Budgeting 101 (Part 3)

Okay, we’ve talked about how to identify good, sustainable, and repeatable financial opportunities. Now we’re going to jump into how to streamline our budgeting process and make it work for us. So, I look at budgeting like a business. I have three financial statements that I make for myself.

First is my income statement. This shows me how much income I am making from what sources and how much it cost me to make that income. Most people think that this is straight forward and there’s no reason to look at it but let me give you an example of why this is important. Let’s say you have three streams of income: a duplex that makes you $5,000 a year, an affiliate website that makes you $10,000 a year, and a job that earns you $50,000 a year. According to the Labor Department’s Pew Analysis, the average American works roughly 1,800 hours a year. That means it cost you 1,800 hours a year plus the costs of transportation, work attire, and other working expenses. After factoring in those costs to you, that means you are earing roughly 27.00 dollars an hour. Now let’s say that your duplex cost you $15,000 with a $150,000 loan and, on average, a couple of hours of work a month. That’s 24 hours. That equals out to approximately $208 an hour. The affiliate site that you bought for $20,000 takes a couple of hours a week to create and update content. That’s 104 hours a year at $96 dollars an hour with basically no risk outside the invested capital. So which income is better and where should I allocate time and money? How do each of these affect my end goal? I will look at these quarterly, and annually.

My second financial statement is my cash flow statement, or as I call it my P&L: Profit and Loss statement. This is probably what most people look at. It tells you how much money came in and how much left and what you kept at a given time. This is the one that really tells a story. This information will tell you more about yourself than anything else. It is the perfect epitome of the idea that “what you say is not important, it’s what you do”, or to put it more simply, “putting your money where your mouth is.” It doesn’t matter what you say or what you post on social media, this is the truth. It reveals what is most important to you and it says where your priorities lie. It shows what your focus is and quite frankly, who you are.

People say they are not concerned with looks but then spend thousands of dollars a month on clothes, makeup, cars, and other things to make themselves look a certain way. I’m not saying that this is necessarily a bad thing.  What I am saying is that your finances will tell you a story and a lot of the time it’s a very different story than the one we tell ourselves and others. For real changes in your financial goals, you need t0 start here!  I look at this monthly, quarterly, and annually.

The third and final financial statement is the balance sheet. This is the big daddy! It shows you the whole picture at any given time. It considers everything. Think of this one as the one the banks want to see. It’s the one that shows you how much you are worth an overall wealth snapshot. This is where you look at things like equity and business interest. This is the one I am trying to change. This is the one that every year will tell me how I improved. Did I pay down debt? Did I buy more investments? Do I have more savings? All roads lead to the balance sheet.

These will show me if I am investing or if I have too much debt. What is my margin? What is my return on equity? If I have a repeatable investment process, I will see it unfold in the financial statements. This is how you keep track and measure. If you’re not doing this then how will you ever know if you are getting closer to your goals?

Now starting off it was simple. We had low expenses, little debt, and very little revenue. We had no plan! No idea at all how to get to our destination. So, to prepare we focused on our P&L and kept expenses low – really low. We lived on 50% of our income and saved the rest. We lived then and still do now, dramatically below our means. Because we knew that debt and high expenses drowned out opportunity and increased risk. We need to be prepared for any opportunity to create a repeatable investment process that worked for us. It paid off and we were able to take advantages of opportunities when others could not. I track my return on equity and debt to income. I don’t overcomplicate it.

My guideline has always been that I keep my long-term debt-to-income ratio at 3. Meaning that if I made $100,000, I thought it was acceptable to have 30,000 in long-term debt. Now the only long-term debt my wife and I allow is for a mortgage. We never put long-term debt into depreciating assets like cars or toys. Short-term debt was simple it always had to be able to be paid off in full at the end of the month like credit card debt. We never use debt to finance play, ever! Although that was our guideline, we have never had a debt-to-income or cash above 0. That means our mortgage was equal to the money we had so we could pay it off.

Now that won’t always be true because I want to invest my capital, but we have never had a mortgage that was more than our annual income. Now I know that cannot always be the case which is why I like the debt-to-income ratio of 3.

I track my key financial ratios as follows:

• Net worth: Total assets, total liabilities. If you have a $200,000 house and $10,000 in savings with $150,000 in debt, then your net worth is $60,000. This is important for banks.

• Savings ratio: this is what’s left over each month from your monthly income. So, if you have $500 left over a month and you make $5000 your ratio would be 10%. The higher this number the better.

• Profit margin: This is the difference of how much you make and spend. So, if you make $50k and spend $25k then you have a 50% margin.

• Real wealth: Investment assets / total assets: So, if you have $20k in the stock market but you have $150k of house equity, car and other non-investment costs then your ratio would be 13%. This one is easy; it should be 100%. Don’t let bankers fool you into thinking you’re rich because you have a lot of stuff!! A key indicator of where you focus really lies and what kind of path you are walking down.

• Passive income ratio: Passive income/primary income: If you make $1k passively but make $50k as your primary income then you are at 2%. The goal again is to be 100%. This was a number I focused on for years. It tells no lies. You are either free or not.

• Debt service ratio: Debt payments/total gross income: If I have debt payments of $2,000 a month with $6,000 income a month, I would have a debt service ratio of 33%. This should be as low as possible and anything 30% or more is way too much.

• Debt to assets: Long-term and short-term debt/total assets: If you have $200k in house and car debt with a $300k house and investments your ratio would be 66%.

• Return on assets: Asset income/Asset net value: If you have an ownership in a small business that makes you $6,000 a year and your ownership is worth $150,000 your return would be 4%. This is important because it tells you how well your investments are performing. This should be as high as possible. You should compare it with safe investments. So, if I could get a return on a safe bond for 4% why would I invest in something risky for the same return.

 The idea is to put yourself in a position to take advantage of opportunities that you can repeat at a high return repeatedly. Creating more income streams increases your profit margin, net worth, passive income, real wealth, and saving ratio all while lowering your debt service and debt to assets.