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“It’s not working.”
A long time client started reading this blog and subscribed wholeheartedly into the idea of saving half her income. She discovered the blog early so she had nearly a year of effort under her belt. Student loans were the worst part of her debt, but credit cards and a mortgage also weighed heavily on her financial plan.
Saving half your income is the floor, not the ceiling. In this case, my client and her husband earn nearly $100,000 a year. They wanted to cut their spending to my levels using my yardsticks for spending. They are down to the mid 40s, a very good sign. The lament, however, has me concerned.
The only way this works is to be consistent. Years of hard work can be destroyed by a short-term spending binge. A new expensive car, a cottage up north, a trip to the casino and a new set of furniture can all be spent in a single month. The penalty will take years to fix.
All Between the Ears
Financial success and early retirement are all mindsets. There is no special ingredient needed. Patience and persistence is all you need. Responsible spending cannot be a chore; it must be an ingrained part of who you are.
My client is nearly in tears as she tells me it is not working. But it is; she just isn’t seeing it.
I question her on why she thinks it is not working. She confesses they are still broke even though they reduced spending. I ask where she thinks the money is going. She says they are putting every spare dime they have into reducing debt.
Ah, the debt bomb!
Digging out of debt takes work. Fixing decades of bad financial habits takes a few years. One year is only the beginning.
The Difference Between Expenses and Cash Flow
There are several things that drive accountants crazy. One of those things is how people have no idea what the differences are between a profit and loss (P&L) statement and a balance sheet. This lack of understanding causes clients significant pain.
A new loan, for example, is a liability, not income. People get that. You don’t pay tax on loan proceeds. They correctly place the loan on the balance sheet as a liability. When payments are made they list the entire payment as an expense on the P&L. Wrong!
My client cut her spending and plowed the excess cash into debt reduction. In her mind she was still spending, putting all the excess cash flow on the P&L when the principal part of the payment belonged on the balance sheet.
Keith’s Rule: Interest on debt is new spending. The payment to reduce principal comes from current cash flow to pay for prior financial indiscretions.
My goal is to get you to think like an accountant. You need to understand where the money really goes on your personal financial statement so you can eliminate debt and build wealth. Let’s walk through the process.
Every transaction in accounting has two sides. We will not bog down on terminology or train you in handling complex accounting transactions. I just want you to understand there is always two sides to every transaction, whether in business or your personal finances.
We will start with taking out a loan. Let’s say you bought a home for $100,000 and took an $80,000 mortgage. How will the money look on our financial statements?
You now have a $100,000 asset on your balance sheet. The other side of the transaction is a reduction of $20,000 from the checkbook for the down payment and you also have an $80,000 liability. The entire transaction takes place on the balance sheet.
You can consider the home purchase spending. In a way it is. However, accountants don’t look at it this way. The home is still worth $100,000 and can be sold, converting it back into cash. Normally a property is depreciated. That is not the issue with a home purchase used for personal purposes. Therefore, I don’t include a home purchase as spending. The insurance, taxes, mortgage interest and maintenance are current expenses only.
When the first mortgage payment is made, what happens? Part of the payment is interest and the rest is principal. In our example the payment is $1,000 with $800 going to interest and $200 going to principal. The second mortgage payment will have less interest since part of the loan has been paid off by the prior payment and the principal portion therefore increases.
The mortgage payment looks like this on the financial statements:
Personal checking account: -$1000 (balance sheet: asset)
Interest: $800 (P&L)
Principal reduction: ($200) (balance sheet: liability)
Notice how the $1,000 coming out of the checkbook is matched exactly by the principal and interest parts of the transaction. We call that having the books balanced.
Why is all this important? Our simple illustration outlines how money moves. My client felt she was not getting traction from all her efforts when in fact she was. Each reduction in spending was used to retire debt. The less debt you have, the less interest accrues, meaning you are further reducing your spending with each principle payment.
Interest expenses are current spending! Reduce debt, and hence interest expenses, and you reduce current spending without any sacrifice!!!
Our example also reveals a bitter truth about money: spending and cash flow are two different animals. If you reduce annual spending to $30,000 a year, about what the Wealthy Accountant household spends annually, you will need MORE income to cover cash flow needs.
Accelerated debt reduction hits cash flow. All the money is still gone, but debt is reduced while you still retain the asset. Your net worth is unchanged! That is what hurts. You moved money from cash to reduce a liability. The bottom line is still the same.
Where you win is next month. The reduced debt means less interest accrued before the next payment is made. Less interest means less current spending. (And what did you get for that interest expense? Use of someone else’s money. That’s all.) The next payment pays off more principle because there is less interest to pay. Before long the debt is gone.
People planning on early retirement (or retirement at any age) need to understand they live in a cash flow world. The bank does not care what your expenses are. They want to know if you have cash flow to pay them back with interest. In our example, the person taking out an $80,000 mortgage will need $80,000 of excess cash flow over spending. Debt is painful and it should be. As painful as it is, people still are too excited about saddling themselves with loads of it.
Debt-Free Cash Flow Needs
Once you are debt free you can live on your income alone. If you have $30,000 in annual spending you only need $30,000 in income to cover those expenses. No excess cash flows is needed to cover liabilities.
Investments are nothing more than moving money from cash to the investment category, both of which are assets. You are just shuffling what you own.
Dividends, interest income and realized capital gains are income available for spending or for new investments. Unrealized capital gains are still working their original job and are not considered income until realized. Don’t be in a hurry to realize a capital gain just so you can put a number on the P&L (income). First, unrealized capital gains are not taxed. Second, if the little soldiers are doing such a good job, leave’em alone. They will keep making more little soldiers (money).
How I think about my finances is slightly different than generally accepted accounting principles. For example: A car purchase is an asset paid for with cash. In my business I would list this on the balance sheet and depreciate it. Same with any furniture or equipment. In my personal (mental) books, a car is current spending—the hell with depreciation—listed in a footnote. I consider most spending core spending. Cars, a home remodel and other major expenses I list separately. In the back of my mind I consider a car a current expense. But I also know it makes it look like my spending is lumpy so I list the car as a footnote so I can track my core spending more accurately.
Great care must be taken when making large purchases. If it doesn’t show up in core spending it might be overlooked. Overlooked spending can get out of control. Remember, a large asset purchase shifts money from an income producing asset (investment) to a wasting asset in many cases. (Cars are wasting assets. They drop in value until the day they hit zero.)
I explained the cash flow issue to my client. She seemed to perk up as I showed her how her efforts were reducing spending (less interest) and how each month her income was now building her net worth a bit faster each month. The student loans really had her down. But she was making progress. In a few short years the debt will be gone and investments will be sizable as long as she stays the course.
Another way of thinking of cash flow is this. You need excess cash flow (income over spending) to fund investments. With rare exception, you are either spending more than you earn or investing excess cash flow, even if in a checking account. Expenses rarely match spending exactly. You need enough excess cash flow over time to fund investments before you can retire.
Understanding the difference between a balance sheet and a P&L will help you reach your financial goals faster with fewer crises. Knowing where each transaction goes on the financial statements allows you to build your net worth faster. Once your assets over liabilities (hopefully there are few, if any, liabilities) reach an appropriate level you can chose the life you live. We call that retirement around here.