I wanted to share a piece I wrote a few years ago. It’s about a simple, but powerful concept that absolutely changed the way I thought about money. Despite having several advanced degrees in finance and accounting, this basic explanation of financial revolutionized my thinking about finance. The beauty of it is that someone really only needs common sense to understand it. And that it does away with all the tax gimics, regulatory rules and “tricks”. It cuts to the heart of finance and how to generate wealth.
The image below can be applied to personal finances and the most complicated businesses in the world (I’ve seen both).
This is simply where you measure what money came in (Revenue) and what went out (Expenses) and what is left over at the end of the month (Net Income). I’ll Income Statement more in depth in a future post, but honestly, the Balance Sheet is more important.
This is what you own (Assets) and what you owe (Liabilities) and if you own more than you owe, then you have a positive net balance (Net Assets).
Rich people create more net income through higher salaries and/or lower expenses and they buy “cash flow” assets with that money. Those assets, in turn, create cash which flows into the revenue box in the income statement each month. That higher revenue, in turn, creates higher monthly net income. That additional net income is used to buy more “cash flow” assets and the cycle continues.
I’ve been enjoying a series of interviews with current day millionaires at the Free Money Finance blog (http://www.freemoneyfinance.com/millionaires/) and interestingly several of them mention that they actively track their net assets. Which tells me that they have an understanding of the balance sheet.
This wealth “machine” that they create is why the rich get richer. This isn’t politics. It’s not because of some secret formula or the unfairness of our economic system. And it’s not magic. It’s just solid common sense and I’ve met several people who have done exactly that over the years to build large amounts of wealth.
Poor people on the other hand are those who have a small amount of net assets. They spend everything they make (and sometimes more), so they have nothing left to invest and start to build their “wealth machine”. They might make a big salary, but if their expenses are also high, then they don’t have much at the end of each month to invest and build wealth. There are numerous stories of people who have small incomes but they build huge amounts of wealth. And it is because they understand these concepts.
So if that is starting to resonate with you and you want to start creating your own “wealth machine”, then where do you start?
First break it into chunks and analyze each square in the image.
Starting an Income Statement strategy
To start, look at the income statement. If you don’t have much left over at the end of the month to invest in your “wealth machine”, you can either try to increase your revenue or decrease expenses. Expenses are usually the easiest to work on quickly and there is a lot of good advice about how to do that. But after you’ve worked on budgeting for a while, you will soon realize there is a limit to how much you can reduce them by. So then you start looking at the revenue box. Do you need to pick up a second job? Focus more on your career? Get more education?
The wealth machine starts slow, but the earlier and harder you work it, the better. It’s astounding to watch it work later is the machine simply builds itself.
Starting a Balance Sheet strategy
Now that you have a basic understanding of the income statement, let’s look at the balance sheet. In the assets box, do you have things that are currently creating cash like rentals, side businesses, etc? If so, you’re off to a good start. If not, then start thinking about what you can buy/build that will generate cash in the long term. And in the liabilities box, do you owe money? And is that debt creating monthly expenses on the income statement and holding your net income down? I once read an article that mentioned that when Steve Jobs came back to Apple one of the things he did was work on improving the balance sheet. You might be a creative, free spirited genius like him but if you don’t understand finances, you probably won’t be as successful as him.
Where has your focus historically been? What parts do you have a plan in place for? Where are your strengths and weaknesses? Where do you need to focus to restore balance to your approach?
In our family, we have a strategy and plan for each of the 4 boxes.
The relational aspect of the financial statements
In our marriage, I’ve realized that I tend to think more about the revenue and my wife thinks more about the expenses. Which is great because those are our strengths. I try to support and encourage her strengths and she tries to do the same for me. What part of these financial boxes is your spouse or you good at? How can you separate responsibilities and support each other to reach your full potential as a family?
The full picture
A lot of financial advice focuses on single boxes in the diagram. A few cover a couple of them. But I haven’t found any that give a complete picture that includes all of them. The financial statements in the diagram are related and focusing on only one part will limit your progress. This hopefully gives an overview that you can use as a map to build your own financial strategy.
If this seems too high-level, don’t worry. I’ll write more posts that delve into each of the financial statement quadrants and basic strategies for each.