Record keeping is the most important skill required to build wealth. In this episode Tom discusses how to keep records, and more importantly, how to use records to make good financial decisions.
02:18 – How Do Good Records Lead To Good Decisions?
05:15 – How Do You Keep Good Records?
07:14 – What Are The 3 Kinds Of Financial Statements?
12:58: – How Do The Best Investors Measure Everything?
16:29 – How Often Should You Be Analyzing Your Records?
21:17: – What Are Realized & Recognized Gains & Losses?
Speaker 1: This is The WealthAbility™ Show with Tom Wheelwright. Way more money, way less taxes.
Tom Wheelwright: Welcome to The WealthAbility™ Show where we're always learning how to make way more money and pay way less taxes. Hi, this is Tom Wheelwright, your host, founder, and CEO of WealthAbility™.
Tom Wheelwright: What if I told you the number one key to building wealth is simply keeping good records. Today, we're going to discuss why record keeping is so important. It always amazes me what poor records I see from business owners and investors. We all remember the Iraq war and we remember that, about weapons of mass destruction. Right? That President Bush said that, “Well, look. It's clear we've got weapons of mass destruction. We need to go in and we need to take care of this.” And there weren't any. And there never were any. That's bad information. So bad information leads to bad decisions. The challenge that most people have is that A, that may not wanna make decisions at all. Most people abdicate their decisions completely when it comes to finance to other people. They are called financial planners. So, we're talking today about those of you out there who are willing to take on responsibility for your own decisions about making money and building wealth.
Tom Wheelwright: It only happens and it's only possible if you have good records and what I mean by that is, think about all the decisions that go into making an investment. Wow, I just need to find a good investment. I really need to make sure I've got a good investment. Okay. Let's say you buy or make a good investment. Now how do you know if that investment is performing? How do you know what the cash flow is? How do you know whether you should sell that investment? How do you know whether you should continue investing with that syndicator, for example. How do you know any of this if you don't have good records?
Tom Wheelwright: You know, I'm an accountant so records are everything to me. We're doing tax returns all the time and we're always seeing, so often we're seeing poor record keeping. Well what does that mean? From a tax standpoint, that means that you're not going to get good results on your tax return. I mean, that's the reality and you are always going to have to worry about an audit because you don't know if your information is good anyway and the auditors are gonna go dig into it. They're gonna see that you have lousy information, you've got lousy record keeping, so they're not gonna trust it and then they're gonna go deeper and deeper and deeper, on and on and on, and you pretty soon you have the audit from hell, right?
Tom Wheelwright: So, that's the IRS, but let's look at it from purely an investment standpoint. Okay? So you're trying to make these good decisions. You've gone through, you've developed, you know what you're trying to accomplish, you've developed your strategy, you've got very specific type of asset that you're investing in, you've chosen an asset class, you narrowed it down and now you've gone through all the criteria and you go, “Okay. This is, I only want three bedroom, two bath homes. And I only want them in this particular market. And I want this particular loan value. And I want this particular cash flow. And I want this to happen in the market.” So, we come up with this great criteria for investing and then what do we do?
Tom Wheelwright: Well what I find with most investors is what they do, they fall back on the old buy, hold, and pray that it all works. They bought it. They worked really hard to come up with that decision. They worked really hard to find an investment that looked appropriate and then they're going, I'm done. Well now it's just begun. That's just the beginning. You just put the money out. The question is are you gonna get the money in? And that's a matter of having accurate records.
Tom Wheelwright: So remember, we really have three different financial statements. I wanna walk through these financial statements here so that you understand what I mean by accurate record keeping. I'm talking about actually having information that is usable, that you can use on a daily basis to make good decisions, that's always there for you and you know how to interpret that information.
Tom Wheelwright: So the first is accuracy. That's why you have a bookkeeper. That's why your bookkeeper is not a relative. That's why your bookkeeper is an independent bookkeeper who will ask you the questions. They won't make any assumptions about what is this expense? Where does it go? They're gonna ask you questions and the first few months of having a bookkeeper I will tell you, they are a pain because you get all these questions over and over again. Well what's this expense? What's this? What's this? What does that do for you? The whole exercise of going through back and forth that bookkeeper, gets you un-tuned to what money is going out and what money is coming in because they're asking you these questions. So it actually forces you into better behavior from an investment standpoint. We have to always be looking at what's going on. So if the bookkeeper, if they're pushing us, then that means we're gonna have a better idea of what's going on in the first place.
Tom Wheelwright: So after a few months, they're gonna get really comfortable with it and your bookkeeper is now going to keep the records. Okay, now let's assume you've done that much and you've hired a good bookkeeper. You've gone through. You've made sure that on a monthly basis they know what expense goes where, how to categorize it, where you would like that information so that you know where to pull it from. And so you actually have accuracy now. So, now what? Now you actually have to read the financial statements. You actually have to pull that information. So let's walk through what makes good financial statements.
Tom Wheelwright: There are three basic financial statements. There's an income statement, also called a profit and loss. It's exactly the same thing. You don't need to distinguish between them. You have income and you have expense. That's your income statement. Profit and loss. It's the same thing.
Tom Wheelwright: Then you have a balance sheet. Now most amateur investors only have an income statement and in fact, they only see the cash flow part of it. They don't really have a complete income statement. A typical investor will at least have something that says here's the cash coming in and the expenses going out. Now we need a balance sheet and the reason why we need a balance sheet was we need to know what are the assets and the liabilities associated with that investment because the investment itself, is an asset.
Tom Wheelwright: And then we have the third financial statement which is statement of cash flow. Well when we made that investment, we took cash out so that depleted our cash and we put it into that investment. That will show up on your statement of cash flow, in the investment section. Then when money comes in from the investment, that goes in through operations. That's going in through your income statement. Right? So that's coming into your statement of cash flow through operations and then you're gonna see that your cash flow from operations is actually different from you income. You go why is that? Well because in your income statement, you're recording depreciation. That's non cash expense. It shows up in your profit and loss statement and it shows up in your income statement as an expense but it's not cash that went out of your pocket. The cash went out of your pocket when you made the investment not the depreciation. So when you look at your statement of cash flows, what you're looking at is, oh depreciation at aback now I have this much cash. I have this much cash from the operations.
Tom Wheelwright: Now here's another thing. You're gonna be paying down your mortgage. Let's say you're in real estate. You're going to be paying down a mortgage. Well that mortgage, paying down that mortgage, that doesn't show up in your income statement. Where would it show up? It doesn't. The amortization of your mortgage doesn't show up in your income statement. It shows up as a reduction to your liabilities, that's your balance sheet and it shows up as in your statement of cash flows as a reduction to your cash because cash going out.
Tom Wheelwright: So all three of these financial statements work together. I'm gonna walk through how you're gonna analyze this because the analysis of a financial statement is really, really simple. When you understand the purpose of income, expense, assets, and liabilities, because in the end, the purpose is always cash. It's all about cash flow. If you look at what the value is of your investment, it is a function of cash flow. Unless you are investing in single family homes that you're gonna sell on the open market to a homeowner, all investments are valued based on a stream of cash coming in from them. All investments, except for super speculative investments, like cryptocurrency, stuff like that.
Tom Wheelwright: So what do you do? So you look at every single item in those financial statements and go what makes that item good or not as good or bad? So income, can we have bad income? Absolutely. Let's say that you have a renter and the renter doesn't pay you. Now they owe you the money, so you book the income as a receivable from the renter, so that's going on your assets as a receivable and it goes in your income as rental income, even though you haven't received it. That's a receivable. Now that's not good income, is it? Because you've actually given up cash to allow that renter in there without having the cash flow from it. So if that renter gets behind, you've lost money. You could've had a renter that paid. So that shows up in your financial statements because the purpose of income is to create cash flow. So if your cash flow, your statement of cash flow from operations, that's the first section in your statement of cash flow, if it shows that you have a lot less cash than you have income, and you have a lot less cash than you have income because you have a lot of receivables, that's gonna show up in your statement of cash flows, then that means that you're not doing a good job of managing your income.
Tom Wheelwright: Now what about an expense? The purpose of an expense is to create income. So if you analyze your expenses and you go wait a minute I don't know what this expense is doing for me. Let's say that you're advertising in the paper for renters and you're not getting anything back, none of the renters are coming from that ad, well that's a waste of money, isn't it? Well the only way you know that is to analyze it and analyze your expenses and you need to analyze your expenses on a very regular basis and go through it, I would go through it with your bookkeeper or better yet, go through it with you accountant whose actually trained to analyze and look at how am I doing with my expenses. Are these expenses? Can I measure the impact of these expenses? You wanna look at the best investors? They measure everything. The best investors measure everything. Remember there's the old Hawthorne principle that says anything that is measured, expands. Anything that's measured and reported, expands exponentially. That's called the Hawthorne Effect. So if you're measuring, you're measuring when you look at those financial statements.
Tom Wheelwright: When you report that to someone else, like your accountant, like your CPA, you report that to your CPA, now it's going to expand even more. You're gonna get better, and better, and better because you're analyze on a regular basis. Now think about it. This isn't that hard. It just takes some time and most investors the challenge is, is as investors we get so caught up in the investing side of it that we forget that it's all about the numbers. And when we forget that it's all about the numbers, we lose any edge that we have in our investing. We go, oh well, we have no control over this. You have complete control over it.
Tom Wheelwright: If you're doing the actual, if you own the property, if you're doing the investing, you need to control this. If you're investing in a syndication, you need to make sure they're controlling it. You need to watch what they're doing because even though you turned money over to them, don't you want to watch their performance? So you should be getting at a minimum, quarterly reports that actually show you all three of these financial statements. If you're not, you should be asking them for them. And if they don't have them, you shouldn't be investing with them. Because if they're not keeping track of it, that's just trouble.
Tom Wheelwright: Syndicators, oh my heavens, if you're taking somebody else's money and you're not analyzing your financials on a monthly basis, I think you're in major trouble with your investors. I think you're doing them a major disservice and at some point if the market has challenges to it, which it will at some point, you're gonna have challenges. And you're gonna have more challenges than just your investment. You're gonna have challenge with every other investor.
Tom Wheelwright: So it's very important that we watch this so expenses, again income. The purpose of income is to create cash flow. The purpose of an expense is to increase income. So what's the purpose of an asset?
Tom Wheelwright: An asset can actually have one of two purposes. An asset can either increase income or it can decrease an expense. Take for example a computer. A computer should actually decrease an expense because it should make things that much faster. You may have to hire fewer employees or consultants to help you if that computer or that computer program is doing its job. So that's an example of an asset, a computer, that actually reduces an expense rather than create an income. Other assets are going to actually create incomes.
Tom Wheelwright: So we think of, for example, we think about the actual investment, the fourplex, the purpose of that investment is to create income. Income from the rent. That's the whole purpose of the investment.
Tom Wheelwright: And when we look at our balance sheet, we need to be looking at every single investment and analyzing what is my return on that investment and that analysis needs to be done regularly. And regularly means, I mean the best investors, they look at this daily or weekly. Even a good investor will at least, monthly, you're looking at this because if you're not keeping track of it, who is? Nobody is and what happens is we end up having underperforming assets. So we may think it's great, but then we actually look at the numbers. I give you an example. I have a client, bless his heart, does a lot of real estate and he's learning. I was telling him, you sure about these investments? What analysis have you done? He said, no, no, no. These are really good. Well, he got into it and he found out that this particular property lost a ton of money. We had all sorts of problems with it.
Tom Wheelwright: Well sometimes we don't know because we're not paying attention. That's the point. If we're not paying attention, how do we make good decisions? So it starts with something as simple as accurate record keeping. Then, we have to go into how do we actually analyze that information so that we can make good decisions.
Tom Wheelwright: So we start with accuracy. Then we go to analysis. Now we talked about an asset. The purpose is to actually increase income or decrease expenses. What's the purpose of a liability?
Tom Wheelwright: The purpose of a liability is one of two things. It's either to buy an asset or to decrease an expense. So what I mean by an asset, obviously a mortgage. You have a mortgage, that's a liability, the purpose of that is to buy that asset. But you might refinance that mortgage into a different mortgage in order to lower your interest rate. That would be an example of reducing your expense. Right? You're reducing your interest expense at that point.
Tom Wheelwright: So, understand that all four of these items, income, expense, assets, liabilities, have very specific purpose and if you analyze them in that simple of a way, and you do it on a regular basis, think about the decisions you're going to be able to make because remember you started out by setting up all these criteria. Now what we have to do is we need to measure the actual performance against the expected performance.
Tom Wheelwright: Once again, we have to measure the actual performance of the asset against the expected performance of the asset. The expected performance of the asset is really our criteria. Right? Our set of criteria for investing. That's the expected performance. So we need to measure how's it doing.
Tom Wheelwright: We also need to measure at, okay, is there a point where it's either doing so well that we need to sell it because the cap rate is so low and we could do so much better in another investment. It no longer, see we have to look at, does it still meet our criteria. And if the price is too high, then it may not meet our criteria. So we may need to sell it because the price is too high. Follow what I'm saying?
Tom Wheelwright: In other words, if you wouldn't pay that price for that asset, maybe it's time to sell that asset. Maybe it's because the cap rate is actually below the interest rate. Well if you have a cap rate below the interest rate, you have negative leverage. Your cap rate needs to be above your interest rate, otherwise you are losing money. You could sell it and now go find something where the cap rate is higher than the interest rate and now you have positive leverage or positive arbitrage. Right, before you have negative leverage, negative arbitrage.
Tom Wheelwright: So what we have to do is we have to look at every single asset on a very regular basis and is it performing so well that guess what, it no longer meets that criteria, or is it performing so poorly that it no longer meets our criteria? If it's performing poorly, what do we do?
Tom Wheelwright: Well now we look at what can we do to increase its performance? It may be that there's nothing we can do. Let me tell you one of the big mistakes that I see investors make and we saw it a lot in 2008-2009. So your, the value of your property drops drastically. Okay, say we have another big downturn. The value of your property drops drastically. Then what? Well, you go, if I sell it I lose money. No. That's not how it works. You've already lost money. You don't understand that there's two terms that we need to understand when we're looking at our investments. One is realized gain or loss and the other is recognized gain or loss.
Tom Wheelwright: Realized. Recognized. Realized means it's there. We haven't done anything. It's just there. So if our property goes from a value of a million to a value of $800,000, we have realized a loss of $200,000. Now if we sell the property at that point we recognize that loss. So we realize the loss when it actually happened. We recognize it when we sell the property. So it's very important to understand that we've still realized that loss even if we haven't recognized the loss. Even if we haven't sold the property. So this idea that I don't want to sell a property because I'd lose money if I sell it. No, no. You've already lost the money.
Tom Wheelwright: It's kind of like people who invest in an IRA and they go I don't wanna pull the money out because I'll pay tax. Well you already owe the tax. What's the difference? What's the difference whether you pay the tax now or you pay the tax later. You still owe the tax. It's still the same proportion and even if it goes up in value, the tax goes up at the same rate. Right? So you have a tax liability whether you paid it or not. That's another case of realized or recognized.
Tom Wheelwright: So understanding financial statements and financial terms is really very simple. I mean if you look at it, income, cash, expense, income, asset, income, or decrease expense. Liabilities increase asset or decrease expense. That's really simple analysis. That's a lot of what you need to do and then we analyze comparing what is it now compared to what was it expected to do. If it's doing great, great. We don't have to do anything more. We look at that analysis and it's all good, great. We move one. It takes five minutes.
Tom Wheelwright: If we have that set up though and we look at it and go wait a minute, it's not performing. Or wait a minute, it's performing so well that it no longer makes sense, that's when we make good decisions. We make good decisions when we have good information. In order to have the good information, it has to be accurate and we have to pay attention to it. And this is again, this is the big mistake that a lot of investors make is that they do not pay attention to their numbers. They don't know how to analyze them. They don't sit down with their accountant. They don't sit down with their bookkeeper. They don't analyze this information and what happens is they end up wondering why isn't my investment doing well.
Tom Wheelwright: Well we are responsible for our decisions. We are responsible for our wealth. That's what WealthAbility™ is all about. It's your ability to create wealth. The point of this podcast is for you to increase your ability to create wealth and one of the most simple things you can do is accurate, useful information coming from good record keeping. When you do that, I promise you, you will always make way more money and pay way less taxes.
Tom Wheelwright: See you next time.
Speaker 1: You've been listening to The WealthAbility™ Show with Tom Wheelwright. Way more money, way less taxes. To learn more go to wealthability.com.