Successful people run their personal finances like a business. They track 5 key numbers. Think about it, you make money, you spend money, you certainly would like to save some of it and avoid bankruptcy and eventually you’d like to build enough revenue streams to be financially independent over the long term. If that sounds like what a business does, it’s because it is.
Your life is your business and you’re the CFO of your finances.
So what are the most important numbers in to Reach Financial Independence?
1. How much comes in : Income
First things first, to have a financially successful life, you need income. It can come in various forms, usually as a salary, but it can also take the form of dividends, rental income, 401k match from your employer and all sorts of financial bonuses or allowances, …
Income is one of the most important number for 2 reasons:
- income has technically no limit, you could potentially double, triple, … your income.
- there’s no financial independence without some sort of income.
The greater the income, the greater the possibility of freedom.
If you were a company, the first thing you’d like to see is its revenue: can it actually sell it products or services? A company with 0$ in sales won’t go anywhere, but a company with 1M$ in sales only shows it can sale. Now can it sale efficiently and actually make money?
It is always great to make more money and increase the size of your paycheck, but this alone is not nearly enough to guarantee financial success.
That brings us to the second most important number.
2. How much stays in : Savings Rate
After all income comes in and all expenses are paid, because obviously you must spend less than you make, what is left are your savings. Divide your savings amount by your income amount and you find your Savings Rate.
This number is critical because it defines how far your earned dollars go.
If you earn 50k$ a year and manage to save 5k$ a year, this is as efficient as making 100k$ a year and saving 10k$, since the Savings Rate is at 10%. Looking at this another way, someone making 50k$ with a 25% savings rate is actually doing better than someone with 100k$ paycheck saving only 10%!
The size of the paycheck doesn’t matter. What matters is what you do with it.
A company that can sell shows that it is finding customers on the market place. But how good is it if it can’t generate a profit? With the exception of Amazon, it’s usually not worth much!
You may know that the average savings rate in the US is around 5%. What that means is that for every dollar earned, you would keep only 5 cents.
As an example, in 2015, my Savings Rate was slightly above 50% and I expect it to be around 60-70% in 2016. Increasing your Savings Rate is the fastest way to creating an efficient cash engine.
3. How much cash is available : Emergency Fund
It’s all good and well to have a high savings rate, but if all these savings are tied up in a 401k, company stocks or other non-liquid assets, you might end up being short of cash when you least expect or when selling assets is the least interesting.
Having hard cash on hand is what keeps your finances running.
In the business world, this is actually a very common source of bankruptcy for startups. They grow very fast, sell a lot but the cash doesn’t come in as fast. They suddenly can’t pay their bills, their salaries or they suppliers and become insolvent. A lack of cash can kill an otherwise strong business instantly.
It’s the same thing in personal finance. It makes absolutely no sense to max out a 401k contribution and be left with no cash at the end of the month. Cash is king, cash is your finances’ blood.
Take the necessary steps to build an emergency fund. I currently hold about 6 months of expenses in cash, you can have less, but I feel like having 3-6 months of expenses in cash should be enough to cover 99% of all unexpected expenses.
4. How efficiently you use these savings : ROI
The first 3 steps are the most important numbers to have a financially secure life.
Are you going to stop here?
To reach Financial Independence, you need to measure 2 other numbers. Having a stable income, a high savings rate and an emergency fund won’t be enough.
The best returns on investment are on yourself. Education is expensive but still remains one of the best ways to become a millionaire. Invest in yourself: learn a new skill, get a higher education degree, get a coach. That’s why companies invest in R&D and buy back their stocks when it’s beaten up. Done with good management and long term in mind, those 2 options yield the best financial results.
To be Financially Independent, you need to invest that money.
The next best option is to invest in assets and make your money work for you. Take advantages of the 401k benefits and max it out. For stocks, pick low-cost index funds and determine what’s the best asset allocation for you. Vanguard’s indices are everyone favorite and for a reason: the fund owns itself and doesn’t have to pay dividends / profits to its shareholders, because its shareholders are its clients. Set up automatic investments every month and let the power of compounding interests do the rest.
My wife and I have invested in her education so she could get her MBA, which by the way, is how this blog started. We also have automatic contribution to our 401k, company stocks, HSA accounts, … essentially maxing out all contributions and investing the rest in Vanguard funds.
5. What you Own vs What you Owe : Net Worth
Yes, I’m listing the Net Worth last and this is somewhat the least important number of your financial life because it will be a consequence of the 4 previous numbers.
A Net Worth by itself has little value. What has enormous value is its evolution over time.
I find it much more impressive to see a Net Worth going from -10k$ to 500k$ in 10 years than go from 1Mk$ to 600k$ in the same period. What matters is the trend, not the value. It shows that the process is working and that you’re on the path to Financial Independence.
As an example, until recently, we had a Net Worth of over 500k$ but it recently was reduced by 150k$ because we purchased a home. If we had a short term vision and wanted to keep our Net Worth high, we would have kept renting our apartment. But since it made sense over the long term, we invested in our future.
The Net Worth should be used as a very long term objective and is the perfect number to follow to know when you’ll reach your Financial Independence Day.
The first 3 numbers : Income, Savings Rate and the Emergency Fund are the most important and they are the foundation of healthy finances. Everyone should know what these numbers are for them. It’s really the only way to know how far your hard earned dollars go.
The last 2 numbers : Return on Investment and Net Worth do not require more work to track but they are key to bring step change to your finances and put you on a path to Financial Independence. Track them closely.
Do you have other numbers that help you manage your finances?