How to Use Financial Statements for Real Estate Investing

How to Use Financial Statements for Real Estate Investing

In the world of finance your progress is registered in a document called a Financial Statement.  Financial statements of financially sophisticated people vary all the time, and are nothing more than a report card of their financial health at a specific time – a snapshot, if you will. Furhter, it can be your guide for investing. In this article, you’ll see how to use financial statements for real estate investing

Grade Point Average Measured Your Academic Progress

When you were in high school, your progress was registered in a document called a Report Card.  A new report card was generated every grading period of your schooling career, and represented a snapshot of your academic circumstance at that moment.  As part of this process, a grade point average (GPA) was calculated based on all of your grades.  This GPA was important because it was considered by colleges to determine whether you are worthy of admittance, and whether you deserved any scholarships.

“No man can teach another self-knowledge.  He can only lead him or her up to self-discovery – the source of truth.” –Barry Long

Financial Statements Measure Your Financial Progress

In the world of finance your progress is registered in a document called a Financial Statement. When an individual applies for a new car loan, a mortgage, or to get funds for a start-up business, his financial statement is evaluated by the lending entity to determine credit worthiness.  Interestingly, the soundness of the financial statement impacts not only the decision to lend money, but also the terms of the loan – the stronger the financial statement, the better the terms.

Cash Flow and Net Worth are Periodic

Similarly to your high school report card, an updated financial statement is generated periodically, usually quarterly and annually.  A financial statement tracks four main components: income, expenses, assets and liabilities.  When these are tallied-up, what you get is your Cash Flow and Net-Worth.  Your Cash Flow and Net Worth are likened to your GPA.  It helps banks and other major investors determine whether or not you are worthy of working with, and if so, to what degree.

How is a Financial Statement NOT Like a Report Card?

This analogy that a financial statement is similar to a report card is effective in all ways but one.  While a report card was forced on you, that is to say that no matter what you did you were going to get one, a financial statement is entirely up to you.  However, avoiding the task of creating your own financial statements is detrimental to your progress.  If this makes you uncomfortable, then go ahead and stick your head in the sand and assume that what you can’t see can’t hurt you.  Unfortunately, the truth is that what you can’t see is hurting you, so I encourage you to go ahead and take the plunge.  If you want to know where you stand then you will figure out how to build your own financial statement.

How to Use Your Financial Statements for Planning

It is a sad reality that most people in America, even those with extensive college education and high salaries don’t utilize a financial statement in their planning.  I once asked a friend whether he and his wife utilize a financial statement to track their finances.  The answer he gave me was shocking, but not surprising.  Turns out, even though he knows what it is… sort of knows what it is, the financial statement apparently takes too much time.  Instead, he told me that at the end of the month they simply look to see if their savings account went up by a certain amount.  The balance in the savings account going up tells them that they have not overspent.  Translation – they spend money first and save what’s left.  It could also be said that they pay everyone else first before they pay themselves.  These folks’ combined salaries are $150,000 per year and this is the best financial tracking mechanism they could think of!

Consult Your Financial Statement Before Making Financial Decisions

On the other hand, I make it a point to consult my financial statement, which I update on a monthly basis, prior to making any meaningful financial decision in life.  I do this because I have discovered that it is the only way of gauging, in real time, the impact that any given decision will have on my overall financial position at that moment and in the future.  For instance, when I want to buy another property, or a new car, or take a family vacation, I can clearly see, down to the last cent, what this will mean to my bottom line relative to both my cash flow position and my net-worth (See Assets vs. Liabilities and Net-Worth vs. Passive Cash Flow).  This is in direct opposition to my friend’s approach.  I save first and then spend what’s left, while they spend first and save what’s left.

Put Your Financial Goals Ahead of Your Expenses

I believe that you must put your financial goals ahead of your expenses whenever possible.  I believe that you should proactively track every aspect of your financial life.  And most importantly – I believe that you should have a plan.  Thus, in my opinion one of the first steps toward financial success must be to understand all of the components of a financial statement, and to be able to construct one for yourself in order to gain a clear perspective on your current situation.

Real Estate Purchases and Financial Statements

Two years prior to my first investment real estate acquisition, I approached a gentleman I knew for guidance. I had my eye on this Prescott AZ real estate for sale and he was the father of a friend of mine who had a reputation in our community as a successful real estate entrepreneur and savvy businessman.  He was laid back and understated, and listened to me talk about my aspirations for over two hours.  He kept his cards close to his sleeve, and really didn’t offer much advice or guidance as I had hoped.  I was disappointed, but more determined than ever to gain his council.  I tried to connect with this man several more times with no success.  Two years later, I was still making regular attempts to build a relationship with this man to no avail.

Then one day, I finally got my break.   We spoke on the phone and he told me of a little 3 bedroom, 2 bath brick house sitting on a corner lot in one of my target neighborhoods.  It was exactly the kind of property I would love to have.  We arranged for a time to meet and walk through the home.  Turns out he had bought it as a flip, fixed it and was tired of waiting for the home to sell.  Patrisha and I didn’t have a lot of money, so he agreed to consider owner financing if I was able to produce a financial statement, “…not anything complicated; something that fits on one page.”  At the moment he said this I knew I would blow it by asking him too many questions about his expectations.  So, I nodded my head, thanked him profusely for his time, and went home to figure out what I was going to do.  Fortunately, several weeks before this meeting my wife and I made a purchase of board game called “Cash Flow” produced by Robert Kiyosaki’s company Cash Flow Technologies, Inc.  This game set us back $200, but we really got what we paid for.  Using the financial statement player cards provided in this game, I was able to construct my own financial statement to give to my mentor the following morning.  This was the beginning of a friendship, mentorship, and partnership which is still going strong today.

Income & Loss Statement and Balance Sheet

A financial statement is made-up of two sets of documents, namely the Income & Loss Statement, and the Balance Sheet.  Usually these two documents are comprised of numerous pages.  However, the example on the next page combines both into one page.  This was sufficient for me in the beginning and it will likely be right for you, too.

Financial Statement

INCOME & LOSS STATEMENT:     
Earned Income Gross Income  
Earned Income 1 Gross

$0.00

Earned Income Total

$0.00

Earned Income 2 Gross

$0.00

Passive Income (R/E Income)

$0.00

Passive Income (business, real estate, annuity, etc.)
N/A

$0.00

N/A

$0.00

N/A

$0.00

 
N/A

$0.00

 
Gross Income

$0.00

Expenses
Personal Expenses
Credit Card 1 (interest only @ 12%)

$0.00

Personal Expenses Total

$0.00

Credit Card 2 (interest only @ 9%)

$0.00

Business Expenses Total

$0.00

Credit Card 3 (interest only @ 12%)

$0.00

Income and Payroll Taxes

$0.00

Rent / Mortgage

$0.00

Car Payment

$0.00

Utilities

$0.00

Groceries

$0.00

Insurance (Auto)

$0.00

Insurance (Health)

$0.00

Gasoline

$0.00

Cell Phone

$0.00

Repairs and Maintenance

$0.00

Child Expenses

$0.00

Clothing & toiletries

$0.00

Entertainment

$0.00

Gross Expenses

$0.00

Business Expenses
N/A

$0.00

N/A

$0.00

N/A

$0.00

Earned Cash Flow

$0.00

N/A

$0.00

Passive Cash Flow

$0.00

N/A

$0.00

NET CASH FLOW

$0.00

BALANCE SHEET
Assets

Current Value

Liabilities  

Balance

Savings Fund

$0.00

Credit Card 1

$0.00

Checking Account

$0.00

Credit Card 2

$0.00

Car 1 Value

$0.00

Credit Card 3

$0.00

Minivan Loan Balance

$0.00

TOTAL ASSETS

$0.00

TOTAL LIABILITIES

$0.00

NET WORTH

$0.00

Income & Loss Statement

The Income & Loss Statement is the component of the financial statement which tracks and reconciles all of the income and expenses.  In my opinion, income and expenses should be tracked monthly, not annually or quarterly, but it can be done either way.  My reasons are simple – vast majority of my bills show-up on a monthly basis, not quarterly or annually.

Most people in America live in the world of earned income.  Furthermore, most households today depend on two incomes.  This is why there are two spaces on the above financial statement for earned income.

Immediately underneath earned income, there are several spaces for passive income.  Since I have 18 rental units in my portfolio, each one of which is a revenue stream, there are eighteen spaces designated for passive income in Income & Loss statement.  Most people do not have any passive income, while others need 100 – 600 spaces to accommodate their passive income streams.

I use the term Gross Income to describe the total of all income, including all forms of earned, passive, and portfolio income, from all sources attributable to you over a specific time period.  It is a sum of everything you earn.

As you can see, the Expense section of the Income & Loss Statement accommodates both personal and business expenses.  In reality, you should keep personal income and expenses separate from business.  But to keep things simple, there is a space provided for Gross Expenses, which is the sum of all of your expenses.  This item should represent the sum of every single expense in your life – period.

The last set of items in the Income and Loss section left to discuss are pertaining to cash flow.  Earned cash flow is the juxtaposition of earned income to earned expenses, while passive cash flow is that juxtaposition on the passive income side.

It is important to note that cash flow calculation should account for income and all other taxes, which should be considered expenses.  Cash flow is really and truly what is left in your pocket at the end of a given period.

Replace Earned Cash Flow with Passive Cash Flow is the Goal

The main objective in my financial life is to replace as much of my earned cash flow with passive cash flow as quickly as possible.  This is THE goal for three reasons:

Reason 1: Passive Cashflow is Intellectual, Not Physical

Passive cash flow, being the result of investment activity, is domain of intellectual pursuit rather that physical.  Statistically, our physical health is much more likely to negatively impact our productivity earlier in life than is our mental capacity.  Being that I am a violinist by trade, this reality carries significant consequences for me.  What happens if I hurt my finger by accident or from playing too much?  It’ll likely put an end to my career – that’s what.  When I was younger I pretended like that could never happen to me, but I do not pretend any more.

Investing is different in this respect.  Simply put, as long as my head works O.K., I can earn!  For this reason I feel that earning money as an investor is a much safer proposition than anything else!

Reason 2: Passive Income is Taxed Least

As I discussed in an earlier article, passive income is the least taxed type of income.  Here is the question: would you rather earn $110k and spend 50% of it on taxes, or earn $70k and spend 15%?  The answer, of course, is the latter because you’d have more left.  What this means to me is that if I were able to generate cash flow through passive income, then I would not need as much income in order to maintain my life style.

Another way of looking at the same problem is this.  Let’s say you determine that in order to maintain your life style you require $35,000 per year of cash flow.  This would mean that if your effective tax rate is 30%, you would have to generate $50,000 of earned income.  However, if you were to generate cash flow by way of investment income and your effective tax rate is only 15%, you would only have to bring-in about $41,176 in order to achieve the stated goal of $35,000 of cash flow.

Reason 3: Passive Income is Scalable

Passive cash flow has much more expandability – that is to say there is much more room for growth.  The reason for this is simple.  The main limitation relative to earned income is time.  There are only 24 hours in a day and seven days in a week.  This reality does not change for anyone.  Time is the ultimate equalizer – wouldn’t you agree?  With earned income defined as trading dollars for hours, time represents a built-in limit to one’s income-potential.  Regardless of your hourly wage, all of us are limited by time.

On the other hand, by its’ very nature passive cash flow is automated to a great extent, which means that it requires much less time commitment.  This is why it may be possible to have virtually unlimited streams of cash flow resulting in great expandability potential.  Thus, if you learn to work smarter, then you won’t have to work as hard!

Cash Flow

An honest consideration of your cash flow is a required first step in the process of financial freedom.  Notice, I referred to financial freedom as a process.  In my 18-step action plan, identifying your current cash flow position is step number 1.  To be able to plot your course, you must identify not only where you are going, but also your starting point.

Balance Sheet and Investing

The Balance Sheet is the component of the financial statement which tracks value.  The concept of positive vs. negative within the balance sheet is represented with Assets and Liabilities.  Traditionally, any item which of intrinsic worth that can be owned is considered an asset.  On the other hand, a liability is generally though of as an obligation of some sort.  For example, $1,000 in the savings account is an asset, while a loan from the bank is a liability.

I don’t think that this traditional view is entirely sensitive to the realities of business.  To this end, you will find an in-depth discussion relative to the concepts of asset and liability in the chapter entitled Asset vs. Liability – It’s Simple Matter of Cash Flow.  For now simply understand that when you enter all of the items of value that you own into the asset column of the balance sheet, and all of your obligations into the liability column, tally the columns up and reconcile the resulting figures, what you are left with is your Net Worth.

Conclusion

I hope that this post has given you some understanding of the structure and the application of the financial statement.  I encourage you to fill-out a financial statement for yourself at this time, and I promise that you will begin to gain a clearer perspective of your financial circumstance.  Be honest.  Research all of your expenses – try not to miss anything.  Do not inflate the perceived values of your assets.  I bet most of you will be shocked to discover how much money slips through your fingers unknowingly, and how little financial value you have managed to accumulate.  Nevertheless, once you see clearly where you are you will begin to see what steps you must take to proceed in the direction of your dreams.

If you’re ready for more, be sure to check out my Cash Flow Freedom University >

6 Comments

  • Lisa Reply

    Great article, nice summary of a critical topic. Nice touch to add the sample pages!

    • Ben Reply

      Thanks indeed, Lisa.

  • Jim Braun Reply

    Ben
    I Like the article.
    I do need to do a statement

    • Ben Reply

      Thanks very much, Jim. Yes – I think everyone needs a financial statement to make intelligent financial decisions!

  • Peggy Reply

    I, too, have Kiyosaki’s Cashflow game years ago. Since then, I have had a financial statement of my own. For me, I basically update it on a weekly basis as it helps me track my expenses for the month. I definitely agree that everyone SHOULD have a financial statement of their own and updated on a regular basis.

    • Ben Reply

      Hi, Peggy!

      I have to admit – I do not update my FS weekly. There’s just so much money moving in all directions that we find it most beneficial to update monthly.

      Thanks so much!

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