‘Hi, my name is Sam. I’m 30 years old and now working as a Project Manager in a mid-sized engineering firm earning a decent salary of RM 7,000 a month. I’m able to save up to RM 3,000 a month from my salary and had already accumulated a total of RM 100,000, consisting of RM 40,000 in EPF, RM 30,000 in Fixed Deposits, RM 20,000 in Unit Trust funds, and RM 10,000 in savings.
I like to ask: ‘How much more do I need to achieve financial independence? and how long does it take for me to get there?’
First and foremost, let us define what financial independence is to you. Is it you having RM 1,000,000 in your bank account? Or, is it you having expensive fancy cars to drive? Or, is it you living in a mansion at a prestigious address? Or… and the list goes on and on.
The point is – Different people have different definitions of what it means to be truly financially independent as we all have different needs and wants in life.
So, how would I answer the question above? For a start, right financial planning starts by asking questions of what Sam wants and aspires to achieve in life as it is personal. Then, a well-rounded financial plan is crafted specifically to cater to Sam’s answers which reveal his objectives and goals in life.
Here, I’ll share my personal views on what being financially independent is, and it is – the ability to sustain our current lifestyle in the absence of active income.
From the details above, I believe it is inconclusive to measure how close Sam is to becoming financially independent, which is, by the way, the first crucial step for anyone to become wealthier. Therefore, assuming that I am Sam’s financial planner, I would ask him for more input and would assess his financial strength with 5 Key Personal Finance (PF) Ratios as follows:
PF Ratio 1: Passive Income Ratio
What It Tells
Passive Income Ratio measures the amount of passive income you are bringing in per month in relation to your total monthly income, both active and passive. If you achieve a high ratio, and the amount is enough to sustain your lifestyle, it means you have a choice to stop working for active income.
From Sam, he has RM 30,000 in fixed deposits which are yielding 3% interests a year. Thus, his annual interest income is RM 900, which works out to be RM 75 per month in passive income. Sam’s earnings from unit trust funds and savings account are negligible as they do not yield much. I’ll exclude EPF for now as his money is ‘locked’ tightly until he reaches 55.
Read more about prison money here when it is locked away.
Thus, Sam’s total monthly income is RM 7,075, which comprises of RM 7,000 in active income (salary) and RM 75 in passive income (FD interest). Hence, Sam’s Passive Income Ratio is 1.06%, which practically means, if he stops working, his income stops flowing.
Passive Income Ratio Formula:
= (Passive Income / Total Income) x 100%
= [Passive Income / (Active Income + Passive Income)] x 100%
= RM 75 / (RM 7,000 + RM 75) x 100%
PF Ratio 2: Savings Ratio
What It Tells
Savings Ratio measures the amount of money you are retaining from your total monthly income. If you have a high savings ratio, you stand a greater chance of converting money retained into investments that produce passive income than another person with a lower savings ratio, assuming that both of you make the same amount of total monthly income.
From Sam, he mentioned that he is able to save up to RM 3,000 a month from his salary. The RM 75 in interest income is retained in his FD account. Thus, his monthly savings is RM 3,075 from total monthly income of RM 7,075. It works out to be a Savings Ratio of 43.5%.
Savings Ratio Formula:
= (Monthly Savings / Total Monthly Income) x 100%
= (RM 3,075 / RM 7,075) x 100%
PF Ratio 3: Wealth Ratio
What it Tells You?
Wealth Ratio measures how long your ‘current assets’ can sustain your current lifestyle if you stop earning active income today. If your passive income is more than your monthly expenses, then, you have achieved infinite wealth and have the ability to sustain your current lifestyle with or without your active income.
From Sam, his current asset stands at RM 60,000. His EPF is a non-current asset as the money could not be assessed until he reaches 55. If he is able to save RM 3,075 from his total monthly income of RM 7,075, Sam’s monthly expenses would be RM 4,000. Based on the wealth ratio below, I had estimated that Sam’s current assets would be able to last him for a little more than 15 months.
It means, if he loses his job today, Sam has around 15 months to find himself a new job before he becomes fully broke.
Wealth Ratio Formula:
= Current Assets / (Monthly Expenses – Passive Income)
= RM 60,000 / (RM 4,000 – RM 75)
= RM 60,000 / RM 3,925
= 15.3 months or 1 year 3+ months
PF Ratio 4: Insurance Cover Ratio
What It Tells
Insurance Cover Ratio measures the amount of total income replaceable from your current insurance sum assured in the occurrence of one of the following events: death, total permanent disability, and critical illnesses. In general, the rule of thumb is to have an insurance cover ratio of 10, which means, if any of the misfortunate events occurred, the sum assured is able to replace 10 years worth of one’s total income.
From Sam, he revealed that he bought an insurance policy from his friend as a gesture of support. Its sum assured is RM 100,000 in the event of death, total permanent disability, and critical illnesses. Sam’s total monthly income is now RM 7,075 a month. Thus, he has an insurance cover ratio of 1.2 years. It shows that Sam is indeed underinsured.
Insurance Cover Ratio Formula:
= Sum Assured / (Total Monthly Income x 12 Months)
= RM 100,000 / (RM 7,075 x 12 months)
= RM 100,000 / RM 84,900
= 1.2 years.
PF Ratio 5: Debt Service Ratio
What It Tells
Debt Service Ratio measures the amount of instalments you are committing a month for your debt in relation to your total monthly income. These debts are inclusive of a mortgage, car loan, credit card, personal loan, PTPTN … etc. If you have a lower debt service ratio, you should have lesser financial stress.
From Sam, he does not have any forms of debts except for his existing car loan where his instalment is RM 1,000 a month. Hence, Sam’s personal debt service ratio is 14.1% of his total monthly income of RM 7,075, which is relatively a low and comfortable figure.
Debt Service Ratio Formula:
= (Monthly Debt Installments / Total Monthly Income) x 100%
= (RM 1,000 / RM 7,075) x 100%
Local banks would use marginally different figures to calculate your DSR before approving your credit applications.
Is Sam Financially Independent?
From the 5 PF Ratios, we have the following:
|No.||PF Ratios||Sam’s Current Status||Ideal Target|
|1||Passive Income Ratio||1.06%||100%|
|2||Savings Ratio||43.5%||> 30%|
|3||Wealth Ratio||15.3 months||Infinity|
|4||Insurance Cover Ratio||1.2 years||10 years|
|5||Debt Service Ratio||14.1%||< 40%|
It shows that Sam is a saver as he has a healthy savings ratio and a debt service ratio relatively low. But, Sam is not able to quit his job presently as he does not have much passive income and his current wealth would last him for around 15 to 16 months.
Also, Sam is underinsured. If he is ‘forced’ to stop work due to illness and being disabled, his insurance cover will last him for 1.2 years.
If I’m Sam, I will do the following to move one step closer towards becoming financially independent:
- Buy Life Insurance Progressively.
The objective is to raise Sam’s insurance cover ratio progressively from 1.2 years to, perhaps, 5 years initially, and subsequently move up to 10 years over the next 3 – 5 years. Sam’s total annual income is RM 84,900 and thus, he may increase his sum assured from RM 100,000 to as high as RM 424,500. It is advisable for Sam (30 years old now) not to incur a premium beyond RM 250 for a life insurance policy where its coverage (sum assured) is RM 300,000.
- Invest in Cash-Flow Generating Assets
This is optional, not for everyone.
Based on the wealth formula, Sam needs passive income to exceed his monthly expenses to achieve infinite wealth. If Sam’s investment in his unit trust funds is not generating ‘cash flow’ returns, he may cash it out and reinvest the money into cash flow generating assets. This could be stocks that pay dividends or properties for rental income and so on and so forth as long as Sam generates passive income from it.
I’ll save that for my subsequent articles.