My SMART Money column in the December SMART Biz set out the first key to financial success: you need to take RESPONSIBILITY; only you can define your goals. The confidence to make your own decisions needs comes with understanding some fundamentals, to avoid being taken to the cleaners by a smooth-talking salesmen and by the plethora of fees hidden in financial products. With the New Year, we talk about the second key to financial independence: CASH FLOW.
The three secrets of business success were location, location and location. It might help a retail store or restaurant to be in a high traffic location, but the real secrets of success in business or in the financial management of your life is cash flow, cash flow, and cash flow. The caveat is that net cash flow must be positive. Charles Dickens, my favourite economist, nailed the essence of financial planning:
Annual income twenty pounds, annual expenditure nineteen pounds and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds and six, result misery.
Reaching financial independence is about making money, without spending more than you bring in.
Begin by making an income. So what do you want to be when you grow up? Parents and grandparents asked this question: cowboy, fireman, nurse, teacher? By your teens the choices might have become more sophisticated: Doctor, scientist, astronaut, lawyer, financial planner? Your mother might want you to be a doctor but you want to be a rock musician. Make your own choice but keep it real. The odds of a (financially successful) rock musical career may be slim, so best get a trade as well – maybe medicine? You can still get weekend gigs to develop your musical calling as well, so long as you have a means such as medicine or plumbing to make a living while you do.
For those graduating high school in the spring, if you do not feel a drive toward a specific vocation, do not waste your time or your parents’ money – you may inherit it someday. Instead, make some money. Get a trade to make more money. Go to where the money is. Travel, see the world. You will grow up. You will know when you have when you realize your parents aren’t as dumb as you had thought. Now you have grown up and know yourself, at least better than at 18. You have a trade to make a living and you have a vocation that you enjoy. If you are extraordinarily lucky, it may be doing the same thing. But having a good trade that supports pursuit of your vocation is not a bad deal either.
The first cash flow is income, a pay cheque. Once you have one, the second cash flow is expenditures. Whatever you end up doing, it is highly unlikely your cash flow will provide all of your wants – unless your name is Justin Bieber. To keep cash flow positive, you will need to set priorities, actually budget. The lease payment on the big truck that is such a great year-end deal may not make this cut. But if you do not subject that allocation to the test of your priorities, it may instead be your drive on the road to ruin. Keep needs and wants in their proper order: “You can’t always get what you want, But if you try sometimes well you might find, you get what you need” (The Rolling Stones).
The first priority for your planned expenditures is to pay yourself by taking a minimum of 10% of your net and socking it away long term where Einstein’s eighth wonder of the world, compound interest, can work its magic. This can be a difficult to do when so many short term wants are competing with this long term need. So trick yourself. Instead of “saving” 10%, tax yourself, be your own CRA. Since we do not have any choice about all the other taxes deducted from your cheque, add one more deduction for the government of You.
The second expenditure priority is debt. Many say this should be the first priority but I think it is more important to establish the saving and investing habit as early as possible. And with today’s interest rates you do have some flexibility in your debt retirement choices. First understand the difference between bad debt and good debt. In a nutshell, good debt is expected to make a profit. Bad debt is blown out the window for fleeting pleasures. The big truck might compensate for feelings of inadequacy, but it is not going to make you money. The worst debt is financing consumption pleasures on high interest credit cards. You would be better off going to a loan shark – at least they will incentivize you to repay the debt! So get rid of your bad debt, starting with the highest cost debt.
Good debt is a student loan, wisely invested for qualifications that will increase your earnings. It is reasonable to pay off good debt on a longer term schedule that matches the income returns it was invested for. Good debt can include leverage like a mortgage to buy a home to save rent, or to buy a rental property to make rent. After paying off bad debt, retire any good debt where the interest is not deductible. Then you might use your great credit for new good debt where the interest is tax deductible to make more money; it may actually be possible to make your “mortgage” tax deductible.
Only after paying (or taxing) yourself first, then managing debt, can you turn to your third priority, food and shelter. Yes, the necessities of life come after saving and debt payment. Finally, you may have some mad money left over for entertainment and other pleasures. You do need some of this too – all work makes Jack a dull boy. So even if you have to live in a smaller house or drive an older car, keep some scarce resources for some fun. Just pay cash as you go.
When you get that first real job, making $4000 a month, you soon realize that after government and other deductions, you really only make $3000. Add a deduction of $300 to pay yourself first, as well as at least as much, another $300 or so, on your debt retirement plan. You then realize you are really only making $2400 a month. Begin your budgeting from that point, not the $4000 gross you thought you were making.
Manage your expectations and it will be easier to manage your cash flow. More on this in February.