Remember the balance sheet is a snapshot (like with a camera) at a point in time. Captured on the balance sheet are the assets and liabilities of a person or family (in the context of personal finance.) The income and expense statement (I&E) is a document that is prepared using amounts accumulated over a time period like a month or a year. A video recorder would be needed to view the happenings over time. The I&E statement is conducted on a cash basis, but this really means coin and currency payments as well as checks we get and write out. On the I&E statement we will pay attention to income, expenses and the difference between the two.
Income Common sources of income Wages Salary Self employment income Bonuses Commissions Interest and dividends on assets Proceeds from sale of assets Pension or annuity income Social security Rent Grants Tax refunds On the I&E statement we should put the gross income amount. This is the amount before taxes and the like is taken out. We will account for the taxes and the like on the expense side.
Expenses Major categories of expenses include Living expenses, asset purchases, tax payments and debt payments. Note that some of these expenses are fixed and some are variable. Only account for expenses where a cash outlay has actually occurred. So if you borrow to make a purchase, do not include it on the I&E statement.
On the balance sheet we had an equation for net worth. There is a similar calculation for the I&E statement. If income minus expenses > 0 we say there is a cash surplus, and If income minus expenses = 0 we say income = expenses, and If income minus expenses < 0 we say there is a cash deficit. An Interesting Connection A cash surplus on the I&E statement means that the balance sheet will show an increase in the asset cash (or checking account balance.) Then the individual may want to change their assets mix. Similarly a cash deficit will show up as either an asset decline or a liability increase or a combination of the two on the balance sheet.
The Savings Ratio – svr for short Svr = cash surplus/income after taxes. Note if you have a cash deficit you are in deep dodo (not necessarily) and this ratio doesn’t really matter. Let’s do some investigating, ok? Cash surplus = income minus expenses (> 0).) Remember we said make income gross and we take taxes as an expense. So the cash surplus can be written Income after taxes minus other expenses. So Svr = 1 – [other expenses/income after tax]. So, if your other expenses are eating up, say 80%, of your income after tax, then your savings ratio is 20%.
The Debt Service Ratio - dsr dsr = total loan payments/gross income. Note the calculation is made with a time period in mind, like a month or year. This ratio is just keeping track of what % of your income is going to pay off loans each month. The authors say a value of .35 or less is the good range. Would you give a loan to a person who has a dsr of .5? If you give them a loan the ratio would rise. Remember people have living expenses as well. So the higher the ratio here the less folks have for living expenses. The person might have trouble paying off the loan.