Learn these personal finance basics and control your financial situation

These personal finance basics are very important so that you can both control and make daily improvements in your financial situation:

1. Learn the difference between assets and liabilities

2. Learn what is income and expense

3. Learn what is a balance sheet

4. Learn what is a profit and loss (or income) statement

5. Learn the relationship between your balance sheet and your profit and loss statement

6. Analyze some special cases which might cause confusion

7. Apply and put into practice the personal finance basics to your own situation

1. Learn the difference between assets and liabilities

Assets are everything which you own and can dispose of, they include: cash, land, stocks, your car, etc.

To clarify, when we say: "own and can dispose of" we mean that you don't have any debts to pay on your asset nor do you have any restriction on disposing of it.

For example, if you took out a loan to buy a car and the car itself serves as a guarantee for the loan, you don't (yet) have an asset because you have a load with the bank and you can't simply sell the car until you pay off the loan.

Liabilities are everything you owe to someone, which could include your mortgage, your credit card balances, bills, taxes, etc.

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2. Learn what is income and expense

Income is everything which "comes in" regardless of whether this is a wage, fees, rent, dividends, interest, royalties, etc.

Another one of the personal finance basics that is important to note is that income can be either earned or passive income (click here -opens a new window- for a more detail).

Expense is everything you pay to acquire things or for services. This includes clothes, food, gas, transportation, entertainment, sports and recreation.

These first four personal finance basics (assets, liabilities, income and expense) and the relationship between them form the foundation of how you manage your money.

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3. Learn what is a balance sheet

A balance sheet is a financial statement which simply aims at comparing your assets with your liabilities to answer the question: Do I have more assets than I owe?  Yes, or no?  What is the difference?  This difference is your net worth.

In simple terms, the formula is:

Assets - Liabilities = Net Worth

which is to say that your net worth is everything you own less everything you owe.

That is why this financial statement is called balance, because your assets are always equal to your liabilities plus owner's equity.

Another way of graphically showing the relationship between these personal finance basics is the following:

You can see that the size of your assets is always the same as your liabilities plus owner's equity.

Another analysis of this financial statement is that the size of your assets is due to two things:  assets from money which you borrowed (liabilities) and assets bought with your own money (owner's equity).

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4. Learn what is a profit and loss (income) statement

A profit and loss statement is nothing more than a comparison of your earnings with your expenses to discover whether you earned or lost money over a certain period of time which might be a day, week, month or year.

The difference between your income and your expenses is the net result which you achieved over the period you're evaluating.

It could be that you have a profit if your income exceeds your expenses or you could have a loss if it is the other way around.

These basic concepts of personal finances can be shown graphically like this:

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5. Learn the relationship between your balance sheet and your profit and loss statement

The relationship between both financial reports exists because in general terms, an asset tends to produce and income and a liability is thought to generate an expense.  For example, if you have an asset such as a term deposit in a bank, this produces an income for the interest you receive.  In the same way, if you have a credit card balance owing, you have an expense due to the interest you are charged.

In practice, however, assets don't always produce income, and liabilities aren't always leading to expenses.  For example, after you have paid off the loan for a car, you have an asset which you could sell, but which does not bring you any earnings and, in fact, is the cause of expenses in the form of maintenance, gas, taxes, insurance, etc.

In another case, for example, if you borrow money to buy a parking space for a car and you rent it to someone for more that the payment you need to pay to the bank, you have a liability which provides you an income.

The relationship can be seen this way:

For this reason, before you choose an asset or a liability you need to see whether it will bring you income or expenses. Ideally you should pick those assets and liabilities which provide income and avoid those which bring expenses.  However, there are some exceptions such as the house where you will live with your family.

This is one of the most important personal finance basics for you to understand because, if you do, it will not only serve you  in choosing between assets and liabilities now and in the future, it will also help you understand the financial reports of businesses which you may need to assess.

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6. Analyze some special cases which might present some confusion

One special case is your home or other assets which you might buy using a mortgage or a loan.  When you prepare you balance sheet you should not enter them as assets because you are not free to dispose (sell) them, yet if you enter only the part which you owe, then you would end up with a negative equity...

In these cases the practical approach is to list your house as an asset with its estimated market value (that is to say the value you could reasonably expect to get if you sold it today) and list the liability according to the balance owing of the mortgage or loan.

Also you might have some assets and liabilities which do not produce income or expenses.  An example of a liability which doesn't generate an expense would be that $1,000 which you borrowed from your uncle without interest and agreeing that you'll pay back when your financial position improves.

Another situation are the bills for basic services like electricity, water, internet, etc. are expenses which apparently do not have any apparent liabilities connected to them but are simply money which needs to be paid. However, at the end of each month you have a debt with the utility companies which provide these services (and for which they send you a bill) because during the month you received these services which haven't yet been paid for.  In other words, each month you pay for what you received the month before.

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7. Apply and put into practice the personal finance basics to your own situation:

To make sure you have an adequate understanding of these personal finance basics, try the following:

a) List 2 assets and 2 liabilities with an estimated value and calculate your net worth:

b) Describe the income and expenses related to the assets and liabilities which you've listed above:

To start it is possible that you'll have some difficulty in sorting out these personal finance basics, but like any learned activity, once you start practicing it will become clear.

If you have any general questions, please feel free to ask. Contact us.

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