A red flag is an indicator of potential problems. It means danger, stop or caution because of something ahead of you. In personal finance there are a number of things to watch for or avoid to be successful. They are things that we all go through, but should pay attention to and avoid the big problems. I am going to use new terms, but I will explain them in simple terms. Take notes because this is important!
An income statement (profit & loss statement) is a company’s financial statement that indicates how the revenue (gross income) is transformed into net income (net profit). It may be your pay check or your business, but you want your income to increase every year. Why? Inflation and it is a strong indication your employer values you. You are your own Chief Financial Officer (CFO) and you want to see increases in income or profitability individually or as a business. The other part of being a good CFO is lowering your expenses to increase profitability. A decline in profitability is a red flag!
A balance sheet is a summary of the financial balances for a company or individual. Assets, liabilities and equity are listed as of a specific date such end of the month, quarter or year. There are a number of red flags if your current assets do not cover your current liabilities. It is a red flag if your current ratio is less than 100%. Current assets represent the value of all assets that can be reasonably expected to convert to cash within one year. They are usually cash, marketable securities and other liquid assets. Current liabilities are debt due within one year. They are usually short term debt and the portion of long term debt due within one year.
Assets equal liabilities and equity. They call it a balance sheet because the two sides must equal. A red flag would be if liabilities exceed your assets or a negative net worth. A typical asset is your personal residence! Depending when you bought it should have built up some equity (market value less mortgage balance). If you are upside down on your home, it is a red flag. That is you owe more than what your home is worth. This is one way of saying you debt to equity ratio is bad, when it is over 100%. Another would be taking on too much debt. This may be a mortgage, car loan or credit card debt. Your payments cannot exceed your operating earnings. It is what is left after your operating expenses.
How are your investments? You can measure or evaluate your investment by calculating your return on investment (ROI). Take the market value at a particular time less the cost divided by the cost of the investment. It is expressed as a percentage. What is a reasonable return on investment? You can compare your return with indices or alternative investments. A red flag would be a negative return or too low of a return over time compared to alternative investments. In simple terms, if your investment return is similar to US Treasuries and you have much more risk.
How many red flags can you handle? I believe you should avoid red flags because they only cause you pain! Additional red flags can be adding to inventory. Inventory is thought of as an asset, but you should not take on debt to buy it. Did you ever think of the things you own as inventory? If your inventory can turn into cash, it may be a good thing. Recently, Leroy Nieman died, I own a Nieman, but I won’t sell. Is it worth more now? You betcha! Assets like inventory can go down in value and you should not finance your inventory. A red flag would be if you add to debt when you add an asset.
Have you ever thought of your finances in this way? Robert Kyosaki says you should only buy assets that produce revenue. That may too extreme or is it? Do you buy investments to lose money? Of course not! I tried to alert you to some of the red flags in your finances in order to make changes. It is up to you! I started buying income producing assets (rental property) before Robert Kyosaki wrote his first book. Real estate is a great way to leverage your investment and create wealth, but it is not the only way. If you control your finances, you can avoid a red flag.
Photo by: Luke Hoagland