Financial Independence, Financial Freedom? (Part 2 of 3)
Maybe we ought to start with a financial reality check
In this series, we've been taking a simple approach to go over some steps that are typically accessible for most people to get started on taking control of, or even just adjusting, their personal finances.
In Part 1, we went over the importance of not just setting realistic financial goals that motivate you but also making a point of revisiting them periodically.
In Part 2 below, we'll be working through our current financial status in terms of cash flow and how we can manage that equation to benefit our financial health.
Knowing your financial status (Cash Flow)
To be more financially secure, for better or worse, it all starts with getting the fundamentals right. This is where the reality check comes in.
Before we can look at things like making investments and taking on debt, we need to have a better understanding of where we currently are. That is, the difference (or net) between our income and our spending.
A simplified equation with clarifications and examples:
Cash Flow (financial status) = Income (job, side work) - Expenses (fixed & discretionary spending)
Is our cash flow positive and therefore accumulating over time (leading to savings), or is it negative and we’re therefore dissaving (leading to or at insolvency)?
I know this sounds very mundane and basic, but I’m regularly surprised by just how often people that I know or talk to aren’t familiar with their current financial state.
While you don’t need to be immersed in every line item that goes in and out on a daily basis, I do believe that a regular review and consolidation of your income and expenses will go a long way towards realizing any goals that you may have, financially or otherwise.
Let’s start with income
It’s funny that whenever we talk about things like “FIRE” (in Part 1), it’s generally the idea of having multiple streams of “passive income” or having enough invested in assets that the returns are enough to maintain or even grow your investments while covering your costs.
While I don’t disagree conceptually, what I don’t think gets mentioned enough—and this is true for most of us—is that you will likely be your own biggest asset and income generator. Period.
The income that you will generate as an adult will likely comprise the lion's share of your lifetime earnings. And should you be fortunate enough to play your cards right, leading to above-average wealth, then that income, while less significant, will have still played a key role in your being able to get there.
The main source of income for most people is work. Whether you see your work as a job or a career, it is at the very least a means to an end in that it generates what you need to spend and live your life.
Dealing with expenses
Spending money is a necessity to live and participate in modern society. It is literally the grease that allows the cogwheels of an economy to turn.
You’ll have fixed expenses that can be denominated in either fixed or variable amounts. Anything that you need to spend money on generally falls here.
As an example, you need to live somewhere and therefore will either pay a set amount in rent or a mortgage. This amount is a “fixed” fixed cost in the short to medium term because you can't easily change it (due to the term of your lease or mortgage contract).
You also need to spend money on utilities, but you can lower your use of gas, electricity, data, water, etc., making your utilities a variable fixed cost.
Discretionary spending is basically everything else.
It’s for anything you want to spend money on. Think of clothing, subscriptions, holidays, etc. This is typically the bucket that most people start with whenever spending needs to be curbed. It’s also often the basket that spirals out of control when you’re not paying attention.
Food is an interesting one because it's obviously something you need and thus has a variable fixed cost, but there's also a discretionary aspect to it in that we can splurge on experiences (i.e., pricey restaurants) or not always opt for the most economical way to eat (i.e., cook) and order takeout.
Managing your cash flow
Now that we’ve briefly gone over income and expenses, we can look at managing the equation. Ideally, I do think that most of us want to be in a position where we’re able to secure an income that supports but also doesn’t compromise any longer-term financial goals.
A lot of the advice I see on the Internet strongly argues that you should never compromise your income in most circumstances, with a personal or family emergency usually being an exception. The reason is a very prudent one. It is not uncommon for people or families to live paycheck to paycheck with little to no savings set aside.
The financial situation in this scenario is precarious, as you’re left with fewer options, and a wrong move can lead to insolvency.
If your cash flow is negative (or barely positive), then income is not something you’d want to meddle with in the short term. The exception to this is, of course, a promotion or a new job with higher pay that can be secured at relatively low risk.
Instead, you may see more success by streamlining your expenses.
This is where a consolidated and accurate picture of what’s fixed and discretionary in your spending can help. Having historical data on your spending habits can not only help you prioritize, but also afford you the option of shaving off smaller cuts here and there, amounting to a larger overall savings, instead of having to arbitrarily cut off one or two large expenses.
For example, reducing some of your utility usage and entertainment subscriptions, and being more frugal when it comes to eating habits and food brand choices, can both save a lot of money over time without changing your lifestyle too much.
If you can make these changes a regular part of your life, they will eventually become habits, allowing you to benefit from them indefinitely.
One dangerous caveat that comes with discretionary spending that should probably be highlighted more is that as you earn and spend more, you typically become accustomed to that “level” of lifestyle.
This can make it harder for us to change how we spend, even when the situation calls for it.
What’s more, it’s not uncommon to resort to alternative ways to supplement a reduction in spending power, including an increased reliance on credit (e.g., higher credit card utilization) or taking advantage of “BNPL” (Buy Now, Pay Later) schemes.
Now, I’m not saying that financial products, like credit cards and “BNPL” schemes, don’t have a role to play; they certainly do. But there’s a lot more that goes into that.
In general, I’d advise against relying too heavily on any financial product that helps you bridge any temporary spending gaps that are discretionary in nature. This is especially the case if your financial situation is more dire.
Following this path may inadvertently increase any associated risks and actually be harmful down the road should any additional unexpected hardship occur.
An argument can be made about frequent shopping habits that amount to fulfilling our wants more than our needs. We’ve been conditioned over time to feel emotionally gratified by buying something.
This is marketing and advertising at its finest; we have all fallen victim to it at some point.
So what steps can we take to try and remove ourselves as the victim and instead potentially even harness it as a reward?
It’s literally very simple but can be practically very difficult; in one word, "willpower."
Instead of shopping to feel better, focus instead on working towards your financial goals to feel better. Yes, it’s harder, but as you get closer, even if it’s just a small step forward, something that truly makes you feel proud, it’s okay to reward yourself.
Just make sure the reward doesn’t cancel out the financial gain!
Achieving a consistent positive cash flow is no small feat. Many take this for granted, but it can be incredibly difficult to manage, especially when taking care of a family and managing a mortgage. So if you’re making progress towards it or have recently achieved it, you should truly be proud.
With all of the economic and political uncertainty we seem to be facing more of every day, I do wish that a positive cash flow that amounts to increased savings over time was sufficient.
While it forms a very important part of our overall financial health, there are other aspects, ranging from investments to liabilities, that we need to talk about to ensure that all “basic” avenues are explored to provide you with as many options as possible in reaching your goals.
In Part 3, the final part of this series, we'll be covering financial health and the importance of being able to grow equity over time when managing your personal assets and liabilities.
Please note that while financial goals, cash flow, and equity are covered as separate topics, they're closely intertwined. Being familiar with not just each topic area but also how they can influence each other is key to being in control of your personal finances and reaching your goals.
See you in the next one!