An insufficient return on investment is your canary in the coal mine, it tells you when your business is failing and, with proper examination, why.  Better still, it does this before all the money is spent and Tony Soprano is knocking at your door, calling in his loan.

Time to Count Some Beans

What is Return on Investment for a Small Business?

If you have experience as an investor then your are familiar with return on investment as being the amount you earn on your investment over the amount that you paid for it.  So when you shop around online to get a half a percentage higher interest rate on your savings account you are looking for a higher return on investment.

How Do I Calculate It?

For your small business, the concept is the same, return on investment is a measure of what you get out of your business divided by what you have invested in it .

The key word here is measure, the return on investment formula is a tool to help you measure how efficient your business is at generating profits.

Why Is It So Important?

Your assets are the resources that you have put into your business, your investment.  When you calculate return on investment you are concerned with two things: first, the opportunity cost of your resources, and second, the trend of your business’s return on investment over time.

Opportunity Cost

The opportunity cost of your resources basically answers the question; “would I be better off putting these assets to a different use.”  Think back to the example of a savings account, if the return on investment from your business isn’t beating the interest you would get if you sold your assets and deposited the money in a savings account, then you’re pretty much screwed.  Either you have to take drastic action to improve the ROI or you should find a more effective use for your assets.

Change Over Time

The trend of your ROI over time is the canary in the coal mine; a steady and increasing ROI means a strong and healthy business while a negative or decreasing ROI is usually a precursor to a long, slow, and painful death for your business.

“Hidden” Assets

When you start your business you are often a one-man band, you are not only the Chief Executive, Sales, and Financial Officer but also the delivery boy, the maintenance man, and the head of productions.   As such, you get a huge amount of time wrapped up into your business and this creates what Steve Wilkinghoff, in his amazing book for business owners Found Money, calls “hidden inventory.”  It is hidden because it is not captured by traditional accounting but it is crucial to achieving success in a small business.  If you are a lawyer and a client hires you to handle a certain legal issue and you go to work at it but then, after putting say 20 hours into the project, get called aside to do a second project and leave the first on hold then you have hidden inventory.  The time that you invested in that project should be billable to the client but you can’t bill them until you’re done.  So there you have hidden inventory, it is the work in process that can’t be collected upon until the job is done.  The danger for the small business owner, who often is a one-man (or woman) show, is that they build up this hidden inventory, and work like crazy to do so, but are too slow at bringing it to the point of billing and thereby run into the trap of too much work and not enough money.  Estimate how much hidden inventory you have and add this hidden inventory to your assets when you calculate return on investment.

What is an adequate return

As we already discussed, if you have another investment immediately available to you (like a certificate of deposit or a savings account) and it offers a higher return on investment than your small business then you should feel really, really, uncomfortable.  I will tell you that so many times I have seen businesses borrow money with a higher interest rate than their return on investment and I just to take them gently and tell them to go spend that cash at the casino, because it is about that bad of an investment.  Your small business should generate for you several times the ROI of just about any investment you can readily find.  Why, because it is very risky investment.  1 million and one things could go wrong and you will find yourself back to square one, only this time you will owe tons of money.   So, the higher the risk the higher the required return you should require.

Please leave your questions or offer your solutions below. As the WebCPA and the author of WebBizFinance.com, my job is to help you grow your business and solve your business finance and accounting problems!

Tyler

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How much is it worth?  You’ve put a monstrous amount of work and time into your business, perhaps now its time to figure out what all of that sweat and stress is really worth.  Maybe you are applying for a loan, raising money for expansion, talking with investors, or considering selling.  Consider this, there are as many ways to value a business as there are potential reasons for valuing it.

Big Dollars For My Biz

Also, value is in the eye of the beholder; a banker will have totally different criteria than a potential business partner or investor.  Below are some of the principle factors in calculating the value of your business as well as a listing of professionals that could help you put everything together and arrive at a number.

Principle Factors or Methodologies in Valuing a Business

1. Discounted Cash Flow – this is the methodology famously endorsed by Warren Buffet when he evaluates a business.  In its essence it involves taking the amount of cash flow you expect a business to generate in the future and then discounting that at some rate (perhaps U.S. long term t-bills or your required rate of return) to get a present value.  The math is simple using Excel, but this methodology obviously requires a great deal of estimation.  Don’t let the preciseness of the number fool you, in fact, you may wish to get a range based upon several different estimated cash flows and let that be a general guide.
2. Value of underlying assets – this is what would concern your banker or the court-appointed trustee of your bankruptcy.  Basically, this would require going down the balance sheet of your business and marking everything to its value if you had to sell it right now and then subtracting what you owe to others from that.  The problem with this methodology is that it only works if your business sucks.  What if your business requires very little capital to be successful but still kicks out tons of cash and profits each year, which you then use to line your pockets?  Clearly this methodology would grossly undervalue your business.
3. Growth potential – This is how the internet businesses of the dot.com bubble era got their outrageous valuations.  If your industry is hot enough and your business plan is sexy enough then your business may be extremely valuable even though your profits and cash flow are negative and your liabilities are greater than your assets.  In other words, people would be willing to put money into it now to keep it going until the day that they gamble it will really take off and pay them back many times over.  Pretty much every business starts this way, the owners invest time and money now in hope of future profits down the road.  Evaluating that “future profit down the road” is more of an art than a science.
4. Comparable business - You see this all the time in the stock market, the stocks of certain sectors correlate with one another because businesses from the same industry face similar economic realities and thus when one is sold it provides a benchmark price for all similar businesses.  Sure, you can expect your business to be worth more or less depending upon factors unique to it, but a potential appraiser might take that other business as a basis and then make adjustments to it to get to the value of your business.
5. Synergies - often when an existing business business is purchased the buyer is another business that is looking for synergies that can be exploited by uniting the two businesses.  The synergies could come in the form of uniting new technology, more efficient purchasing through economies of scale, lowering cost by sharing overhead, or cross-selling in complementary markets.  For a big business example think of a big pharmaceutical company buying out a bio-tech firm to access new technology and diversify its products.  Closer to home, if you run an online store that specializes in hip handbags for young, professional women you might be bought out or merge with another online retailer that has a niche in chic but not-too-expensive jewelry for a similar clientele.  The merger would allow them access to your client lists and a chance to cross-sell their product through your channels, as well as the continued revenue of your business.  This creates synergy and might mean that your business would be more valuable to this potential buyer than to someone who doesn’t yet have an online presence.

A Second Opinion

A number of professions have sprung up that provide specialists in valuing businesses.  The BizSeller has already put together an excellent list, so I will use an excerpt of their post and add hyperlinks to the institutions mentioned.

• Initials: C.B.A.   Title: Certified Business Appraiser   Institution:Institute of Business Appraisers
• Initials: A.S.A.   Title: Accredited Senior Appraiser   Institution: American Society of Appraisers
• Initials: CPA/ABV   Title: Certified Public Accountant Accredited In Business Valuation   Institution: American Institute of Certified Public Accountants
• Initials: CVA   Title: Certified Valuation Analyst   Institution:National Association of Certified Valuation Analysts

Why would you need a specialist? Usually, if you are calling in one of the above professionals, it is because you are being asked for an independent third-party valuation by a potential lender, by the courts, or you need to provide it for estate tax purposes.

How does the specialist arrive at a price? Usually the specialist takes the factors above that they feel are most relevant to your business and then run a set of calculations using a range of factors.  They do the math several different ways to provide a range of potential values and then they pick a number and the middle of the range and then, abracadabra, just like a magician pulling a rabbit out of his hat the specialist pulls a number out of her, well, range of numbers.  This is great fun in divorce cases or other legal cases because you get two specialists, one representing the plaintiff and the other the defendant, coming up with two very different values.  Almost invariably each specialist (expert witness, in this case) chooses a number that favors the party that pays them.

Conclusions

• The business has different values to different people
• There are many different ways to value a business
• Retained Earnings have little to do with value
• Earnings + positive cash flow = great business, earnings + negative cash flow = future bankruptcy ,

Please leave your questions or offer your solutions below. As the WebCPA and the author of WebBizFinance.com, my job is to help you grow your business and solve your business finance and accounting problems!

Tyler

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More Time/More Money

Since reading “Found Money, Simple Strategies to Uncover the Hidden Profit and Cash Flow in Your Business” I have developed an enormous man crush on Steve Wilkinghoff.  Really, if I had a poster of him I’d put it up right between the ones of Michael Bradley and Voltaire.  I cannot preach too much that, in my experience, there is an overwhelming correlation (I would maintain causation!) between businesses that take accounting and financial management seriously and businesses that make their owners rich.  Now Steve comes along and gives the world’s productive class new tools to make themselves more money and give themselves more time to enjoy it with.

Found Money is the type of book that elevates accounting out of some crap that the IRS requires and into one of the sharpest tools in the entrepreneurs tool chest.  Steve’s Found Money Method not only tells entrepreneurs what the important influences on their business’s profitability are, it gives them the tools to maximize that profit potential and do what every good business must do, put money in its owner’s pockets!  Some of the nuggets of wisdom from Found Money include:

• Why “Getting More Customers” is often the most ineffective method of growing your business.
• Why it isn’t enough that your business is profitable, it must also be cash plow positive and provide a sufficient return on investment.
• Why the worst method of marketing is often the first used.
• Why some of your customers are most likely taking money out of your pockets and how to find them and fire them!
• How to find out which of your products is really making you the most money and what products you want to sell more of.
• Why most businesspeople actually under-price their products and how to find the best price for your products.

How much would that information be worth to you; perhaps thousands, maybe even millions of dollars?  Steve’s book set me back about $15 including shipping when I bought it online.  Only I had to buy it twice because I lost the first copy after reading just enough to get me really hungry for more.  Big Business spends gigantic sums each year poring over their accounting records and using them to make the important decisions that are often life or death for a company.  Now Steve puts this ability in your hands and adds the Chief Financial Officers cap to the Chief Executive Officer’s and Chief Operating Officer’s caps that you already wear.

As the WebCPA and the author of WebBizFinance.com, my job is to help you have more time and more money!

Tyler

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Cash is the lifeblood of business and understanding how the statement of cash flows works is essential for every aspiring Richard Branson or Mark Zuckerman. Putting together your cash flow statement can be tricky for the newbie but is actually very easily mastered with this simple hack.

The Indirect Method

The Philosophy of the indirect method is that cash flows should be in essence driven by profits so, to calculate the indirect method of cash flows, you start with your profits and then make adjustments for everything that are not profits until you get to your change in cash flows. When you think about it, this is very intellectually satisfying. After all, our main obsession is with profits, and rightly so. However, profits don’t keep the employees coming back and the lights on, cash does. So by closely examining all the uses of cash we can see where our cash is going and locate any potential problems; which makes the indirect method of calculating cash flows a fast, efficient, and very powerful weapon in your arsenal of business management for maximum profits!

Balance Sheet for Cash Flows

The Hack

Debits equal Credits and the balance sheet must balance, or assets = liabilities plus equity, got that? That’s all the accounting you need to know for this exercise. Now take this a step further. Download your comparative balance sheet into Excel, you know, it’s the assets = liabilities plus equity page. Comparative means that we show two periods, usually year ends, side by side; like in the first graphic. Now, in the immediate column to the right make a total subtracting the current periods assets from the prior periods and copy it all the way down, except in the totals cells [see the first image]. Now move down to the liabilities and equity section and do the opposite, subtracting the prior period from the current period. We do the opposite because credits (liabilities and equity) have the opposite value (-) from assets (+), but that’s really not important at the moment. Now sum the new column that represents the change in the balance sheet. If you did the exercise right then the sum should be zero. If you’re not getting zero that means that you forgot to reverse the formula for the liabilities and equity section or you included subtotal rows in your new column. Pretty frickin’ cool, huh? But that’s not the coolest part. Now redo your sum to exclude the difference in cash, usually the first line. The sum of all the other changes must be exactly opposite any single change, or in other words the sum of every other change equals the change in cash flows times negative one!! Flippin’ mindblowin’ stuff! And the basis of the Indirect Statement of Cash Flows.

Putting This Into the Statement of Cash Flows

You’re 80% of the way there and, if you are only doing this to understand your business and not to make a real, bona fide, according-to-GAAP cash flow statement then skip over the rest of this post and head to the next. The next step is to turn this information into the required format to have an official looking statement. Well, if you take a look at my sample Cash Flows Statement you will see that the first line is net income, and what is net income but part of the change in retained earnings? If you read my earlier post on retained earnings you will remember that the change in retained earnings is comprised of net income plus capital contributions less distributions. So your net income, the first line on your statement, less your distributions or plus your contributions in the investing section will equal your number for the change in retained earnings on the balance sheet you worked on in the paragraph above. And so it is down the line, every line on your cash flow statement must either alone or in aggregate with another line equal a line in the change column that you just calculated on your balance sheet. This is brilliant stuff kids and I wish my accounting professor would have explained to me this way. Actually, maybe he did but I sat next to this really cute mamacita that day; I could be a moron like that.

Transfer the Difference to the Statement of Cash Flows

The Challenges

The next big challenge on your statement of cash flows will be the change in fixed assets, which will be a component of plus depreciation expense less any new assets purchased plus any assets sold plus or minus the gain or plus the loss on that sale. The key is, when you add up those factors they must equal that line for the change in fixed assets. If not you’re forgetting one component so review the equation in the first sentence of this paragraph and figure it out.

After fixed assets the next most complicated line is the change in notes payable or debt. The formula is that new monies borrowed minus debt payments plus interest expense will equal your change in debt. This is important because all three components will go on a different line on your statement of cash flows, but their sum must equal the change that you calculated on your balance sheet or you’re doing it wrong and you need to review.

Other than that everything else pretty much matches line for line between your balance sheet calculation and the statement of cash flows. Just plug in the numbers and voila! your change in cash flows will equal the amount that you calculated on line one of your balance sheet! If for some reason it doesn’t just go back over and make sure that you can reconcile each line for the changes that you calculated on your balance sheet to the cash flows statement. If you can’t you must be missing a line.

Finished, Miller Time!

When you’re done patting yourself on the back for a job well done then it is time to get down to the really important business, what all this madness means to you and your business and how the statement of cash flows can help you run your business better. Alas, that is the source of another post as I’m tired and turning in for the night; so stay posted!

Any questions? Do you think that this is absolutely brilliant and that all business people should make a pilgrimage to the grave of the Portuguese bookkeeper who first invented this madness 500 years ago? Do you think I am a moron and have no idea what I’m talking about? Feel free to let me know in the comments section below.
As the WebCPA and the author of WebBizFinance.com, my job is to help you have more time and more money!

Tyler

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For a business to be successful, i.e. put money in its owner’s pockets, it is not enough that it be profitable, it must also be cash flow positive.

Image Cash Flows

Ever wonder why your business seems to be doing so well, I mean, sales are up and growing steadily, but still you struggle so hard to scrape up the cash to pay the bills? Or how about this, you seem to be doing alright, at least treading water, but then all of the sudden you realize that you have a lot of bills coming due, and soon? Where are you going to get the cash? Understanding cash flow and the process in how revenues become profits which become cash is one of the most misunderstood concepts for all small businesses and new business owners. After all, you say, if I’m out there selling sooner or later all that will take care of itself, right? Not so fast, McFlash! The successful business is both profitable and cash flow positive. Anything less is a sinking ship and you’re the captain that’s going down with it. So take a few minutes, read below, and see if it doesn’t help you understand how your business is milking the cash cow.

Understand the statement of cash flows

Recently I did a post on calculating cash flows which, even if you have an accountant and don’t ever plan on preparing your own cash flows, is a great primer on how every other item on the balance sheet effects cash flow. The basic equation is this: net profit minus any increase in assets plus any decrease in assets plus any increase in liabilities minus any decrease in liabilities minus distributions to the owner equals your cash flow for the period. Read this as an algebraic equations and think about its implications, the most important of which is this, profits are only one factor of many that determine your cash flow.

The Curse of Big Profits, or how you can have profits without cash flow

The Robert Kiyosaki Strategy, positive cash flow, negative profits

The Positive Cash Flow Now, Chapter 7 Bankruptcy Later Strategy, positive cash flow, negative profits

If you are serious about being in business, and if you just read through all this you must be, then you will want to really understand your cash flow and profit and how they interact. One excellent source I absolutely recommend is Steve Wilkinghoff’s “Found Money: Simple Strategies for Uncovering the Hidden Profit and Cash Flow in Your Business.” Steve may be an accountant rather than a preacher, but I jumped up more than once and let out a booming “Amen!” as I read it. Scared the hell out of the the people in the barbershop, but I got faster service because of it.

As the WebCPA and the author of WebBizFinance.com, my job is to help you have more time and more money!

Tyler

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How much are you worth? Many self-made business people, famously including Robert Kiyosaki in his best-selling blockbuster “Rich Dad’s Prophecy,” emphasize the importance of creating a personal financial statement to help the entrepreneur track their income and change in net worth. At their simplest, personal financial statements include a statement of net worth and a cash-based statement of income. If you run your own business or you are an independent contractor you should already track income and expenses, perhaps on software such as Quicken or Mint because, at the minimum, you will need them to prepare your tax returns. By preparing your statement of net worth along with it you are giving yourself a powerful tool to help you understand if you’re getting richer or poorer and why. Read on for more information on why personal financial statements are such powerful tools, and how to prepare them.

Top 5 reasons for preparing your personal financial statements at least once a year:

1. You can keep track of all your investments in one place. If you’re like me then you have a 401(k), the wife a 403(b), an IRA, and a few miscellaneous investments in comic books, antique chamber pots, and real estate in third world countries all on separate reports. I like to put their values all on one financial report each year to get an idea how my portfolio is performing as a whole. This way, if I am assassinated in the night by anti-capitalist accountant-haters, my wife will have a summary of our assets or, if I live, I can see if we need to do some diversification of the family portfolio into say, cocoa bean futures or works of art by minor Midwestern celebrities.
2. In case someone wants to see them. For example, if you are applying for a loan with the Small Business Administration, if you are about to take on a business partner, or if you are engaged to be married and are about to ask your future father-in-law for permission then there are people who would be very interested in seeing what your resources are and how responsible you are in managing them!
3. To examine where the money is coming from and where it is going. This is a hard look at the income side of the statement. I like to put my expenses into categories and compare how much I am spending in each category from one year to the next. That way, if I notice a big increase in a certain category, say “Wife’s Boyfriend,” I can nip that excess spending in the bud before it gets out of hand!
4. It can be the basis for preparing the budget for the next year, or for making goals for the next year. My wife and I are saving to buy a piece of property in Costa Rica and we need the cash by August. Using this years budget we projected the cash we would normally have by then and then made some adjustments (she and I working harder and us all tightening the belt) to get to the necessary sum. If we didn’t have this information then we would be flying blind, with only a vague guess as to how much we could reasonably expect to have.
5. Celebrity endorsements; Robert Kiyosaki, in his book Rich Dad’s Prophecy, says about personal financial statements “all through this book, I refer to financial greats such as Warren Buffett, America’s richest investor, Alan Greenspan, chairman of the powerful Federal Reserve Board, and Paul O’Neill, the secretary of the treasury, who all say basically the same thing my rich dad said to me. All of these financially smart men stress the importance of financial literacy and that financial literacy begins with a financial statement. None of these men said start with real estate, savings, a business, tax liens, stocks, day trading, options trading, or mutual funds, which is where most people start building their arks … and that is why so many arks cannot stand rough seas.” Wow, not only does Robert recommend them, he implies that Warren Buffet, Alan Greenspan, and Paul O’Neill do as well!

What they are

So, have I sold you on the value of preparing your personal financial statements yet? Great! So next you will want to know how. The essence of a statement of net worth is the total of items that you own that have value (assets) less the total of your debts and future obligations (liabilities) equals your net worth. Investopedia has an excellent page that gives the details of what to consider for assets and liabilities. The essence of the cash-based statement of income is total income (your salary, payments received for jobs or sales, etc.) less total expenses (money spent) plus (less) any increase (decrease) in the value of your assets that were not the result of putting more cash into them equals your net income, which is the same as the change in your net worth from the prior year to the current year. Got it? Take a look at this sample brought to you byprovided by the AICPA (Professional Bean Counters of America).

There are two essential elements to any financial statements, the first is that the statement of net worth, which is called the Statement of Financial Condition here, has at minimum two consecutive time periods represented and the second is that the statement of income, here called the Statement of Changes in Net Worth, sums up to the difference between the two periods. To put it simply, your statement of income explains the change in net worth over a period of time, usually of one year. So, if you can get your net assets correct and then your income has to be correct as well, you may have to back into it (the technical term in accounting for this is a plug) but there you are!

Below are links to several free templates that will allow you to put together your own personal financial statements. Please note, in order to maximize the entertainment and utility values of preparing your own personal financial statements, I recommend pasting as many prior years as possible into the spreadsheet. That way, 2008 aside, you both get the heady rush that comes from seeing steadily increasing net values march across your screen and you can start crunching those numbers, calculating different ratios and comparing your performance over time. I warn must warn you, it is such an incredibly satisfying experience that you may find the hours go by until you squander an entire weekend just playing with the numbers!

Caveat Preparer, there are many philosophies about what exactly should go onto your statements; the AICPA has one way, Robert Kyosaki has famously made the case against including your residence, and the SBA has their own criteria. My opinion is that you really don’t need to expend gigantic amounts of time into this project for it to be useful. Stick to a method and be consistent over time. I rent, but if I had a house I’d probably include it at the price I paid for it less the amount I owed for it. I definitely would not include my car or any personal property though; the valuation would get to be a hassle and that’s not the point for me. I want to know how much my investments are going up and what I am spending my money on. On the other hand, if the debt you owe on those items is greater than their value, perhaps you do want to include that in order to be conservative.

What about you? Can anyone recommend some nifty spreadsheets or templates? Has it been a worthwhile experience to prepare your own statements? Is there anyone as geeky as me who can’t leave a comment because they want to do theirs right now? Let us know!

Templates

http://www.spreadsheet123.com/ExcelTemplates/personal-financial-statement.html

http://tyronesolee.googlepages.com/personalfinancialstatement.xls

http://office.microsoft.com/en-us/templates/TC010175221033.aspx?pid=CT101172761033

Blogs

http://tirikuimbakul.blogspot.com/2009/12/introduction-to-my-book-young-money.html this Cat is from PNG!

http://www.mikefanelli.com/2009/09/personal-financial-statement-template/ Another CPA with his own blog, trust him, he’s a professional!

http://shanelyang.com/2009/12/02/rich-dads-prophecy-part-4/ a Robert Kiyosaki disciple that gives Robert’s idea of what should be included.

http://www.millionaireacts.com/1734/preparing-your-personal-financial-statement.html Includes a sexy template by Robert Kiyosaki

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For the Newbie businessperson finances and accounting can be intimidating and too often frustrating. Fortunately, there are a number of excellent tools out there to help out and with a little bit of basic accounting knowledge you can turn this task into an incredibly useful tool to grow your business. Besides, there is nothing more entertaining than counting your own money!

Concept of a Separate Entity

One of the most difficult concepts for people to grasp is that of their business as a separate entity. The entity concept in its essence requires the exclusion from your business records of activities that are personal in nature. Example, its OK to record as a business expense drinks with a potential client while you are in the process of selling your products or services are business, but never drinks with your pals while watching a football game. The easiest way to maintain this separation is to open a new bank account just for your business and to religiously funnel all activity through that account and only through that account and to record said activity using detailed and accurate records. While you are at it you will probably want to get a credit card in the businesses name and use that strictly for business activity. It doesn’t have to registered in the name of your business if you don’t have a federal identification set up for your business; just put it in your name and refer to it in all documentation as XYZ Co. account. All this isn’t just good accounting and a valuable tool in managing your business, it also clearly shows your intent to manage a successful and independent business if the IRS should happen to start poking its big schnoz into your affairs.

Schedule C Filers

Partnerships and Corporations

If you have gone a step further and registered your business as a partnership or corporation (including the many sub-variations of partnerships and corporations such as an S Corporation, a Limited Liability Company, or a Limited Partnership) then your organization is probably a little more complex and your business will usually file a separate income tax return (with the exception of a single member LLC.). This means only preparing an income statement based upon your personal financial software will no longer suffice, you will need real financial statements with assets, liabilities and equity accounts. It also means that you will have to understand the concept of retained earnings. If your business doesn’t require carry much debt or require many fixed assets and you have a decent grasp of accounting then the personal finance software above is probably more than up to the task. I use a combination of Quicken and a few Microsoft Excel spreadsheets and it works just fine. However some will require more advanced software that can help them with transactions like payroll or depreciating fixed assets and they will end up buying an off-the-self accounting solution created especially for small businesses. I scoured the web for you and my favorite review of the options available is by Mary Girsh-Block at the CPA Technology Advisor. She rates and discusses the pros and cons of the Big 5, the by far most popular programs available.

Garbage In Garbage Out

As the WebCPA and the author of WebBizFinance.com, my job is to help you have more time and more money!

Tyler

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How much are you worth? Many self-made business people, famously including Robert Kiyosaki in his best-selling blockbuster “Rich Dad’s Prophecy,” emphasize the importance of creating a personal financial statement to help the entrepreneur track their income and change in net worth. At their simplest, personal financial statements include a statement of net worth and a cash-based statement of income. If you run your own business or you are an independent contractor you should already track income and expenses, perhaps on software such as Quicken or Mint because, at the minimum, you will need them to prepare your tax returns. By preparing your statement of net worth along with it you are giving yourself a powerful tool to help you understand if you’re getting richer or poorer and why. Read on for more information on why personal financial statements are such powerful tools, and how to prepare them.

Top 5 reasons for preparing your personal financial statements at least once a year:

1. You can keep track of all your investments in one place. If you’re like me then you have a 401(k), the wife a 403(b), an IRA, and a few miscellaneous investments in comic books, antique chamber pots, and real estate in third world countries all on separate reports.  I like to put their values all on one financial report each year to get an idea how my portfolio is performing as a whole.  This way, if I am assassinated in the night by anti-capitalist accountant-haters, my wife will have a summary of our assets or, if I live, I can see if we need to do some diversification of the family portfolio into say, cocoa bean futures or works of art by minor Midwestern celebrities.
2. In case someone wants to see them.  For example, if you are applying for a loan with the Small Business Administration, if you are about to take on a business partner, or if you are engaged to be married and are about to ask your future father-in-law for permission then there are people who would be very interested in seeing what your resources are and how responsible you are in managing them!
3. To examine where the money is coming from and where it is going.  This is a hard look at the income side of the statement.  I like to put my expenses into categories and compare how much I am spending in each category from one year to the next.  That way, if I notice a big increase in a certain category, say “Wife’s Boyfriend,” I can nip that excess spending in the bud before it gets out of hand!
4. It can be the basis for preparing the budget for the next year, or for making goals for the next year.  My wife and I are saving to buy a piece of property in Costa Rica and we need the cash by August.  Using this years budget we projected the cash we would normally have by then and then made some adjustments (she and I working harder and us all tightening the belt) to get to the necessary sum.  If we didn’t have this information then we would be flying blind, with only a vague guess as to how much we could reasonably expect to have.
5. Celebrity endorsements; Robert Kiyosaki, in his book Rich Dad’s Prophecy, says about personal financial statements “all through this book, I refer to financial greats such as Warren Buffett, America’s richest investor, Alan Greenspan, chairman of the powerful Federal Reserve Board, and Paul O’Neill, the secretary of the treasury, who all say basically the same thing my rich dad said to me. All of these financially smart men stress the importance of financial literacy and that financial literacy begins with a financial statement. None of these men said start with real estate, savings, a business, tax liens, stocks, day trading, options trading, or mutual funds, which is where most people start building their arks … and that is why so many arks cannot stand rough seas.”  Wow, not only does Robert recommend them, he implies that Warren Buffet, Alan Greenspan, and Paul O’Neill do as well!

What they are

So, have I sold you on the value of preparing your personal financial statements yet?  Great!  So next you will want to know how.  The essence of a statement of net worth is the total of items that you own that have value (assets) less the total of your debts and future obligations (liabilities) equals your net worth.  Investopedia has an excellent page that gives the details of what to consider for assets and liabilities.  The essence of the cash-based statement of income is total income (your salary, payments received for jobs or sales, etc.) less total expenses (money spent) plus (less) any increase (decrease) in the value of your assets that were not the result of putting more cash into them equals your net income, which is the same as the change in your net worth from the prior year to the current year.  Got it?  Take a look at this sample brought to you byprovided by the AICPA (Professional Bean Counters of America).

There are two essential elements to any financial statements, the first is that the statement of net worth, which is called the Statement of Financial Condition here, has at minimum two consecutive time periods represented and the second is that the statement of income, here called the Statement of Changes in Net Worth, sums up to the difference between the two periods.  To put it simply, your statement of income explains the change in net worth over a period of time, usually of one year.  So, if you can get your net assets correct and then your income has to be correct as well, you may have to back into it (the technical term in accounting for this is a plug) but there you are!

Below are links to several free templates that will allow you to put together your own personal financial statements.  Please note, in order to maximize the entertainment and utility values of preparing your own personal financial statements, I recommend pasting as many prior years as possible into the spreadsheet.  That way, 2008 aside, you both get the heady rush that comes from seeing steadily increasing net values march across your screen and you can start crunching those numbers, calculating different ratios and comparing your performance over time.  I warn must warn you, it is such an incredibly satisfying experience that you may find the hours go by until you squander an entire weekend just playing with the numbers!

Caveat Preparer, there are many philosophies about what exactly should go onto your statements; the AICPA has one way, Robert Kyosaki has famously made the case against including your residence, and the SBA has their own criteria.  My opinion is that you really don’t need to expend gigantic amounts of time into this project for it to be useful.  Stick to a method and be consistent over time.  I rent, but if I had a house I’d probably include it at the price I paid for it less the amount I owed for it.  I definitely would not include my car or any personal property though; the valuation would get to be a hassle and that’s not the point for me.  I want to know how much my investments are going up and what I am spending my money on.  On the other hand, if the debt you owe on those items is greater than their value, perhaps you do want to include that in order to be conservative.

What about you?  Can anyone recommend some nifty spreadsheets or templates?  Has it been a worthwhile experience to prepare your own statements?  Is there anyone as geeky as me who can’t leave a comment because they want to do theirs right now?  Let us know!

Templates
http://www.spreadsheet123.com/ExcelTemplates/personal-financial-statement.html
http://tyronesolee.googlepages.com/personalfinancialstatement.xls
http://office.microsoft.com/en-us/templates/TC010175221033.aspx?pid=CT101172761033

Blogs
http://tirikuimbakul.blogspot.com/2009/12/introduction-to-my-book-young-money.html this Cat is from PNG!
http://www.mikefanelli.com/2009/09/personal-financial-statement-template/ Another CPA with his own blog, trust him, he’s a professional!
http://shanelyang.com/2009/12/02/rich-dads-prophecy-part-4/ a Robert Kiyosaki disciple that gives Robert’s idea of what should be included.
http://www.millionaireacts.com/1734/preparing-your-personal-financial-statement.html Includes a sexy template by Robert Kiyosaki

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