Have you achieved financial independence? (2)

July 2, 2014 by Usiere Uko 0 Comments

   

 

Author of   ‘Practical Steps to Financial Freedom and Independence’, USIERE UKO, writes on calculating the gap between your expenses and income from your assets

In part 1 of this article, I simplified the definition of financial independence in a form of a mathematical equation I came up with.

Overheads – cash flow from fixed income assets = the gap

I simply made up this equation to illustrate a point hence you may not come across it somewhere else. My main reason for coming up with this equation is to develop a metric you can measure and track to see where you are in terms of achieving financial independence. If you measure the gap over the years, you will see what you have been doing with extra income that has come into your hands. You are either widening the gap or closing it. Most people widen the gap without intending to. They are unaware of the fact that they are making it harder to escape a situation they murmur and complain about. They are in effect, shooting themselves in the foot or scoring an own goal.

Early retirement

Most employees dream of early retirement but very few actually work towards it. To retire early, you simply have to close the gap. In Europe and the US, many opt to close the gap and embark on early retirement through frugality – lowering their standard of living to meet their passive income. They move to a smaller house or a cheaper city or country (e.g. Asia, South America etc) and live a very simple life. Many give up their cars altogether and move around with a bicycle and public transport. In this case, they value freedom more than security.

For us Nigerians, we seem to be more status-conscious. Nigerians abroad are hard to miss. They drive the most flashy cars and throw the biggest parties. You hardly find someone willing to take a pay cut to pursue his dreams. Rather than scale down and go to do something that makes one happy, we rather remain strapped to golden handcuffs and wait till age 60 to start finding our way in our twilight years. Some still look for another job after retirement.

There is no one right answer as to how you should live your life or what your standard of living should be at each point in time. The important thing is that you know what your life is about and what you really want, and be true to yourself. If you desire to escape the rat race, you have to mind the gap. In the event that happens to your primary source of income (be it your business or job), you do not get a one-way ticket to the poor house.

An actual illustration

To further illustrate the concept, I will use numbers from Bayo (not his real name) who works for a multinational company to illustrate the gap.

Bayo lives in Omole Phase 2 on the mainland and works in Victoria Island. He is married with two kids, a girl and a boy aged 9 and 7 years old respectively. His wife owns a hair dressing salon but does not contribute financially to running the home. He maintains two cars (each for himself and the wife). His annual expenditure annual profile looks this:

Net annual income (including allowances and bonuses): N8,800,000

1) Gifts (including tithes etc): N850,000

2) Annual Rent: N1,000,000

3) School fees (3 terms for both kids): N1,500,000

4) Housekeeping allowance N2,160,000

5) Personal allowances (phone calls, car fuelling and maintenance etc): N520,000

6) Vacation expenses: N1,850,000

7) Miscellaneous expenses (insurance, health etc): N420,000

Total annual expenses: N8,300,000

Savings: N500,000

His direct overheads are items 2 – 7, which totals N7,450,000 per annum, (N620,833 per month). Item 1 can be factored in later since it is optional. Bayo has N750,000 in treasury bills at a rate of 9.75 per cent which yields N73,125 per annum (N6,093 per month).

Now let’s plug these figures into our financial independence formula to measure the gap based on Bayo’s income and expenditure profile:

Monthly overheads = N620,833

Monthly cash flow from fixed income assets = N6,093

N620,833 – N6,093 = N614,740 (the gap)

Conclusion:

Bayo is N614,740 away from achieving financial independence. If he loses his source of primary income, he will be N614,740 in the hole in his finances. He cannot afford to resign to go and start his own business, as his house rent, children’s school fees, housekeeping expenses etc will be staring him in the face. If he loses this job, he needs to get another job – an equivalent or better paying job to be able to maintain his current standard of living.

To close the gap, he needs to freeze his expenses and funnel extra income into fixed income assets. Cutting down expenses is an option to Bayo, but his wife has to be on the same page if that is to be a viable option. Cutting down his expenses accelerates the process of closing the gap as he has more disposable income to invest.

Looking at the budget, there are many candidates for cost reduction, e.g. vacations and children’s school fees. There are no right and wrong answers. It depends on the individuals involved. We spend for emotional reasons. For example, you will see parents who attended village public schools and came to the city to do better than kids with silver spoons who went to expensive private schools, yet these same parents bankrupt themselves to send their children to expensive private schools.

You may have other sources of income (e.g. dividends from stocks, book sales, profit from your shop, forex earnings etc), but in the calculation for financial independence, the income source has to be guaranteed. Any income source that varies from month to month is not applicable in this equation. Such other sources of income add another layer of protection, and you can also convert such income to stable sources of income, e.g. you made a very good profit on a deal and move the money into treasury bills, commercial real estate etc. In the case of real estate, if it is not managed properly, your money can get stuck.

Do take time out and really calculate how much you need annually and monthly to sustain your current standard of living. How much guaranteed income do you make from your assets? How far away are you from financial independence? Is the gap closing or getting wider?