Saturday, July 14, 2018

Be your own financial planner – The Income Statement

This is the last in a series of 3 consecutive postings. If this is the first posting under this title that you see then click here to go to the beginning. 

In some ways this is the most important spreadsheet for your planning.  By now, I hope you realize that life is not about retirement but about today!  You should forget about this destructive ‘Freedom 55’ thinking. You are already free! You need a road plan, a goal to reach in your life. Your financial plan is a crucial tool into reaching this goal. But the travel towards that goal should be pleasant as well.  That is why I am talking about becoming ‘financial adult’, the goal of which is to no longer depend on a 9am to 5pm industrial revolution type of job. Maybe you already own the assets to lead a financial adult lifestyle.  I think, a financial adult or someone aiming to become financially adult is a way of looking at life. It is about realizing your personal power, your self-accountability, your integrity; about not depending on government handouts and about not believing that society owes you instead you owe society. 

You should always pursue the goals in life that you have chosen as worthwhile to achieve. It doesn’t matter whether you get there because typically, your goals change with life. What is worthwhile for a 20-year old is different than someone who is 110 years in age. And let’s assume that, at least theoretically, you are immortal (unless hit by a truck tomorrow).  The old retirement planner had you run out of money at the average life-expectancy of 83 years old.  What were you going to do the day after reaching your 84th birthday?  Eat out of garbage cans? What about euthanasia in that case?

Even at age 20, when you are unlikely a financial adult, you should enjoy what you do and get paid for it.  Wouldn’t that be ideal?  Yes, you cannot be oblivious of what society around you values. But often, that what you like doing most is what society appreciates as well. If not, then you have to accumulate assets that can help you do what you like best later on in life and now you do everything in your power to get there ASAP.  That means doing paid work that allows you to learn the skills for your future dream work.  You may like computers and building robots. Why not start as a webpage-designer and learn that way to better program? Become an instrument maker so that later you have the skills to machine the parts of your robotic dream.  I bet that there is nearly always such an opportunity.

Really, it is not about reaching 55 and then forever being on vacation!  Or watch soap operas the next 65 years!  No, you build the means towards your life goals, your personal ‘Belize’. You do that using financial planning as a tool. In the previous posts I showed you how to take inventory where you stand. Now, we convert all that into the revenue stream that makes your dreams financially doable until the end of time. So, lets first start with making the money that you need to live until the end of times while doing what you want.  You always need a goal to work towards, otherwise you’ll drift aimlessly through life not knowing what you want. I think, life is about living up to your potential and that means working towards an ever-changing goal. If you are always comfortable then you probably fall asleep behind the wheel of your life.  Go for something you feel is a challenge and worthwhile achieving. 

So, assets generate revenue and whatever costs money are liabilities. What you spend are expenses and when you generate money you have ‘revenues’. That is what the income statement is about – a financial score card in the game of life. Money makes the world go around. As such, there are many score cards in life, but the financial ones ensure you have or will get the means to do what you feel is worth doing in life. It is about becoming filthy stinking wealthy. Or another disgusting thing, being successful! Heaven forbid that we are successful and happy in life, the rest of society would be so envious! Now that that BS is out of the way, lets get to it…

How much do you need to live and how much do you need to do what you want?  Net Income.  Oh… wait! What of purchasing power or inflation?  Hmmm.  Did you know that you can invest to make profit and make up for lost purchasing power of your local currency, i.e. inflation?  What do you need on an annual basis?  Right, cost of living, money for your project(s) and the cost of inflation to protect purchasing power. Getting more assets would be fine as well but for now we aim to maintain our resources and purchasing power.

 On the income statement we entered the current inflation rate (something that most income statements don’t consider).  On the balance sheet we have our net worth and each year as a minimum our net worth must increase with inflation. Now, inflation is only in terms of local currency. It is not that eggs are really going up in price or that a day’s work costs more every year. It is that our local currency loses purchasing power. Thus, as Canadians we must know how much value the Canadian dollar loses each year in purchasing power!  The assets don’t necessarily increase in value it is just that their price in Canadian dollars increases with inflation. Thus on the balance sheet we added the column that shows how much appreciation or other forms of revenue we need to compensate for the inflation. The sum of inflation in our spreadsheet example is $28,640. On the Income statement below that is shown on the row named: Reinvestment offsetting Inflation.  If our net revenue equals the latter then we have compensated for inflation. If we have a surplus on the following line then we are actually adding to our real or inflation adjusted net worth. If it is negative we don’t make enough money and we better figure out how to break at least even, otherwise we will indeed run out of money in our lifetime. Difficult?  No too simple!
In the above example, we assume a more-or-less typical 65-year old financial adult.  His/her house has been nearly paid off and there is a job as greeter at wallmart or a small business such as creating greeting cards. But there also are Canada Pension, OAS and a lifetime of accumulated paper investments. 
Another strange thing on our income statement is the Rate of Return column.  It specifies the expected annual rate of return (averaged over many years, including inflation which is set at 2% annually). Your Net Worth will fluctuate with the markets but so does everybody else's. Your assets will not change, just the way it is expressed in currency, i.e. Canadian Dollars.



Click on image to magnify



To calculate revenue, we multiply the rate of return with the asset value in the Balance Sheet and… voila out comes the revenue. Exception is wages (income from career) . You must enter those specifically. If you own a business, it pays you a salary and it makes a profit. The business return is the profit the corporation makes while you enter the salary you take from the business (before calculating profits).  If you like to be employed, enter your salary from employment but there is no business profit.  Do realize that salary from employment is one of the least favorable income forms that exist in terms of taxes. It is how the government hoses the masses.  The rich really don’t make a salary but rather they make a return on their investments which they sometimes sell and then pay a capital gains tax or a capital loss tax credit.  If you don’t sell an asset, then you get basically an interest free loan from the government until the day you sell the investment. Dividends are taxed somewhat less favorable but still not as bad as salary since the dividend paying corporation already paid income taxes on its profits (dividends are paid out of after-tax profits). 
You may also receive pension income from a previous employer or from Canada (Canada Pension and Old Age Security). I estimate the asset value of such pensions as 10x the annual payment. Now, what is the asset value of a Teacher’s full benefit pension of say $70,000 per year?  You think they have any right to complain when compared to someone working in the private sector? All revenue from these assets are offset by interest payments on debt (both good and bad) as well as by the cost of living and explicitly the costs of vacations or other worthwhile projects. As said above, this is all adjusted for inflation and expressed in the purchasing power of today’s Canadian dollar.  After tax income is very important but goes beyond this story. However, if you are taking a salary out of your own business you can regulate your income tax and I used my Alberta tax rates to give an impression of how that may look. Unfortunately, employees have not much tax flexibility compensating for the ‘security’ of their income. Once they ‘retire’ they also will pay a lot less in taxes. 
Note this is based on a net worth of $1.4 million dollars which includes a nearly paid for modest house as many 60 plus people have; a $126,000 valuation of their state pensions. Through employee savings plans and other forms of saving most Canadian’s – even of moderate means but with good savings habits should be able to get over their lifetime an investment portfolio of $700,000 or so together.   

But yes, it is a choice of lifestyle and of focused savings that enable you to do so. That is where self-accountability comes in.  If you use your first pay cheque to take out a loan for that BMW, you have quite a bit of payments ahead. Especially if you crash that car without insurance.  What you spend in a bar can prove quite costly over time.  My advice: first build the assets that allow you to buy a drink in a bar without much consequence.  That is probably good health advice too.  Say you have $2 million in assets and your revenue is $200,000 per year (10% return) do you think you could buy, if it is still that important to you, that BMW cash?  You bet and... you could do so nearly every year!
As repeatedly said on this blog:  it are your actions, thinking and attitude that makes you a wealthy person with all the means to lead a happy life.




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