Our mission is to make finance accessible to all, luckily for us core financial & accounting principles are actually very easy to understand. If you can do 3rd grade math (adding, subtracting, multiplying & dividing) then you can handle 97% of the accounting calculations needed for finance. While all of our tools have detailed explanations & examples of financial concepts built in, its always important to understand the basics, the super basics, the baby basics.
Run Your Finances Like A Business
Every company in the world faces this simple reality.
Revenue (i.e. sales) - Expenses = Profits (or Losses)
When a company's sales are bigger than its expenses it makes a profit. With the profit it can then invest in business growth, pay down debt or give money to its owners.
An individual faces a very similar reality, though usually worded differently.
Net Income from all sources - All your expenses = Savings
When an individual's income is greater than their expenses they generate savings (or profit, if you prefer). With your savings you can then invest in new income streams (growth), pay down debt or spend money on yourself (i.e. purchases like TVs, partying, designer clothes etc.).
As discussed more deeply in our opening blog post, to build wealth you need to invest the majority of your savings into productive assets. Overtime the increase in value of the assets and the income they generate will surpass your expenses, at that point you will achieve financial independence!
Ok ok, but what actually is an "asset"? What's that formula above mean? I DONT SPEAK FREAKY DEAKY FINANCE!!
Glad you asked! And you make a great point, its critical to understand finance terms to ensure we are all speaking the same language.
The following is long (sorry), but an important starting point and future point of reference. If you learn and understand the following the rest of your financial journey will become much easier.
The Language of Personal Finance
Income: Is money coming to you. This includes employment income, side gigs/hustles, tax credits, investment income, interest income, rental income, royalties, business income and any other type of income you receive.
We always only count the net amount (i.e. after tax) to ensure it closely resembles actual cash inflows.
Expenses: Is money leaving you. This includes all your living expenses (mortgage, rent, property tax, utilities, cable, phone, food, scheduled debt repayments, gas, insurance etc.) and it includes all other things you spend money on a regular basis (streaming, going out, yearly vacations, gifts etc.).
Expenses should not include big purchases like cars, renovations, appliances etc. or any investments. These are things that last long (3-10+ years), therefore are not recurring expenses.
Savings: Savings is what is leftover after expenses have been paid (Income - Expenses = Savings). Savings are the engine of wealth creation, without consistent savings you will have to either sell things you own, take out new debt, or work more just to cover expenses. Therefore, its critical that your expenses are kept under control.
Once you have a stream of consistent savings and have built up some savings in your bank account you can begin your investing journey. As a rule, you should always have at least 3-6 months worth of expenses saved in an easily accessible high interest savings account. The rest of your savings can then be put towards more useful assets.
Income Statement: The income statement organizes your incomes, expenses and savings all on one easy to view sheet. Income & Expenses are measured over a period of time (day, month or year). Meaning they answer the questions:"How much did I earn during the year?"
"How much did I spend during the year?"
"How much was I able to save during the year?"
The income statement is governed by this equation:
Income - Expenses = Savings
Assets: Are what you own. Everything you own is an asset as long as the potential future benefit of its sale (or income) belong to you. So, a house is an asset, cash is an asset & so on; but, your organs (which you could theoretically sell for a lot of money) are not an asset since you would not be alive to enjoy the proceeds. When you mark the value of an asset always put in the current market value (not the price you originally paid). There are 3 main types of assets:
- Financial Assets: Include cash, savings accounts, GICs/CDs at banks, foreign currencies, stocks, bonds, ETFs/Mutual Funds, cryptocurrencies, traded commodities, investment funds, etc. These are highly "liquid" (their swings in value sometimes referred to as "paper gains/losses"), and can usually be converted into cash very quickly.
- Real Assets: Are physical, they include things like houses, land, vehicles, electronics, furniture, clothes, ownership in a business, etc. Some of these can be considered investments (like a house) while others may be a cost (like a car) but they can still be sold to generate cash. Real assets are less liquid than financial ones, meaning it may take a long time to convert them into cash (weeks or months).
- Intangible Assets: Are non-physical assets like patents, a copyright which pays a royalty and education. Unlike other assets these should only be accounted for on a cost basis. These are optional to include, since banks will usually not include them for you, even though it's financially complete to do so.
Liabilities: Liabilities are what you owe. For an individual this usually means your financial debt, including any private debt you owe to individuals.
- Short Term Debt: Is debt that needs to be paid off within a year. This type generally has higher interest rates. It includes credit card debt, lines of credit, short term loans etc. You should only use short term debt to fund short term expenses, and should use high interest debt as little as possible.
- Long Term Debt: Is debt that is scheduled to paid off over a period longer than a year. This type generally has much lower interest rates and includes mortgages, car loans, student loans, long term loans etc. When interest rates are low, utilizing long term debt to purchase valuable assets or refinance higher interest debt is a good hack to build wealth.
Equity (or Net Worth): Your Equity is your personal Net Worth. Its the value of your assets after the debts are subtracted from them. When your income property gets appraised at more than you bought it for, when you get income from your job, when you get income from your investments, those are all equity.
Balance Sheet: The balance sheet tracks Assets, Liabilities and Equity on one easy to view sheet. Balance sheets are a snapshot in time, or what you own & owe at a particular time. Meaning they answer the questions:"How much are my assets worth today?"
"How much debt do I have today?"
"What is my net worth today?"
The Balance sheet is governed by these simple equations:
Assets - Liabilities = Equity
Assets = Liabilities + Equity (<- the same just re-arranged)
Interest: This is the price of money charged as a portion of the principle. When you loan out money the interest is the return/income you get, when you borrow money the interest is the cost of getting the money.
Risk vs. Reward: The higher the risk in an investment the higher interest rate or return investors demand. That's why a mortgage (which is secured by a physical house) carries a very low interest rate while credit card loans (which are unsecured) carry a high interest rate.
Credit Score: Enables financial institutions to evaluate your potential for a loan. If you have a good score you will more easily get loans. Your credit score depends on a history of payments (do you pay in full/on time?), the amounts borrowed, length of your history, requests for new loans and types of credit used.
Access to Credit: Having lines of credit & credit cards open means you have a limit which is your access to immediate credit without having to request another loan. Your Cash + Savings + Unused Credit limit should equal current spending power (the amount you can spend without selling investments).
Brokerage Account: Is a type of bank account that enables you to buy & sell financial securities like stocks, bonds, funds etc. They can usually be setup within a government's tax advantaged vehicle (like RRSP/TFSA in Canada, or a 401k/IRA in the USA).
Stocks: Are shares of ownership in corporations. They are bought and sold on stock exchanges (such as the Toronto Stock Exchange or the NASDAQ in New York). When you buy a stock you own a piece of the company and are entitled to that portion of its future profits and dividends (direct payments to shareholders).
Bonds: Are corporate debt that is tradeable (similar to a stock). Bonds are usually difficult for retail investors to trade individually but you can easily gain exposure by investing in a Mutual Fund or ETF that solely invests in bonds. Bond ETFs offer stable monthly dividends and are less volatile than stocks of companies.
Indexes: Track groups of stocks (dozens to thousands) on the stock market. They provide an average value for how that basket of stocks is doing. Common examples are the S&P500 (top 500 companies in the USA), TSX60 (top 60 companies in Canada). Some Mutual Funds & ETFs are designed to track the performance of an index.
Mutual Funds: Invest in stocks, bonds, commodities, themes (like tech or retail), or track an index. They are usually diversified, professionally managed and charge fees. To buy & sell mutual funds help from a financial advisor is usually required.
Exchange Traded Funds (ETFs): Are very similar to Mutual Funds except that they trade like a stock on an exchange. This makes them very easy to buy and sell. ETFs are excellent tools for retail investors to easily gain exposure to an industry, a specific index, a commodity, or to bonds (which are hard for individuals to trade).
Real Estate Investment Trusts (REITs): Is a holding company that invests in real estate and trades on a stock exchange. REITs are easy to buy & sell, usually pay out a strong monthly dividend (essentially 100% of their net income from renting properties is given to shareholders) and offer a diversification benefit.
Commodities: Are tradable undifferentiated goods like; gold, silver, other metals, oil, natural gas etc. The best way for individuals to gain exposure to a commodity is through ETFs.
Cryptocurrencies: Are internet based currencies or tokens in companies that are backed by blockchain technology. Transactions are verified using cryptography without the need for a financial institution as a middle man.
Passive Investing: When you buy into diversified funds that track a broad stock market index (hopefully for a low fee), you are investing in a passive fund that simply tracks the market. Over the long run passive investing tends to beat most active investors.
Active Investing: Is when you (or a fund you invest in) buys & sells stocks unrelated to the holdings of a broad index. The goal of Active Investing is to beat the average return of a stock market index.
Diversification: Simply means to have your money in many different assets. As the old saying goes "never keep all your eggs in one basket". For full diversification you need to be invested across; stocks, bonds, real estate, gold, cryptocurrencies, foreign currencies and foreign stocks.
Capital Spending: Is the purchase of a good that will last a long time (at least one year, usually 3-10+ years). Your Savings are used to fund both financial investments and capital spending. Things like buying a house, a car, renovations, furniture, etc. are examples of capital spending. Ideally, the majority of your Savings should go to either a financial investment or to purchasing a capital asset that will produce income, appreciate in value or both.
Re-financing: Means getting new loans to pay off old ones. It generally makes sense to refinance all of your high interest debt into lower interest debt (e.g. moving credit card debt at 19% over into a line of credit at 7%) if you cannot pay off the debt right away.
Re-financing Real Estate: Is an important tool for real estate owners. If the value of a property has appreciated significantly (i.e. built up equity) and/or if interest rates have declined, then it might make sense to refinance. Essentially, the new mortgage is larger but pays off the old one and allows you to keep the difference. This is usually tax free enabling you to "pull out" equity as cash at the low mortgage rate. This then enables you to reinvest the proceeds into something more productive (it could be a down payment for another property, investments etc.). As long as the rate of return is higher than the mortgage rate you will increase your wealth over time (all else being equal).
Return on Investment (ROI): Your ROI is the annual return you get from a particular investment. If you invest in an asset your return is made up of any income that it generates plus any appreciation in its value. This net increase divided by your initial invested amount is your ROI.Example: $10,000 is invested in to a stable dividend stock that pays a 3% dividend and appreciates 4% over the year. Calculated as:
ROI = Dividend Income% + Appreciation% = 3% + 4% = 7%
ROI = ($300 dividend + $400 appreciation) ÷ $10,000 = 0.07 = 7%
Inflation: Is simply the increase in the price of goods & services over time. If you save your cash as just cash it earns a 0% return, if inflation is 2-4% (which it roughly is in most western countries) then the real value of your cash "savings" is cut in half every ~17 years. "Inflation is paying $30 for the same haircut you could buy 20 years ago for $5". When you think about returns on investment & interest rates its always important to compare to inflation.
Insurance: Is a contract that protects you from rare events. Things like floods, car accidents, injuries, illness, theft, death and other terrible things. While its important for your financial wellbeing to have insurance, its also important to make sure you are getting a fair rate and have an appropriate level of coverage. If you are paying above average or covering more then is reasonable, the benefit of insurance will not match its costs.
Your Financial Journey
Ok, I know that was a lot. Finance is a deep subject area, but the terms and concepts above need to be well understood as the groundwork for your own personal progress towards financial independence.
Once you have a footing with this stuff, you will be ready to further accelerate the learning process by utilizing our tools.