Evaluating your financial health – personal income statement
In last week’s article we described how to develop a personal balance sheet in order to calculate your personal net worth. The personal balance sheet is simply a snapshot of you financial health at a given point in time. In order to move on in the process of creating your personal financial plan, we now need to determine your spending pattern. This is done by developing a personal income statement which is what will be covered in the following article.
Personal income statement
A personal income statement will help you track both how much you earn (income) and how much you spend (expenditures) over a period of time. It will determine exactly how much money (if any) you are left with. This is the money that you can then use to meet your financial goals. If your income statement is negative, it will help you spot exactly where all the money is going and to take corrective actions in order to reduce the expenditures.
How to develop a personal income statement
First of all, all personal income statements are developed on a cash basis. This means that you actually have to receive money or spend money. For example, if you pay for a new TV with your credit card, you would not record the expense on the income statement. However, once you pay the credit card company you would record the expense. A real cash flow transaction has to occur.
Developing a personal income statement is not a complicated task but you need to keep track of all your income and most of all, expenses.
For the given period of time you have to:
- Record your overall income
- Subtract the total expenditures incurred
When you record your overall income, don’t simply indicate the number that appears on your paycheck. You must record the total dollar amount that you have earned. From this dollar amount you will then subtract income taxes (federal, state and social security). This will leave you with your take-home pay, which is the money that you can use for your expenditures:
- Total income (all sources of income, full amount)
- Total income taxes (federal, state and social security)
- Take-home pay (1- 2)
- Living expenses (housing, food, clothing, medical transportation, recreation, insurance, other expenses)
Calculating your income is easy because the information is easily retrievable. However, recording all your expenditures might be tricky because you have to keep track of every cent being spent and not all expenditures leave a paper trail. But in order for your personal income statement to be valuable you need to ensure that nothing is left out.
One way of tracking your expenses can be to classify them either as fixed expenses (you have no control over this expense) or variable expenses (expenses that can be controlled). For example, your mortgage monthly payment is a fixed expense while clothing and food expenses are variable expenses. By reducing your variable expenses you can increase you income available for savings to meet your financial goals.
Now that you have developed your personal balance sheet and your personal income statement you are ready to interpret the numbers in order to draw conclusions and move on to step two of the personal financial plan development process.
In next week’s article we will describe the main ratios that you can use to make sense out of all the information that you have collected. Stay tuned for updates and if you haven’t already done so, sign up to our newsletter to always be informed on our latest articles.