I strongly believe this.
If you are reading this article, you have a desire to become financially wealthy.
Many aspire to that, dreaming as to how superb life could be once they achieve financial freedom. But, most struggle to attain such a feat. Some even fall into a deeper financial hole, especially when they make more money. So here, the key question to ask is, ‘What is financial independence and how do we attain it?’.
While there are 1,001 ways to become wealthy, I would not get into them. Over here, I believe the one thing that most people lack in attaining wealth is to have a financial scorecard, which helps to assess our financial progression.
What is a Financial Scorecard?
It is one that could accurately tell us if we are rich or poor financially.
You see. We can’t tell if one is really rich or poor from his outer appearances for impressions can be deceiving. A rich man can drive a Mercedes Benz but so can a poor man. A man with RM 1 million is usually considered wealthy. But, here is the thing. What is less known to the public is that a man can be financially poor despite having RM 1 million in his bank accounts.
Essentially, one that looks rich does not necessarily indicate that he is truly rich. As a matter of fact, it could mean the opposite and that would be unwise.
What Does a Financial Scorecard Look Like?
Basically, financial planning or accounting is merely a mastery of these 5 words, which are income, expenses, assets, liabilities, and net worth.
A rich man has good control and understanding over these 5 words.
A poor man doesn’t.
So, let’s start with the definition of these words at the level of personal finance:
There are 2 types of income namely, active income and passive income.
Active income is income earned from your labour. It can be your job or business that requires your physical involvement. Meanwhile, passive income is a kind of income that is earned from your ownership of assets, which include your stocks and real estate.
There are 3 types of expenses.
First, it is fixed debt-based expenses. They include your debt instalments, which include your car loan, mortgage, and PTPTN loan.
Second, it is fixed non-debt based expenses. For instance, they include rent and utility bills, insurance, phone bills, and other subscription-based bills.
Third, it is variable expenses. For instance, you can decide the amount of coffee that you like to consume. You might have 10 Starbucks Lattes in one month and have 20 Starbucks Lattes in the following month. You could go on a holiday for a week this month and not go on a trip in the following month. So, any other cost which you can decide on its quantum would fall under variable expenses.
There are 4 types of assets.
First, they are doodads that you consume such as your personal residence, your car, your private yacht and so on and so forth. They are meant for your pleasure and enjoyment.
Second, they are speculative assets, which you bought with an expectation that they would go up in prices in the future. They include stocks and real estate you bought to trade or flip, unit trust, ETFs, cryptos, land, gold, silver, and so on and so forth.
Third, they are income-productive assets, such as stocks bought for dividends, a portfolio of real estate bought for their rental income, EPF, FDs, and intellectual properties.
The fourth asset would be yourself, especially if you are still income-productive.
There are 2 purposes for getting into debt.
First, it is to buy income-productive assets, which mainly include a property you bought for its rental income. Thus, such a debt is a form of ‘productive debt’.
Second, it is to fund your consumption, which mainly includes all your doodads, such as your house and car. So, this is a form of ‘consumption debt’.
#5: Net Worth
This is simple. It is what you really have after deducting all your liabilities. If you could increase your net worth over time, it indicates that you are moving closer towards becoming truly financially wealthy.
Assets – Liabilities = Net Worth (Equity)
The Difference between the Working Class and the Rich
It lies in their priority, once they make more money.
For the working class, their financial scorecard would look like this:
To sum it up, the more money they make, the more they spend and borrow. For them, their doodads will grow as they upgrade their homes and cars with larger consumable debts. They look impressive and have it all together. But in reality, I believe they are worsening their financial positions as they are funding all these expenses and debt commitments with one main source of income.
One Income to Fund Multiple Larger Expenses
For the rich, their financial scorecard would have the following:
I’m not against anyone buying a larger home or car. What I’m saying is this, ‘The rich earn passive income from income-productive assets.’. Thus, the question is, ‘Are you paying for your home and car with active income or passive income?’. I would say that the truly rich would first prioritise on buying ‘Income-Productive Assets’ and then only on other luxuries in life.
Hence, for the rich, it is:
Multiple Income to Fund Controlled Expenses
Next, the question we should ask ourselves is this:
Are we becoming financially richer or are we digging our own financial graves?
With that, let’s look at the 5 metrics:
Metric 1: Savings Rate
This measures the amount of money you could save from each $100 made on a monthly basis. If you earn below $5,000 a month, you should aim to save about 20% of your income consistently. Theoretically, you should be able to grow your savings rate easily from 20% to 30%, 40% and >50% if your income grows in the future.
As such, if your savings rate is consistently above 30%, you are moving closer to becoming financially wealthy.
Metric 2: Passive Income / Total Expenses Ratio (PI/E Ratio)
You are considered financially free if your passive income exceeds your monthly expenses. This would be a great feat for many people. In this case, you could be working out of passion and not just solely for survival. However, if you currently do not have passive income, you will need to continue on working for money.
Practically speaking, if your active income is below $5,000 a month, it is ideal to focus on increasing your active income to $7,000, $8,000, or above $10,000 per month through career or business building. Without increasing your living costs significantly, you could achieve a higher savings rate (>30%) consistently. Then, I believe it is practical to invest these savings to raise your passive income.
If your active income is above $10,000 a month and have little passive income, I think you could be either hoarding money in FDs or worse, you might be a large spender of money with higher expenses, doodads, and ballooning consumption debt. In this case, your financial standing is weakening despite a raise in income on a monthly basis. It is best to rethink the direction in your financial life.
Metric 3: Current Ratio
This tells us how long could you last if your active income stops today.
Here is a new term: liquidable assets. They refer to all kinds of assets that could be sold off and converted into cash easily in 12 months. Some examples include cash, FDs, stocks, unit trusts, ETFs, cryptos, gold, and silver. They come in handy to support your current lifestyle in a job termination and business slowdown.
So, if your monthly expenses are $5,000 (or annual expenses of $60,000) and as of today, you have $60,000 in liquidable assets, your current ratio is 1.0. Hence, it means that you can support yourself financially for 1 year (12 months) should you lose all of your sources of active income presently.
I believe all of us should aim to achieve >1 in our current ratios. It indicates that we are resilient financially and have resources to invest to grow our wealth. But if your current ratio is <0.5, it is best for you to work on this first and not invest.
Metric 4: Debt-Service Ratio (DSR)
This tells us how much debt instalments are you paying each month from every $100 made in total income (both active & passive income).
So, if let’s say you pay $1,000 in car loan and $2,000 in mortgage instalment per month and your total income is $10,000 a month, your DSR is 30%. I believe the level is quite manageable. If your total income falls to $8,000 a month, you may not feel good about it but this fall in income is not financially fatal to you.
But, if you pay $1,000 in car loan and $2,000 in mortgage instalment per month and your total income is $6,000 a month, what happens if your income declines to $4,000 a month due to a pay cut or a business slowdown? This dip in income would be more painful to you.
Hence, it is okay to have debt. But, it is smart to keep it at a prudent level which is at below 30% in DSR.
Metric 5: Insurance Coverage Ratio
If you have a factory that generates $1 million a year in earnings consistently, as its owner, how much would you sell it off for?
If you say $10 million, it means that you are valuing the factory 10x its earnings, or a P/E Ratio of 10. If you say $20 million, then, the P/E Ratio is 20.
Now, the question is, ‘What if the factory is yourself?’. How much will you value you?. So, if your annual income is $100,000 and you insure yourself for as much as $100,000, then, your P/E Ratio is 1.0. You might be undervaluing yourself. Or, in this case, you are underinsured.
So ideally, it is best to at least aim to insure at least 5 years’ worth of income, or a P/E Ratio of 5.0. If you achieve that, you may go for 10 years and beyond that. The amount of insurance you buy reflects how much you value yourself.
Conclusion: Putting Them Together
Once again, the 5 metrics that could tell you your level of wealth are as follows:
Metric 1: Savings Rate – How much can you save from every $100 earned?
Metric 2: PI/E Ratio – How close you are from being financially free?
Metric 3: Current Ratio – How long can you last if you lose your active income?
Metric 4: DSR – How much debt instalment you pay from every $100 earned?
Metric 5: ICR – How much do you value yourself as an income-generating asset?
If you are bad in finances, just stick to these 5 metrics and you should do fine. If you happen to not do well in all the 5 metrics today, just pick 1 metric and work on it first before proceeding to the next metric.
With that, I wish you a fruitful journey ahead in managing your finances. Here, if you wish to learn more about how the rich manages money, join a free 1-Hour Training Session as follows: