This is the second post in the Financial Planning Basics series, if you have not read the first post you can find it here.
This is pretty much the first step into financial planning, well actually it’s more like the pre-work. At This stage you want to take a snapshot of your current financial position. You want to know how much liabilities you have, and how much assets you have, this will become your balance sheet and will determine your networth. You also want to have a clear picture of your income and expenses; this will be your cashflow statement. Download worksheet for Balance Sheet and Cashflow statement worksheet.
What is Balance sheet?
You can visualize a balance sheet as a two column page, on the left side you have your assets and on the right side you have your liabilities.
You can further define your assets as “liquid” assets, these are assets that are available on a short notice such as savings accounts, and short term investments. You can also have ” non-liquid” assets, these are assets that are not readily available, such as your house and other property.
You can do a similar thing for your liabilities, you can also mark your liabilities as “fixed” or “variable” depending on what type of liability it is and short-term vs long-term.
Your networth is simple to calculate. Ones you have all your assets and liabilities organized you simply subtract assets from liabilities and that is your networth (Asset-liabilities=Networth). This is basically what you will have if you would sale all your assets and payoff your liabilities. Can this be negative? YES, it can. In fact way too many people have a negative networth in North America. I myself currently have a negative Networth, for me it’s due to high amount of student loan, although my education is a definite asset I unfortunately can not give it a value.
Why is Balance Sheet important?
Having a balance sheet will give you a clear picture of your financial strength, usually when you apply for loans the lenders will want to know your networth. This will tell you how strong your financial position is and how you can handle potential financial problems. You should take a look at your Balance sheet at least every quarter, I recommend updating it on monthly bases it will help you keep track of your progress.
The cashflow statement is an overview of your “cash in-flow” and “cash-outflow”. Your inflow is mainly your employment income plus any other income you may have (investment, royalty etc) your outflow is all your expenses and savings, these include your taxes and RRSP contributions. You will either be cashflow positive or negative, if you are positive you have excess cash to contribute to your savings plan, if however you are negative it means that your expenses are higher than your income and adjustments need to be made immediately.
Why is Cashflow Statement Important?
Cashflow statement gives you different information than the Balance sheet. Cashflow statement will help you determine if your income is sufficient to cover your expenses. Just like your networth your cashflow can be positive or negative, however unlike networth if you are cashflow negative you are in serious trouble. If you can not meet your monthly obligation you may lose your assets such as home or even go into bankruptcy. Although I have a negative networth, I have a very strong positive cashflow which helps me increase my networth.
These two documents are cornerstone of your financial plan, if you do not have them and update them on regular bases you will not be able to develop a realistic financial plan. Remember that these two documents do not replace each other, they are complementary to each other.
Together the Balance Sheet and Cashflow Statement will give you a good picture of your current situation and help you make realistic financial goals.
Financial Planning Basics- Guide To Financial Planning