When trying to understand personal finance, the best thing to do is to understand what personal finance is NOT.
Many people think that accounting and personal finance are the same, but personal finance is NOT accounting.
On the surface, they may seem the same; they both have something to do with money. However, definitions will help us better understand the differences.
According to Merriam-Webster’s definition, accounting is “the system of recording and summarizing business and financial transactions and analyzing, verifying and reporting the results.”
Based on this definition, we see that accounting is the process of analyzing and recording what you have already done with your money.
This is why having an accountant is usually not enough when it comes to your personal finances.
Accountants generally don’t deal with personal finance (there are a few exceptions to this rule). Unless your accountant is also a financial advisor or coach, he or she will probably just look at what you did with your money at the end of the year and provide you with a report of their analysis.
This report is usually your tax return, what you owe the government or what the government owes you.
Very rarely does an accountant provide an individual with a balance sheet, income statement or net worth statement, all of which are very useful tools that are needed to effectively manage your personal finances.
Personal finance is about looking at your finances from a more proactive, goal-oriented perspective. It is what provides accountants with something to record, verify and analyze.
The definition of finance from the Merriam-Webster Encyclopedia (Concise Encyclopedia) is “the process of raising money or capital for any kind of expenditure”. Consumers, businesses, and governments often do not have the funds to make purchases or conduct their activities, while savers and investors have funds that could earn interest or dividends if used productively. Finance is the process of channeling funds from savers to users in the form of credit, loans, or invested capital through organizations such as COMMERCIAL BANKS, SAVINGS AND LOAN ASSOCIATIONS, and non-bank organizations such as credit unions and investment companies. Finance can be divided into three broad areas: corporate finance, personal finance and public finance. All three involve budgeting and managing funds to achieve optimal results.
Personal Finance Simplified
By understanding the definition of “finance”, we can break down our “personal finance” into 3 simple activities: – 1.
- The process of raising funds or capital for any type of expense = Generating income.
A business gets money from the sale of its products and services. This is called “revenue” or “income”. Some businesses also invest some of their revenues to generate more income (interest income).
A person earns money from a job or small business (self-employment, sole proprietorship, network marketing or other small business). The money received can be a salary, hourly wage or commission, and is also called income.
A government gets money from the taxes we pay. This is one of the main ways the government generates income which is then used to build infrastructure such as roads, bridges, schools, hospitals, etc. for our cities.
- Using our money to make purchases = Spending money.
The amount of money we spend versus the amount we earn is what makes the difference between optimal outcomes in our personal finances. Making good spending decisions is critical to achieving financial wealth – no matter how much you earn.
- Achieving optimal results = Keeping as much of our money as possible
It’s not what you MAKE that counts – it’s what you MAKE that really matters when it comes to your personal finances.
This is the part of personal finance that almost everyone finds the most difficult.
Often, people who earn high incomes (six figures or more) tend to spend as much (or more), which means they get into debt and that debt starts to earn interest. In a short period of time, this debt can begin to grow exponentially and destroy any hope of achieving wealth.
Personal Finance Made Simple
Personal finance doesn’t have to be complicated if you keep this simple formula in mind:
INCOME – EXPENSES = WHAT YOU KEEP
For best results, you simply need to earn more than you spend and spend less than you earn so you can keep more for yourself and your family!
If you don’t actively work for optimal results, you will by default get less than optimal results.
It’s that simple!
Now that you understand personal finance and what you need to do, the next step is to learn HOW to do it!
The best way to start is to follow these 3 simple steps:-
- Know what you want to achieve – “if you don’t know where you’re going, any road will get you there” has become a very popular quote, probably because it is so true. One of the habits that Stephen Covey highlights in his book “7 Habits of Highly Successful People” is to always start with the end in mind. Knowing where you want to go will go a long way in ensuring that you get there.
- Have a plan – one that you can follow and that will get you to your goals. Knowing how you are going to achieve your goals in a step-by-step plan is invaluable. Sometimes this is easier with the help of an advisor or financial coach.
- Use tools and resources – that will help you stick to your plan and not get distracted by the things in life that might limit our income and make us spend more than we should. Don’t try to calculate everything in your head! You’ll end up with a huge headache and your finances will be a giant, dark fog!