Updated: Dec 25, 2022
With industry experts expecting a recession in 2023, I will not be just sitting around the sidelines. If you want to come out stronger and not be left in the dust, then I will walk you through how an accountant prepares for an economic downturn.
Today, I will be putting an accountant’s twist and walk you through two types of financial statements: an income statement and a balance sheet. And before the sound of financial statements scares you off, I will be breaking it down so you know exactly how it applies in your daily life.
So financial statements are often used by investors when looking at a company’s performance to see the financial health of a company and whether it's worth investing in.
However, today we will be looking at financial statements and how they can be applied to you on an everyday basis.
Let’s tackle the first one - The Income Statement. Also referred to as a profit and loss statement. It is basically a summary ofhow much income you make, and how much expenses you are incurring, which gets you to your profits or in other words, savings - money you can choose to do whatever you want with.
So the formula is profits = income less expenses.
So how do we end up with more profits or more savings?
Let’s start off with where a lot of people focus their attention on and believe they have the most amount of control over, and that is expenses.
Expenses are basically any cash outflows you have. Your rent, monthly mortgage payments, car payments, groceries, shopping, hobbies, traveling, etc. Taxes are also a big one that people tend to neglect and don’t think much about. Cash outflow can also mean debt payments you have such as student loans and credit card balances.
There can also be many miscellaneous, unaccounted-for expenses that always happen - if you have a pet, it can be an unplanned vet visit, you need to get a new phone since you accidentally dropped and broke your old phone on the pavement, etc.
You can also have automated payments for subscriptions like Amazon, Netflix, Uber, etc, and monthly payments for gym memberships and phone plans.
One way to stay organized and to know how much you are spending monthly is to have a budget. In business, this is called bookkeeping, where you account for all your income and expense items.
As part of the profit equation, it's important to know what you are spending your money on and how much you are spending. I know that budgeting doesn’t sound abundant, but when you are starting out and really trying to get out of debt or trying to build up your emergency fund, it will help you towards financial independence since every $1 you save is a $1 you can use towards something that really matters to you.
So while the goal is to be as lean as possible with your expenses, it's a matter of using common sense and just being honest with yourself. Like, was going on a $500 shopping spree really something that you can afford? Was eating out for $300 this month really worth it or was I too lazy to cook?
That being said, I wouldn’t want to deprive myself but instead, be intentional about where I’m spending my money. Instead of eating out for $300 because I was too lazy to cook, why don’t I buy groceries for $150 to meal prep and allocate $50 to eat out with friends on the weekend? That way I still save $100 and I can look forward to going out on the weekends.
Think of it as what purpose did my money serve? So take this time to go through your expenses, and label them according to:
N for necessary expenses
U for unnecessary expenses, and
H for modest indulgences that make you happy.
Aim to cut at least 10% of your expenses by targeting the unnecessary expenses first.
Income is money coming in, and for lots of people, it may seem out of your control if you earn a salary from a job. It’s not like you can go to your boss and ask for a 100% raise.
People tend to focus on expenses because it seems like it's within their control. But if you think about it, it’s actually quite limiting because the most you can ever reduce your expenses down to is zero, which is impossible since you still gotta eat and put a roof over your head.
As for income, the sky's the limit. You can earn as much income as you can, it just might not come from just a salary. And as part of the profit equation, you want your income to be as high as possible. And the main way to do this is to increase your value.
You can do this by investing in yourself and upskilling. This way, you become indispensable to your employer since they value what you bring to your table, and your chances of keeping your job during recessionary times would be higher.
Though, if you are serious about financial independence, I strongly believe in starting your own business to see that limitless upside potential. I’m not saying it's easy nor is it for everyone, but the payoff can be life-changing.
The goal is to have as big of a profit or savings as possible. That way it gives you more options by ramping up your emergency fund, paying off your debts faster, investing in your retirement fund, putting a downpayment on a home, saving up for a wedding, starting a business, or if you already have a business, reinvesting back into scaling and growing your business.
So to figure out how much you are saving, take total income less expenses.
Based on data released by Statistics Canada, the average net savings for Canadians under 35 are around $20k by the 4th quarter of 2020. Savings peak between 35 to 44, and then decline until you are 65 years and older, in which you have negative savings since you are withdrawing funds for retirement.
Moving onto the balance sheet, there are three main components: Assets, Liabilities, and Equity.
The formula goes Assets = Liabilities + Equity, but if we rearrange it to make sense to us, we come up with Assets - Liabilities = Equity. Does this look similar to what you know?
In other words, your equity is basically your net worth. Take all the assets you own, less any debt you have, to come up with your net worth. Like profit, you want to have as high of a net worth as possible, and that is by increasing your assets and decreasing your liabilities.
Assets in your life are investments like real estate, stocks, and your business. Assets have economic value that you own with the expectation that they will provide a future benefit. In the case of real estate, you can rent it out and earn passive rental income, while benefiting from appreciation in value over time. Stocks can provide you with dividend income and capital gains. Your business produces profits, which can fund your lifestyle, and then even be able to sell it for many multiples later down the road.
Assets are the types of investments you want to make with the profits or savings you have.
On the flip side, a liability is something you owe to someone else, like banks or credit card companies. Taking on too much debt is bad since it can put you at a negative net worth. This can be the case when you use a credit card or personal loan to buy things that you can’t pay back in full every month - this is bad debt since whatever you are buying likely doesn’t have a future benefit and whatever purchase you made is actually declining in value the moment you bought it.
However, debt can also be used as leverage if done properly. For example, if you were able to get a good deal on a real estate property that you were only able to put 10% deposit and borrowed 90% as a mortgage, but saw that asset appreciate 30k in a few years, you only need to pay back what you borrowed and the appreciated value of $30k is yours to keep. And you were able to do this by putting down only 10% and using 90% of “other people’s money”
At the same time, leverage can go south if you borrowed money and weren't able to manage your risk. In the case of margin trading, if you make a couple of bad calls and your investment portfolio goes down 50% in value, this financial decision would result in costly consequences.
In this case, you may not be able to pay it back and need to declare bankruptcy, which will affect your credit score and ability to borrow money for years.
As we are on the brink of a recession, it's important to be more intentional about where you are spending your money - are you buying assets or liabilities? If you are too leveraged, are you focusing on paying down debt?
Net Worth (Equity)
You can figure out what your net worth is by taking the market value of all your assets less all your liabilities. Do you have a positive or negative net worth?
Based on Statistics Canada, 2019 data (before the pandemic) states Canadians under 35 years old have a median net worth of 48,800, and the average is $79,100. The number of households, which includes spouses, children, and relatives living in the same residence.
If you look at the net worth based on provinces and territories, the average Ontario household leads, followed by BC - this is probably due to the surging house prices and strong economies.
What was your biggest takeaway? Comment down below and let me know!
Disclaimer: Note this post is not accounting nor tax advice and should be used for entertainment purposes only. Consult with your own accountant and/or tax advisor for specific advice related to your business situation and needs.