Continue the series on Financial Independence
The first step is having a financial fuel gauge. A gauge to track the rate of income vs expenses and developing the discipline to monitor the ratio and avoid running out of fuel. The second step is having 1 year worth of free cash or high liquidity assets. The heart of the matter for financial independence, the only metric that matters, is net worth / annual expenses. To achieve the milestone, I need to decrease the denominator by managing my expenses. I believe reducing the denominator is the critical second step because (1) we have more control on our spending patterns, (2) small changes have outsized impact on the ratio, and (3) freeing up more cash flow will accelerate the increase in the top line.
One can decrease the denominator by being more frugal or reducing bad debt. I review my expenses annually, especially regular subscriptions: netflix, internet, car insurance, home insurance, cell phone plans, etc. I review usage and coverage to make sure the family is on the right plan at a good price. But there is a limit on how small the annual expenses can be and at some point there will be lifestyle sacrifices that I’m not willing to put my family through.
I also review my debts annually. I think bad debt is any debt where the annual interest rate is higher than the annual appreciation worth of the asset or the reallocation of that fund is less productive. For example, I got an auto loan when I purchased my Tesla. Was it a bad debt? The car loan would be considered a bad debt by the first definition since the car depreciates (have negative annual worth) compared to the interest rate. However, using the second definition, by borrowing that money, I didn't have to sell my stocks and money market funds that were appreciating faster than the loan rate, it’s actually not a bad debt. When the stock market trend or the money market interest rate changes. The auto loan will switch from a good debt to a bad debt, then I will pull the trigger to pay off that loan. I regularly play arbitrage between the cost of the loan vs my earning opportunity.
The objective of managing the annual expense is to free up cash flow. Yes, living within your means is good, but the point is to think of family finance like a business. Valuable business generates cash flow and invests it properly. That is why the second step to financial independence is having 1 year worth of free cash or high liquidity assets. One year is fairly arbitrary, it could be 6 months or 2 years. It depends on the stability of your primary income sources, and your comfort level with risk. Once there is sufficient cash flow then you can proceed to step 3 and grow the top line and increase your net worth!
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