Time and again, man has attempted to explain the complexities in life through simple analogies. So let’s attempt to explain personal finance through the simple analogy of a bird in flight.
For a bird to fly, its forward thrust, as generated by its wings must be greater than the drag created by the same wings and the bird’s body. At the same time, a bird’s wings and body must be so aerodynamic so that they create more than enough lift from the net thrust to offset the bird’s weight.
In a way, managing your finances is like getting a bird to take flight but with a major assumption: you must first treat your household finances as those of a separate enterprise, a business if you will. This way, you can make decisions regarding your finances in a emotionless way (as much as possible).
For your business to take flight, its revenues (forward thrust) must be greater than its costs (drag). This begs the question, “Why not just target breakeven since the cost of the current lifestyle would already have been covered?”
The answer to the question is two-fold. One, the cost of living does not stay static. Inflation is the invisible financial moth that eats away at our wealth. By just targeting breakeven, there will not be any funds that can be reinvested in your household finances to produce additional income to offset the negative effects of inflation.
Secondly, lifestyle costs tend to grow over time as your family grows. Your children move on to more expensive education, you purchase your car/s and dream home and you set aside funds for a comfortable retirement. All of these necessitate more growth in your finances, a state that only reinvested income can facilitate.
As an employee, you may not be able to willfully grow your salary. But you can still reinvest your household finances’ net income or savings in financial securities or even a business to boost your income. And this is where lift comes in.
If all you bought with your net income or savings were non-earning assets like a large house, properties to pass on to your children, large and expensive cars, jewelry and appliances, then your household finances will not have the capability to provide lift even though you may be earning a lot. That lift is needed to offset any borrowing costs on loans that you may have contracted to purchase both of your earning and non-earning assets (weight).
The same lift is used to offset the withdrawals from your household enterprise, which are made in the form of cash dividends (weight) that are paid to household members for discretionary spending. Remember that just like with companies, only your household’s earnings that do not need to be reinvested for future growth can be paid out to the members of your household enterprise as dividends. Shocking as it may sound, some households resort to borrowings just to pay out dividends for discretionary spending.
Paying out dividends to household members is not bad. In fact, all things being equal, a household that has a high level of discretionary spending is one that is enjoying life more. Dividends should just be funded out of the unrestricted earnings of a household.
So remember, for your finances to take flight, revenues must exceed the cost of lifestyle while the majority of assets must produce additional earnings to help offset the cost of debt and provide funding for cash dividends used for discretionary spending.
(Originally written by Efren Ll. Cruz, RFP at http://www.savingstips.com.ph)
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