The 5 Recipes for a Personal Financial Disaster
Here are five sure shot recipes for a personal financial disaster:
1) You buy a liability, thinking that it is an asset.
You buy a car or a house, by taking a loan, thinking that you are buying assets.
Well, think again.
They are not assets, they are liabilities.
Buying a car is not a one-time expense.
The car will force you to make monthly expenses, and you know what those monthly expenses are.
Same goes with the house.
Since both a car and a house result in a cash outflow every single month, they are liabilities, they are not assets.
Assets are things that put money in your pocket whether you work or not.
I am not saying don't buy a car or don't buy a house.
All I am saying is that, do not buy a car or a house, thinking that it is an asset in your life.
A car or a house is not an asset, unless you put it on rent.
Sometimes even if you put a house on rent, it is still a liability because the monthly expense for managing the property is more than the monthly rental income that you are earning from that real estate unit.
So, whether or not something is an asset or liability is dependent on the cashflow it is producing.
If it is giving you a positive cashflow, it is an asset.
If it is giving you a negative cash flow, it is a liability.
By the way, this concept is nicely explained in Robert Kiyosaki's famous book, 'Rich Dad Poor Dad'.
Read that life changing book, if you haven’t yet read it till now.
2) You are accumulating liabilities in your life.
It does not matter whether it is a personal loan, a home loan, a car loan, an education loan, or a credit card or any other kind of a loan.
Each of these liabilities results in a cash outflow.
It takes money out of your pocket.
Anything that takes money out of your pocket, whether you work or not, is nothing but a liability.
And if you keep accumulating liabilities in your life, you will keep increasing your cash outflow, which will obviously put a strain on your personal finances.
So, look to reduce your liabilities, if you want to avoid a personal financial disaster in the future.
3) You have only a single source of income, and that too, it is an active income.
There are two types of income.
One is active income and one is passive income.
Active income are things like salary & consulting, where you have to trade your time for money.
Passive income are things like interest income, dividend income, real estate rental income etc.
This is an income that does not require your time.
The more streams of passive income that you have in your life, the better off you are.
Depending on a single source of income is another recipe for a financial catastrophe.
4) You are spending more than you are earning.
This is very obvious.
If your expense is more than your income, it will result in a cash outflow.
This will deplete your existing savings.
Warren Buffett once said that, "If you buy things you don't need, you will soon find yourself selling things you really need."
That is a profound statement.
What he is trying to say is that, 'don’t spend beyond your means.'
As long as your income is more than your expense, you have some savings, which can be invested in a productive asset which can give you a cash flow every single month.
That passive income has the potential to make you financially free.
5) You have absolutely no control over your cashflow.
You have no idea where the money is going.
You have no financial budget in your life.
You have not planned for the future.
You do not have financial goals.
And in any given month, you don't know whether you have incurred a cash inflow or a cash outflow.
In short, you are completely lost and out of control.
Is this situation not prone to a personal financial disaster?
How can you expect the outcome to be great, if you do not have control over your own cashflow?
The formula for improving your financial life is very simple: Reduce your liabilities, increase your assets, build more streams of passive income, focus less on active income, spend less than you earn, thereby producing positive cashflow, which you can invest in productive assets to generate even more streams of passive income.
As long as this positive cycle continues, you will be in good financial health.
Else a personal financial disaster is just round the corner. Be ready.
Rohit Musale, CFA
23 December 2022