Thursday, 10 November 2011

Achieving Financial Independence

Although, we all almost love money but its difficult for us to understand money and very surmountable to achieve financial independence. That’s simply because we all “work for money” rather than making “money work for ourselves”. In this article, I make an attempt to try to understand what is money, solve its mysteries and work towards achieving financial independence.

I am a Chartered Accountant and hence understand the Profit & Loss A/C and the Balance Sheet but even those with non commerce background, I explain it simply and how it relates to solving your money problems.

Enhance your Income: The first and foremost thing is income. We all have to learn to enhance our incomes. We all have some talent – we have to identify our talent, horn our skills, gain experience, improve our net working and increase our knowledge because that is the key in the current high flying technology and information era. We all have to try to consolidate our strengths and minimize our weaknesses and aim to earn as much as possible because Income is the first tenant of the P&L A/C. 

Increase your Net (After tax) Income: Earning more income is just the beginning and will not in any way solve your financial problems unless you follow the other rules. The second most important thing is to enhance your net or after tax income. There are lots of financial predators and the biggest amongst them is Income Tax which legally takes away money from your pocket. There are three different kinds of Income – Earned Income (like Salary where the person actually works to earn money), Guaranteed Income (where the return is guaranteed like Bank FDs and hence there is negligible risk) and Portfolio Income (where neither the principal nor the return is guaranteed like dividend from shares, rent from real estate, capital gains etc). Kindly remember, the tax structure is discriminating, in the sense as general rule there is maximum tax on earned income as if the Government punished you for working hard to earn your income. Also, there is maximum tax on guaranteed income because you are not innovative with your money. However, there is a lower rate of taxation or even no taxes in some cases like dividends on equities, all of which come from portfolio income. Hence, rather than working hard for your money and paying higher taxes, you have to be smart to let your money work for you and pay lower or no taxes.

Don’t do any unnecessary Revenue Expenditure or Gruesome / Bad Capital Expenditure: Unnecessary revenue expenditure means a foreign trip, costly five star dinners etc. Gruesome capital expenditure would mean those assets which produce negative income or take away money from your pocket like car, beach house etc. Bad capital expenditure would include those assets which do not give you any income like a house property. But, we all have to live in this world and incur some expenses for our existence like food, clothing, medical etc – therefore we have to learn to budget for these expenses and do a judicious use of our finances. And remember, as you would budget some amount for food, clothing etc, the same way budget some amount for yourselves i.e. your savings. And finally what is the use of money if we can’t enjoy life, so at some point of time everybody has to incur unnecessary Revenue Expenditure or Gruesome / Bad Capital Expenditure, but then you don’t pay for them – let you assets pay for them (explained later on). And remember, treat all money equally i.e. the money you got from say a lottery ticket or from an estate of some deceased relative or any windfall gain with same respect as the money you have earned from your handwork – execute same caution in utilizing your money whatever may be the source – just because it is free money or windfall gain don’t squander it away.
Liability side – Good Debt and Bad Debt & the Power of Leverage: Learn to distinguish good and bad debt. According to me, bad debt would be that debt which is used to create Gruesome / Bad Capital Expenditure – those assets like car, beach house which take away money from your pocket or a house which do not put any money in your pocket. On the other hand, Good Debt would be that which helps you in creating an Asset which then puts money in your pocket (income) as well as scope for future capital appreciation e.g. rental property which earns rent, shares which earn (tax free) dividends and both having potential for future capital appreciation. Never borrow to incur a revenue expenditure like foreign trip or gruesome / bad capital asset like a car, beach house because they will not only take away money from your pocket in the form of interest payments but also put you into recurring waste revenue expenditure in the form of maintenance of that gruesome / bad capital asset like petrol, repairs, property taxes etc.

Asset Side – Create Good Assets: Always aim to create good assets which will provide income to you. For example, equities which will give you tax free dividends, rental real estate which will give you rent etc There are multiple advantages of them like they are either tax free (dividends), subject to lower rate of taxation after exemptions (rent) than earned income (salary). Then use the power of leverage to create good assets – let the income from the good asset pay your loan interest. And once the loan installments are over – the future income (taxed at lower rate) on the good asset as well as the good asset itself is yours for life. And the trick of enjoying life as well as securing your financial future is to ensure that the portfolio income from your good asset pays for your Revenue Expenditure or Gruesome / Bad Capital Expenditure. I think once you reach this stage you are close to achieving financial independence.

Don’t forget that income tax reduces your gross income; interest on loans (on revenue expenditures / bad assets) diminishes your net incomes and inflation eats out your remaining income. So, earn more money, increase your after tax income, budget properly for your money, you don’t pay for revenue expenditure or gruesome / bad capital expenditure (let your good assets pay for it) and therefore use leverage (debt) to create good income generating assets. Follow the simple rules stated above and work towards achieving financial independence. All the best!

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