How can you tell how healthy your finances are? How do you know whether you’re on track to financial freedom? This article answers both questions and, along the way, maps out a route to follow using a few financial formulas. As far as possible, you should try to stick to them, or at least not stray too far.
A while ago I answered the question of how to measure your financial health. In that article we explained that the best way to gauge the health of your finances is to look at how much money comes in without you having to work for it, in other words, passive income from your assets. By assets we mean things like shares, bonds, rental properties or a business. We also explained the difference between liquid and non-liquid assets.
A formula to measure your wealth and financial freedom
Some people have a better house than yours, a better car, live in a nicer neighborhood and so on… but they also have higher expenses. The following formula tells us who is actually freer financially, or richer, because wealth isn’t really measured by the things you own but by the financial freedom you have. This is the formula:
Years of financial freedom = (liquid assets ÷ monthly expenses) ÷ 12
We take the liquid assets a person has and divide them by that person’s monthly expenses, including their mortgage, loans or credit, electricity, property upkeep and so on. In other words, we also count the costs those assets generate. Then we divide the result by 12 months.
Liquid assets are those you can turn into cash from one day to the next when the time comes. The most liquid of all are cash, shares, bonds, gold and the like. A home wouldn’t normally count as a liquid asset, because it’s hard to sell overnight, but for this exercise we’ll include it too.
So let’s say a person has €500,000 in assets and monthly expenses of €5,000. Dividing one by the other gives 100. Divide 100 by 12 and you get 8.33.
This means that if this person decided to retire and do nothing, they could get by for 8 years. Put another way, their wealth would give them 8 years of financial freedom.
Now imagine someone else with only €200,000 in assets and expenses of just €1,000 a month.
Dividing gives 200, which divided by 12 comes to 16.6.
So the second person, despite having less than half as much in assets, is twice as rich as the first: they can last twice as long because their standard of living is more balanced.
Note: although this is how I prefer to use it, the original formula only counts liquid assets and the expenses those assets generate. Personally, I see flaws in that approach and think it’s much more accurate to use it the way I’ve set out here.
A formula to measure your financial health
Financial freedom only happens when you receive enough passive income (money that comes in without working for it) to maintain your lifestyle without having to work. Once that happens, you can say you’ve reached financial freedom, but even then you need to be careful. This is the formula:
Passive income ratio (%) = (monthly passive income ÷ monthly income from work) × 100
This formula takes the money that comes in from your assets (bonds, shares, rents, a business running on autopilot…) and divides it by the income you earn from your job each month. Multiply that number by 100 and you have the percentage of money that comes in without working, or, put another way, how dependent you are on a job. Here’s an example.
See also: 8 traits of people who will achieve financial freedom
Suppose that between share dividends and a house you rent out, you receive €500 a month, while you work for a salary of €1,000. Dividing gives 0.50. Multiply by 100 and you get 50%. In other words, for now your passive income is 50% of your salary, so you still depend on that salary.
The break-even point is 100%, when your passive income matches your salary. At that point, losing your job would no longer be a problem. Even so, the ideal is for that percentage to reach 200% or 500%, because that’s when you could really start to achieve financial freedom.
See also: Assets that generate passive income
The 20-30-50 rule: the best route to financial freedom
To me, this rule is one of the fundamental pillars of financial education, and not following it can cause you a lot of trouble down the road.
20%: the minimum share of your salary you should save
We’ve said this over and over: it’s what’s known as paying yourself first. If you earn €1,000, €200 should go straight into savings. If you can’t manage that, your finances are in trouble and you’re hanging by a very thin thread. And bear in mind that 20% is the minimum; ideally it should be 30 or 40 percent.
30%: the maximum debt you should carry relative to your income
We’re talking about debt, not expenses. That’s why we always say it isn’t a good idea to take out a mortgage if the payments will take up more than 30% of your income. The same goes for car payments.
50%: what’s left for spending and leisure
It’s a formula as simple as it is useful.
Further reading
Featured image: Ken Teegardin, CC BY-SA 2.0, via Flickr.
