In one of the earlier posts I had written about how we can use the 3 financial instruments normally used by companies, namely the Balance sheet, P & L account and cash flow statement to achieve control of our own finances. I had also written about how to build a string balance sheet by acquiring the right assets and being mindful about controlling liabilities. In this post I will try to address how you can look at your finances through a personal P & L statement.
Before we look at the strategies to manage the P & L account, let us first understand how the elements of a company P & L account can be mapped into any individual’s personal P & L statement. Observe the following:-
- A company will have sales income through it’s product or services. This can be mapped to the Active income of an individual, which will normally be through salary or business income.
- A company will have Other income from interest, dividends, sale of assets etc. This can be mapped to the Passive income of an individual, which can be through interest, dividend, rental income, capital gains and so on.
- A company will have expenses under different heads and this can be mapped to the expense categories that you have. These could be regular expenses like payment of salaries to employees, supplies or one time ones such as capital expense on purchase of assets etc.
- For capital expenditure you should not take the entire expense in the year. Companies depreciate an asset over time you need to do that too. For example, if you buy a car and pay 5 lacs for it then take expense as 1 lac per year for 5 years, if that is the life of the car you are expecting. You will have to take expenses such as car insurance every year.
- All insurance premiums are to be taken as expenses and not as investment.
- For a company taxes are after profits but for an individual we have to treat tax as an expense too.
- The difference between total revenues and total expenses, inclusive of taxes is the surplus that can be used for the purposes of investment.
In order to manage our P & L account as an individual, we will need to adopt the following strategies:-
- You need to maximize your Active income for the period you want to work. It is fine if you want to give up your corporate job after working 20 years at it but you must ensure that you are earning to your full potential for those 20 years. Remember, you may not have active income in your state of Financial independence.
- Try to maximize your Passive income to the extent possible. The best outcome we can achieve is when our passive income is adequate to meet our expenses. At that point we have achieved Financial independence. We may still keep working if we like but the constraint of having to work because we have expenses to meet is gone.
- Plan your expenses, keeping in mind your investment needs but do not go overly conservative. For example, when you are starting a family and have a home loan EMI to pay your surplus available will be low. It does not matter, as over the years you will be able to meet your investment goals by channeling more money as you have more.
- In case you cannot afford an asset based on your personal P & L do not buy it.
- Do not add to your expenses by taking consumption loans for depreciating assets.
- Keep track of expenses such as vacations, school fees, insurance premiums etc which occur annually.
- Project your total revenues, total expenses and therefore surplus available at the beginning of the year. Like a company publishes it’s quarterly results, you may also need to review these quarterly to see you are on track.
- The surplus is to be used for investment. In case there is some windfall gain, you may want to check whether you can meet some of your indulgence related plans or increase the investment.
- Like a company has a target of profit, you will have a target for investment every quarter and every year.
In the next post I will cover how we can deal with cash flow situations like a company does.