#5 - A Crash Course in Financial Literacy; or A Roadmap to Financial Independence

“It is better to have a permanent income than to be fascinating.”

Oscar Wilde 

I. Introduction 

Most people’s biggest financial problem is their lack of financial education. In this blog, my intention is to share all the knowledge I’ve acquired in the last five years through personal experience and the study of financial books so you don’t have that problem. In fact, I can guarantee that if you read this blog you won’t have that problem although you might have other ones since knowledge alone does not lead to wealth. What we do with the knowledge we acquire is what really makes the difference between failure and success.

This will be the most important post so far because I will deal with financial statements which are the base of financial knowledge and success. In fact, until you can write and read financial statements, you don’t really understand how money works. Fortunately, this will no longer be a problem for you, since this post, if I do my job right, will teach you how to read and write financial statements.

II. Income Statement

A basic personal financial statement has two main parts, and each part is divided into two columns. The first part is the income statement, which is something most people are somewhat familiar with. An income statement has two different columns: the income column and the expenses column.

Your income column is composed of all the money you make every month. For the average poor or middle class person, this column will only have one item: his or her salary. This is because, for the vast majority of people, their income is equal to their salary or some other form of active income. For liberal professionals such as lawyers or doctors, their income might actually be a sum of fees paid directly to them by their clients. For sales people, their income will usually be the sum of a base salary and the commissions they were able to earn that month. All these types of income are active income, which makes up the totality of most people’s income altogether.

However, if you read the last post, you know that there are two essential types of income: active income and passive income. Most rich people will have both types of income in their income column and some will only have sources of passive income and no active income at all. There are several possible sources of passive income: rental properties will produce income in the form of rent. Stocks and bonds will provide you with dividends, usually on a quarterly basis. Business owners receive income generated by their businesses. Both active and passive forms of income are good since they put money in your pocket, the difference is that you don’t need to work for passive income.

The second column in an income statement is a lot less pleasant. Everyone is familiar with this column to some extent, they just aren’t accustomed to put it into writing. I’m talking, as you might have already guessed, about the expenses column. Everyone has expenses. Usually, those expenses come in the form of accommodation, clothing, food, leisure, transportation, utility bills, communication and other life expenses. Each of these different expenses should constitute an item in your expenses column and the sum of all of them will constitute your total expenses figure.

After you have exact figures for your total income and your total expenses, you can see how well you’re doing financially by determining your cashflow. Your cashflow is essentially how much money comes in or out of your pocket each month. You’ll always want to have positive cashflow, that is, more money coming in than going out. Cashflow is the most important word in personal finance, so always keep it in mind.

People generally associate a large income with great financial success but this is incorrect since what really matters is not how much you earn, but how much you keep at the end of the month. If you only look at someone’s income column you’re only getting half of the picture. If you want to draw any meaningful conclusions about a person’s or a company’s finances, you really need to look at the whole picture. Remember, an income statement is composed of two columns: income and expenses. It is only when you compare the two that you understand if someone is financially successful or not.

If you want to be financially independent you have to stop thinking as most people do. Most people tend to react to an increase in their income by increasing their expenses proportionally. As a result, their net income (total income – total expenses) tends to remain always dangerously close to zero. As a matter of fact, in some cases, people’s net income decreases even if their income increases. That’s because the more money they make the more willing they are to spend a lot of money in unnecessary things like big houses, expensive cars and luxurious consumer goods.

A financially savvy person, on the other hand, knows that cashflow is king. That person is always looking straight at the net income figure (total income – total expenses). Almost no one becomes truly wealthy by just producing a great income. In order to become wealthy one needs to produce a considerable positive gap between income and expenses. Make a lot of money and spend a lot less money than you make. Save and invest the difference. That’s the formula for success and that’s how you have to shape your income statement if you’re serious about becoming financially independent. You don’t want to look rich by having a Porsche and living in a huge house. You want to be financially free and never have to work on something you hate ever again in your life.

III. Balance Sheet

As important as the income statement is, however, it is certainly not the whole picture. Actually, it is only half of the picture. The other half is called a balance sheet and, just like the income statement, it is divided into two columns: the asset column and the liabilities column.

Let’s begin with the asset column. In last week’s post I already talked about assets and explained why they are so important. In fact, assets are essentially like money-making machines since they create passive income for you. As Robert Kiyosaki would say, assets put money in your pocket. Examples of productive assets are: real estate, stocks, bonds or private businesses. Hopefully, those assets will be producing money for you on a monthly or quarterly basis.

Assets, however, can also be of a non-productive variety. That type of asset won’t necessarily put money in your pocket, but they possess a certain market value. In other words, you can still sell non-productive assets if you wish to do so and receive a considerable amount of money in exchange for them. Examples of non-productive assets are: precious metals and stones, commodities such as oil or natural gas, raw land or even currencies such as dollars, euros or British pounds. These assets, even though they don’t put money in your pocket on a regular basis, can be sold at any time in exchange for money. As a result, they contribute to increase your total assets value, which is the sum of the value of all your assets (productive and non-productive) combined. 

Your liabilities column, on the other hand, is an inventory of all of the things you owe. It’s a picture of your debt to others. Examples of liabilities are: private debts, credit card debts, mortgages, consumer debts, car loans or tuition fee loans. As a general rule, you want to have as few debts as possible because debts usually have to be paid sooner or later, and that means money coming out of your pocket. In other words, whereas assets tend to increase your income, debts (liabilities) tend to increase your expenses. There are, of course, some exceptions to this rule, since some types of debt are good. However, most debts are bad, and those are generally the debts most people have. Generally, all the following types of liabilities are bad and should be avoided: credit card debts, consumer debts, car loans, boat loans and private debts such as asking money to friends and relatives. There are debts that might be desirable at times, debts that actually put money in your pocket, but that will be the subject of another post.

For now, let us establish that, as a general rule, one must accumulate as many assets as possible and contract as few debts as one can. The objective is to achieve a great total assets value and have a small or inexistent total liabilities value. The final and most important number in a balance sheet is what we call net worth, which the total assets value minus the total liabilities value. Essentially, the higher that number is, the richer you are.

IV. Conclusion

So now that we’ve covered the different sections of a personal financial statement, I believe we are in a good position to track the essential elements that lead to durable wealth building and financial independence. At first sight, one may conclude that the most important part of a financial statement is the income statement. After all, everyone’s primary concern is to pay for one’s key monthly expenses, such as accommodation and food, and the way to do that is to generate enough monthly income. However, things get a bit more complicated, and a bit more interesting I might add, when we start looking deeper into the nature of income.

Even though active income is mostly unrelated to one’s balance sheet, this is definitely not the case of passive income. In fact, there is a very intimate connection between one’s passive income and one’s asset column, since one’s passive income is entirely generated by one’s productive assets. Therefore, we must conclude that the more and better productive assets one can accumulate, the higher passive income one will be able to generate. This establishes, to a considerable extent, a relation of cause-effect between balance sheet and income statement. Thus, if one wishes to achieve financial independence, one must acquire enough productive assets in order to generate a sufficient passive income. This, I believe, is the path to financial freedom and it requires at least some knowledge of personal finances as you can see. 

As a way of concluding this essay, I want to direct you to some easily accessible resources that will help you understand these concepts more clearly and in more depth. Firstly, I want to recommend that you read Robert Kiyosaki’s seminal book Rich Dad, Poor Dad. I’ve already recommended that book before but if you still haven’t read it you absolutely must if you’re serious about becoming financially independent or even just financially literate. If you like this essay, you will like that book even more! Secondly, and perhaps most importantly, I want you to play Robert Kiyosaki’s board game, which is called Cashflow. You can easily play it online and you can do so completely free of charge.  I’ve played that game dozens of times and I emphatically suggest you do the same. The game is a simulation of real life and it’s a great opportunity for you to learn and use the concepts outlined in this essay in a fun and intuitive way. Trust me, after playing the game a dozen times you will become very familiar with essential concepts such as income statement, assets, liabilities, passive income, cashflow and so on. The goal of the game is to generate enough passive income to cover all your monthly expenses. In other words, you win the game by becoming financially independent. As we have seen, you achieve that by building your assets column.

I think you now have a roadmap to financial freedom, it is your job to use it to get there!


Online Resources:

- Cashflow game: www.richdad.com/apps-games/cashflow-classic

- Podcast on Balance Sheet: www.getricheducation.com/project/52-building-you-how-much-are-you-worth/

- Podcast on Income Statement: www.getricheducation.com/project/53-building-you-whats-your-income-and-cash-flow/