Welcome to the basics of understanding your financial. To help you understand your financials, I’m going to use George as an example. George wants to start a real estate business. Well, how does George move towards financial freedom?
Knowing your numbers could be the difference between where you are right now and where you want to go. There are six basic things you need to know to understand your financials.
- What you have, your assets.
- What you need to have, capital contributions or liabilities.
- What you have, earned income.
- What you have spent, expense.
- What you take home, net profit.
- And, what you keep in the business over time, retained earnings.
Assets, what you need to produce income. Now assets are those things that we need to produce income. It can be tangible or intangible. So, tangible assets are things like cash, equipment, computer. Intangible assets are things like knowledge base, a labor force.
George has $30,000 in cash and a computer to help him get started. In addition, George has his knowledge which is an intangible asset. For you to produce income in your business, you need assets. Even if that asset comes in the form of your knowledge. You need something that customers can pay for in exchange of cash.
Your assets or maybe you don’t have enough assets and you need more assets. So, in the case of George he had, and he needs a property. Well, he only has $30,000 cash and has knowledge. He needs to turn that into something that can produce income. Unless you’re in the banking business, cash by itself does not produce income. So, in this case, George needs to buy at least one property so he can collect rent.
In his area, the average property price is $100,000. Well, he has $30,000 cash. He needs to get $70,000. So, the $30,000 cash he had in his business, that was a capital contribution from his personal funds. Basically, that’s money he put in his business that he does not have to pay back. But that’s not enough to get a property, so he needs to borrow $70,000 from the bank, which is is his liabilities or debt in order to get that income producing asset.
So, once he gets the $100,000, he can get his first asset that can produce income. And with that he’s now ready to produce income. So, he just needs to get a tenant to sustain his asset, which is the property, and start paying rent.
Income comes from the assets in a company. So, this is what income is what your customers pay, your tenants or clients pay you, in return for the benefits they receive from your assets. So, your assets, like I said, could be your knowledge base. It could be property, could be whatever. Whatever the asset is, income comes from an asset.
In Georgia’s case asset is the property he purchased. In a service business, the asset will be intangible. It will normally being form of a knowledge base, or the way the labor force is organized to produce benefits to the customers.
George will get income from this tenant when they rent his house. If you’re in the service business your income will be exchanged for the service you provided to your customers. The more income producing assets you have, the higher your income will be. So, the more properties that George has, the more his income will be. If you’re in the service business, the more your knowledge is, the higher your knowledge is, the higher you can charge.
Expenses is what you spend to maintain your assets or produce income. Assets and expenses are similar but there’s one difference. The difference is assets have the ability to produce income both now and in the future, while expenses are used up immediately. That means once an expense has served its purpose, it has no more value. Unlike an asset which continues to have value. Take an example with repair.
George has this property. Maybe the sink breaks, he needs to call a repair man’s repair to sink. So that’s an expense to him. However, once that repairman repairs the think it’s done. There’s no future value to it. But however, he used that to maintain his asset. Because, if he’s not repairing the asset, his tenants are going to move out. So, he needs that asset in a good shape to keep that income producing asset. That’s not only true for property, that also works for service business. You need to maintain your asset. If it’s your knowledge base. If it’s your knowledge base, if it’s your labor force, your expenses are used to maintain their assets so your asset can keep producing income. Remember assets don’t have to be something we touch. It could also be intangible. That’s a key point. This is so key because this is where the knowledge of this is what gets you from where you are right now to where you want to go.
George would need to pay to buy items to keep his business going, which are expenses. It’s not unusual for business owners to become wasteful by incurring expenses that have no bearing to income. Remember, and I say this again. I know I’m sounding like a broken record, but I’m saying it because it’s so crucial for you as a business owner to understand this Your expenses are used to maintain your assets, which you use for this income. So, it maybe you go, you do continue in education to maintain your knowledge base to keep charge, so you can keep charge your customers. You know or make more money from customers or getting new customers. The trick is maintaining a good balance between assets, income and expenses.
In an optimal business, expenses will be used to maintain assets which produce income. The business owner will try to maintain that link and not lose sight of what is important. This is why a lot of businesses go out of business because they don’t understand this concept. This is so crucial for you to get it! And you want me to do more videos about this, just leave a comment on the bottom because it’s very crucial as a business owner that you get this.
So, net profit is the excess of income over expenses. Net profit is what you technically take home but it’s not always the case. I’m not going to address this here because it will just complicate this video, so let’s just keep moving forward.
Regardless, you want, you have a net profit. You want that number positive. You don’t want a net loss. If you keep a, keep a good eye on your numbers, you should be able to control expenses well enough, so it stays in line your income. As income decreases, expenses should go down too. As expenses go up, income… expenses go up, income should go up to. A well-managed business will show a profit.
However, there are instances where some business owners choose to offset loss for a time they plan to gain from economies of scale. And that’s okay. The only thing is, don’t fool yourself. You’ve got to give yourself an expiration date or things could quickly spiral out of control.
So, we take earnings as net profits that stay in the business over time. If you never take money out of net profit, your retained earnings should be the sum of all your net profit since you opened your door. Over time, net profit in the business builds up. The buildup of net profits is known as retained earnings. Think of it this way, if you had a bank account and only made deposits, your bank balance keeps growing over time. We take earnings as a great place to find money to grow your business. You can see in that chart over there, that you can see the longer lines, those are the retained earnings line. If profits end up being taken out, that retained earnings keeps growing. In a very simple business, retained earnings equals cash. But there are complications that makes it not the case, but we’re not going to go into that today.
So, conclusion. These six consider, six most important things you need to know to build your business. Let’s wrap it up with George. George project purchased an income producing asset, property. He used debt and capital contributions to purchase the property. The asset produced income and incurred expenses, like repair expenses, to maintain an asset so it keeps producing income. Excesses of income over profits become net income and net income accumulates as retained earnings in the business.
This is the six basic, base baseline you need to understand your business. Later we’ll see how we can find this information in your financial statements. This concept applied to all the business models not just real estate business. But just simplified, I’m just using one business model as an example.
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