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What gets measured, gets managed.
This axiom by legendary business consultant and author Peter Drucker indicates how we should be thinking about our money.
Unless we track and measure some important money figures, we will not be able to assess and improve our financial situation.
In most cases, our perception about our financial status is miles away from reality, and only cold, hard data can align those two.
If you wish to get ahead in life and and take control of your financial situation, you will need to figure out certain numbers and track them over time.
Whether you want to eliminate debt, achieve financial security or reach a millionaire status, it all starts with having accurate knowledge of your financials.
Be aware that during this exercise you will need to be perfectly honest with yourself. You might have some painful and harsh realizations along the way, but in order to succeed, you need to follow through.
Here are eight things that you absolutely need to know about your money.
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1) Your Net Worth
By “Net Worth” we mean the amount by which your Assets (cash, investments, real estate holdings etc.) exceed your Liabilities (consumer debt, bank loans etc.). It is the most common expression of wealth and perhaps the most important one to track over a period of time.
In order to calculate your Net Worth, you need to list the monetary value of all of your assets and subtract the value of all your liabilities.
There are certain online tools to help you with this, but I personally prefer to do it manually using a custom made spreadsheet. This gives me a better feeling of what is really going on.
Note that it is possible to have a negative Net Worth, if for example you are heavily in debt. Certainly not a nice position to be in, and one you should get out as soon as possible.
Once a month, you should calculate your current Net Worth, note it down and plot the number over a timeline. What you want to see is the line to tread up and to the right!
The way to accomplish this is to increase your assets and decrease your liabilities. Over time, this happens by raising your income and lowering your expenses. The surplus that occurs is then used to eliminate debt, increase savings and fund new investments.
2) Your Total Debt
Although this number is technically a subset of your Net Worth, I am mentioning it in a separate section here because of its importance.
Debt is usually categorized into short term debt (e.g. credit card debt) and long term debt (e.g. mortgage loan).
Getting into debt can be destructive to your finances and should be done with extreme caution. Since debt can be a huge burden, it should only be assumed when it is justified to do so.
There are no hard fast rules for this, since everyone’s situation and context is pretty much unique.
In general, consumer debt is the one to be avoided at all cost. If you need to fund a purchase with credit, it means that you can’t afford the item you wish to purchase and should stay away from it.
However, it is not enough to just have assets that exceed your liabilities. There should be a nice buffer between those. That is why you should also track your assets to liabilities ratio and make sure it is in a healthy range (usually a ratio of 3:1 is acceptable for a person in their 30s).
3) Your Cash and Liquid Assets
Next on, you should be aware of how much cash and liquid assets you have. By liquid assets, we mean assets that can be liquidated (sold) in a very short time, without losing their value.
Again, those are actually part of your total Net Worth, but they should be tracked separately too since they indicate if you are positioned to react to an emergency or an opportunity.
For example, investments in public stocks are very liquid since you can easily and quickly sell them in the public market via an online broker.
On the other hand, an investment in a piece of art is very illiquid. It will take a lot of time to sell it and you probably have to sell at a much lower price if you wish to accelerate the transaction.
By having a healthy level of liquid assets you are confident that you can properly react in the case of an unexpected event (e.g. an accident, health issue etc.).
At the same time, you will also have the “dry powder” to invest in opportunities that might arise and need you to act swiftly to seal the deal.
So far, we have discussed items that are essentially the outcome of two factors: your take-home income and your expenses. Let’s examine those too.
4) Your After-tax Income
Perhaps the most important factor if you wish to achieve financial security is your income.
Please note that I am referring to “after tax” income, and not your gross income. The reason is obviously that taxes can amount to a large portion of it, especially if you are a salaried employee.
Your total income might originate from a variety of sources, such as your salary, freelance gigs, investments, business proceeds and other. You should add all those and track that figure over time.
What you want to see is your income to rise as time passes. Up and to the right.
For most people though, this is not the case since they work as employees and only receive miniscule increases in their salary. On the contrary, people with successful businesses routinely double their income from one year to the next.
As a side note, it is also a helpful exercise to calculate your actual hourly rate. This is not as simple as it sounds and it might also lead to some harsh realizations.
People severely overestimate their hourly rate since they do not include the extra time that their work consumes (e.g. commuting, answering emails at home etc.) as well as the miscellaneous expenses that come along with their job (e.g. take out food, official clothes etc.).
5) Your Expenses
The next part of the equation is your expenses. You need to track your money outflows and be aware of where your cash is spent.
Even if you have a very high income, you will make zero progress if you squander all of it.
People tend to severely underestimate the amount of money they spend in useless things. Unless you track every transaction and evaluate those on a monthly basis, you will not be able to understand where your money is going and what unnecessary expenses you should be slashing.
There are countless apps for this task, but again I prefer to do it manually using my awesome spreadsheets.
On the expenses front, make sure to put your focus on the Three Big:
It is pointless to cut down on your coffees if you then proceed to move in a large house that you can’t really support with your current income.
You should be very strict about what you can afford and what not when it comes to these items.
Here are some fast rules: Make sure that the cost of your car does not exceed 3 months of your (after-tax) monthly income, and your house cost does not exceed 1 year of your (after-tax) annual salary. Otherwise, you are heading deep into the “rat race” zone!
6) Your Savings/Investing rates
Taking it a step further on the income/expenses tracking, you should also be aware of your savings rate. This is what percentage of your income is left after your monthly expenses are paid.
Conventional advice call for a savings rate of 10%. That is ridiculously low.
It is obviously better than having zero savings, or even living on credit, but long term it will have minimal impact. It will fool you into thinking that you are making progress when in fact you will be just treading water.
As I have mentioned many times, you should be saving/investing north of 80% of your income.
In order to achieve this, you will quickly understand that you should be focusing your attention on the “income” part of the equation, and not the “expenses”.
For example, saving 80% of your income is virtually impossible if you have a monthly salary of $1-2K, but easily doable if you have an income of $10-20K per month.
As a general guideline, your expenses should increase linearly whereas your income should grow exponentially.
Like a lot of millionaires, you should strive to live of 10% of your income and have the rest of the money work for you.
Which brings us to the part of investing. Saving is good, but in order to take it to the next level, you need to start investing.
Unless your money grows at a decent rate per year, its purchasing power is going to erode due to the savage forces of inflation.
Take the time to study investing. Keep it simple and be patient. In the long term, you will reap extraordinary rewards.
7) Your Credit Score (or equivalent)
Your credit score (or equivalent in other countries) is not only an indicator of your financial health, but also a critical factor of how much interest you are going to pay if you take a loan (hopefully for the correct reasons).
Having a solid credit score means that you are credible in the eyes of financial institutions (like banks) and this will allow you to take the best loans and also to negotiate the best terms for those.
You should educate yourself on what a good credit score is, how it is built, and then patiently proceed into building one. In the long run, this will handsomely pay off.
8) Your financial Goals
Finally, in order to wrap everything up, you should track your progress on the various financial goals you have set for yourself.
Of course, the first step is to actually set those goals, something that the vast majority of the people around us do not do.
Your goals should be categorized into short term (3-6 months), mid-term (3-5 years) and long-term (10 years horizon). You can event take it up a notch by also setting life goals (horizon of decades).
These goals should be personal and aligned with your own values and aspirations., as well as the time and effort you are willing to invest into achieving them.
Here is a an example of how one person’s timeline might look like:
Short-term: “I will pay down my existing credit card debt of $5k within 6 months.”
Mid-term: “I will raise my income to at least $5K per month, and build a net worth of $50K, within the next 3 years.”
Long-term: “I will build a business that generates at least $50K per month for me, and increase my net worth to $3M within the next decade.”
Life-long: “I will amass a fortune of at least $10M which I will leave to my descendants and to charity after I leave this planet.”
As it is painfully obvious, building wealth is a long term game and not something that occurs in a timeframe of months.
What you need to do is set the right goals, and then proceed to work on them on a daily basis.
In order to get your finances in order, and achieve the financial status you aspire to, you need to be tracking certain financial numbers. This habit will force you to stay on track with your goals and not deviate from them as things get tough.
In this article, I have discussed the most important things one needs to know about their money. Although these metrics are not groundbreaking, they comprise a powerful framework that will assist you in making solid progress.
Knowing about these numbers is of course one thing, but actually acting upon them is a totally different situation. The only way to make progress is to take massive action.
These things act as your map. Now, it is on you to take the steps.