retained earnings”) by subtracting the corporation’s liabilities from its assets. On a personal level, equity is the same as “net worth”.

This may sound complicated, but it’s not. You can create a balance sheet in less than an hour by looking up your account balances online. You can do so in mere minutes if you’re already tracking your accounts with personal finance software.

With his permission, here’s a sample personal balance sheet from Luke Landes. Because he tracks his money with Quicken, it’s easy for him to export the numbers to a spreadsheet. Note that he also compares his progress from month to month and year to year.

As you can see, Landes’ total assets are equal to the sum of his net worth and his total liabilities. By definition, these numbers must match. If they don’t, something is wrong with the calculations. Also, if his total liabilities were greater than his total assets, his net worth would be negative.

The balance sheet doesn’t reveal much detail about the financial health of You, Inc., but that’s not its purpose. It gives a glimpse of the Big Picture. It’s a snapshot of your current situation.

Among other uses:

The balance sheet is the best way to know exactly where you’re starting with your financial plan. It should also be the starting point for all of your financial decisions, from taxes to estate planning, from insurance to investing.
The balance sheet yields your net worth, which is an important barometer of your financial health. As you earn “profits”, these show up on your balance sheet as an increase in net worth. When you lose money – through debt or overspending, for example – your balance sheet reflects that, as well. In general, your net worth should be positive, and it should grow with time.
The balance sheet takes on even greater value when it’s used to track changes over time. In the example above, Landes is using his current balance sheet (from June 2006) to compare his finances with past periods (June 2005 and April 2006). This allows him to spot problems and to see what he’s doing right from one month to the next and one year to the next.

Creating a balance sheet every month is like tracking your diet with daily weigh-ins, or measuring the growth of your children by marking their heights against the wall. Over time, your balance sheet acts as a record of your journey toward your monetary goals.

While the balance sheet is quick and easy to create, it doesn’t tell the full story. For additional insight, let’s turn to the income statement.

The Income Statement

The income statement (also known as a profit-and-loss statement) measures revenue and expenses over a period of time, such as a month, a quarter, or a year. It groups individual transactions into categories. For example, while you might make a dozen trips to the supermarket in a month, your income statement could group these as a single line called “groceries”.

Corporate income statements can be complex, but we’ll stick to a form that’s easy to create and understand.At its core, your income statement will look like this:

INCOME

Income source$###.##

TOTAL INCOME$###.##

EXPENSES

Expense category$###.##

Subcategory$###.##

Expense category$###.##

TOTAL EXPENSES$###.##

NET INCOME$###.###

To create an income statement for You, Inc., you’ll need records of recent transactions from bank statements or computer software. Once you’ve gathered the info, follow these steps:

Decide which time period you’re going to measure. This could be a week or a decade, though neither of these would provide useful feedback. A single month is a meaningful period that can provide the info you need to make smart decisions about the future of You, Inc.
List the various sources of revenue in your life, including salary and bonuses, gifts received, interest earned, alimony, and so on. Write down the total received from each source during the time period being measured. Once you’ve tallied the individual revenue sources, compute your total income.
Next, list the sources of expense in your life. Keep these simple, especially in the beginning. Common spending categories include: charity, clothing, entertainment, food, housing, household, insurance, interest, medical, miscellaneous, personal, transportation, utilities, and vacation. Find the total you spent on each category during the period of time you’re tracking. After you’ve finished with the individual categories, calculate your total expenses.
Finally, subtract your expenses from your income. This number is your net profit (or loss) for the time frame in question. It’s alsosomtimes referred to as cash flow.

As an example, here’s an actual income statement from Luke Landes.

Landes tracks a lot of detail. For instance, he lists five sources of miscellaneous income, six types of automobile expenses, and six utilities. If you like this sort of granular approach – so that you can see how much you’re spending on gasoline or electricity, maybe – you’re free to use it. But it’s also fine to lump all related expenses together in a single larger category, such as “other income” or “automobile”, or “utilities”.

I recommend starting with a handful of categories (and subcategories) that give you the info you need most. Later, you can go deeper if you really want (or need) more detail. As CFO, you prize efficiency. Complexity is the enemy of efficiency, and you should steer clear of it whenever possible.

This report has many uses. For example:

The income statement helps a CFO analyze his company's past performance. Your personal income statement provides clear feedback on your behavior, showing how much you spent and where you spent it. You can use the income statement to compare how your actual spending compares to your perceived spending. You might feel as if you don't spend much on your car, but what do the numbers really say? You can also use the income statement to find places to cut back to create more profit. For example, when I was getting out of debt, I used info from my income statement to slash spending on books, comic books, and computer equipment.
The income statement also allows the CFO to make predictions about the company's future, helping him prepare budgets and formulate long-range plans. You can't build a budget on ideals and dreams; to be successful, it must be based on reality. The income statement is the best representation of reality you have. The income statement can also guide you in creating plans. If You, Inc. isn't profitable, you won't want to take on any major purchases, for instance. Instead, you should focus on increasing income and reducing expenses until profitability has been achieved.
The primary purpose of the income statement is to demonstrate profitability. The success of a business depends on its ability to continually earn profits. Although profit may not be its primary motive, a company cannot survive without one. And neither can you. Just as your body needs food and water to survive, your finances need profit to provide not only necessities such as food and shelter, but also to fuel your dreams. Without profit, your goals will remain always out of reach, unobtainable. Your profits fund your future, from travel to marriage, from education to retirement. The bigger your profits, the bigger the dreams you can realize – and the sooner they'll come true.

The balance sheet is a snapshot of your finances at a single point in time. An income statement is more like a movie that shows what happened over a prolonged period of time

Here’s another way to look at it: Your balance sheet is like a report card at the end of the year; the income statement allows you to see what grades you earned on individual assignments.

Important Numbers

Financial statements allow a CFO to “keep score” of his company’s performance, but they don’t always tell the full story. Sometimes the final score of a football game is misleading, and you have to read the box score to find statistics that explain the result. The same is true with money. Let’s look at a few ways to dig deeper so that you can use this data to make better decisions about the direction of You, Inc.

Net Worth

To begin, let’s take a closer look at your net worth, which is found on the balance sheet. Your net worth measures how much wealth you’ve accumulated over the course of your life. In the classic Your Money or Your Life, Joe Dominguez and Vicki Robin write, “[Your net worth] is what you currently have to show for your lifetime income; the rest is memories and illusions.”

In a business context, net worth is also known as "book value". It represents a company's value on paper, leaving aside intangible assets such as brand recognition, intellectual property, and customer goodwill.

People often wonder what their net worth should be, but there's no real way to gauge because it depends on where you live, what you spend, and how much you earn. If you're a computer programmer in Toronto, your net worth will probably be greater than a schoolteacher in Ecuador. That said, here are a couple of rules of thumb:

Your net worth should be as high as possible. That might sound glib, it's true. A high net worth is always better than a low net worth.
Your net worth should grow with time. Until you retire, you should see your net worth increase every year. Ideally, it will increase substantially.

Some people have created benchmarks for comparing net worths. Perhaps the best known is found in The Millionaire Next Door by Thomas Stanley and William Danko. They argue that your "expected net worth" can be found with a simple formula:

Divide your age by ten.
Multiply this result by your current annual gross (pre-tax) income.
From this total, subtract inheritances.

The final number, say Stanley and Danko, reveals how much money you should have.

If your net worth is at this level, you're an "average accumulator of wealth". If you have less than half the expected amount, you're an "under-accumulator of wealth". If you have more than twice the expected wealth for your age, you're a "prodigious accumulator of wealth".

In June 2006, Luke Landes was thirty years old. His net worth was $49,872.99 and his income the previous year had been $61,191.38. Based on these figures, the rule-of-thumb fromThe Millionaire Next Door says his net worth should have been about $183,500. Because it was less than $91,787, the Stanley and Danko would say Landes was lagging behind his peers. If he’d had more than $367,000, he would have been considered an overachiever. (For the record, Landes continued his financial recovery and today would be classified as a prodigious accumulator of wealth!)

Net worth is a useful benchmark, but it takes on even greater value when combined with other measures of progress, such as your saving rate.

Profit Margin

The economic definition of saving is “current income minus spending on current needs”. That ought to sound familiar. It’s essentially the same definition used to calculate profit on an income statement! Unspent money is money saved. It's profit.