Financial Lives and Financial Statements

While reading an Annual Report this morning, I got an idea for this blog: isn’t our financial lives also a lot like the financial statements? And just as we learn a lot about a company by looking at its financial statements, can we look at our own financial statements and see what they tell us? I’ll try and show you how.

The Balance sheet:

As we know, the Balance sheet consists of 3 parts- Assets, Liabilities and Equity.

  • Assets: Our material possessions like home, cars, investments in securities, gold, money in the bank etc. would go under the various heads of the Assets section of the Balance sheet.
  • Liabilities: Money that we owe to others such as EMIs, Unpaid utility Bills, unpaid bills and salaries to helpers etc. would go under the Liabilities section.
  • Equity: The difference between the Assets and Liabilities would be what we own- the Shareholder’s equity.

balancesheet

The P&L statement

Say for the year 2016, our income from salaries or payouts from business would go as the Income in the P&L statement. Our income from other sources such as dividends, interests etc. would be Other Income. Our expenses on our home, our consumption of products and services, (our purchases on Flipkart and Amazon) would all go under expenses in the P&L statement. Interest that we pay on borrowings would be classified as Finance Cost and yearly mark downs of assets like cars, electronics etc. would be classified as Depreciation. The difference between the Income and Expenses would be our Net Profit or what we saved.

pl

The Cash Flow statement

The Cash Flow statement has three parts- Cash Flow from Operations (CFO), Cash Flow from Investments (CFI) and Cash Flow from Financing (CFF).

  • CFO: Our income and our expenses would go under the Cash Flow from Operations.
  • CFI: Money that we set aside for investments in securities, gold, FD, Real Estate etc. would go into Cash Flow from Investments. Sale of assets would also go into the Cash Flow from Investments.
  • CFF: And if we need to take out personal loans to meet current expenses, or repay loans, then those items would go into Cash Flow from Financing.

cashflow

As I was writing the above, I hit upon some of the following insights.

  1. Don’t ignore the Intangible Assets

I would classify our family, our health, our education, our qualifications, our network of colleagues, our reputation, our learnings and wisdom, our relationships, the goodwill that we have amongst friends, family and in the society as intangible assets. Like Tangible Assets, these can come handy sometime in future. However, unlike tangible assets, intangible assets cannot be bought or acquired overnight; they need to be earned over a long period of time and when they will come handy is not in our control. All we can do is work on these assets with earnestness and someday in the future, the universe will give us the benefit of that. In order to give luck a chance to find you, you need to work on the intangibles.

  1. Equity = Assets – Liabilities

Assets can be bought with a combination of Equity and Liabilities. For example, a car can be bought with down payment + car loan. Alternatively, I can invest in stocks with borrowed money. But, the more I increase my liabilities, the lesser it belongs to me. And vice-versa. The lesser the liabilities, more is my ownership. And that is what we must aspire for- to have as many high quality assets with as few liabilities as possible.  The more you own an asset, the lesser you will have to share the benefits of that asset with another party such as a bank.

  1. Earn- Save = Spend / Earn – Spend = Save

Mathematically both of the above equations are right. But financially, only the first one is correct. You see, in the first equation, I am constraining my Spending by Saving. Only after I save per my personal targets, I give myself the permission to spend. This kind of thinking forces us to be more frugal and to look for ways to be creative with our spending, of forcing us to avoid unnecessary expenses, of making us find ways to cut costs and look for ways to make the Rupee go further.

On the contrary, if I spend first, I may or may not leave enough savings that can be reinvested. Thus it’s important to get this very simple yet powerful equation, right in our lives.

As Charlie Munger said, “Spend less than you make; always be saving something. Put it into a tax-deferred account. Over time, it will begin to amount to something. This is such a no-brainer.

  1. Reduce Financial Costs

Here is what Charlie Munger had to say:

Once you get into debt, it’s hell to get out. Don’t let credit card debt carry over. You can’t get ahead paying 18 percent.

So you see, reducing interest payouts allows us to keep more in our pockets which can then be used to buy more assets.

  1. Reduce Depreciation

Have you wondered why our newspapers, magazines and TV channels – whom we look up to for answers never ever preach frugality? I think part of the reason for that is the way the media business is set up. Their primary source of revenue is earned through advertisements from other businesses that sell products and services to consumers like you and me. If the media preached frugality with earnestness, fewer people would buy the advertised products which would lead to fewer advertisements in future and lower revenue for the media company.  So, instead, the newspapers, TV channels, magazines are always creating a buzz on new products and how they will lead us to happiness, just so that we buy those goods. So, what is good for you, isn’t good the media business. And so we end up consuming content that isn’t in our best interests.

You lose money when you buy a fancy car and you lose money when you sell a fancy car. That’s because, Depreciation is a silent killer. Slowly and silently with passing time, it erodes the value of the items that you own. So, we must try and own more and more of assets that appreciate in value over time and own fewer of assets that depreciate over time. For example, I bought an expensive phone in 2013 for 20,000 Rs and when I sold it in 2016, I got less than a tenth of that.

  1. Its all connected.

The more money you save, the more profits you would have. These profits can be ploughed back to buy more assets that appreciate over time and will add to other income in future. Or, you could use the profits to pay down your borrowings faster which would result in savings in Finance Costs which would lead to extra profits in the future. And the cycle would continue.

 

We live in a consumerist society. Our newspapers, radio channels, internet, bill boards are all awash with advertisements that promise more happiness through their products. Our happiness comes from our attitude to life and our choices that we make and not through material possessions, as seen in the workings above. Therefore, it’s in our own interest to opt for a more prudent and productive lifestyle – something which is not taught to us enough.

 

 

 

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