Financial Independence an Overview

The purpose of Financial Independence is not about money.  It's about having options.

The following is an overview of the process.

First, some pictures.

The Income Statement and the Balance Sheet

And a definition ...

Passive income: persistent cash flow from assets.

Examples:

• Stock dividend income
• Rental income
• Capital Gains from Buffett-style stock investments
• Interest income from savings
• Royalty income
• Covered Calls

1.) The Definition of Financial Independence

An individual reaches  financial independence once their passive income is equal to or greater than their expenses. For example, someone with monthly expenses of $2,000 and $2,000 of monthly passive cash flow is financially independent. This person can sustain their current lifestyle without working.

2.) The Interaction Between the Income Statement and Balance Sheet for the Different Societal Classes

A) For a Broke Person

In this model, income heads out the door before it can be invested.

B) For a Middle Class Person

The liability column is loaded down and feeds the expense row with income draining expenses.  Income heads straight out the door due to liabilities in this example.

C) For the Financially Independent

The asset column feeds the income column with passive cash flow and provides financial independence once cash flow is equal to or greater than expenses.

3.) Q: How Do I Know What My Expenses Are? A: A Monthly Budget

One of the cornerstones of financial independence lies in developing a budget which helps define and manage monthly expenses.

Sample budget:

Income $4,000.00
Extra Income $100.00Gross Income $4,100.00
Fixed ExpensesElectric $100.00
Cable $80.00
Trash Pickup $30.00
Water $18.00
Phone $70.00
Groceries $500.00
Gym $50.00
NetFlix $9.59Total Fixed $857.59
Variable ExpensesMy Food $110.00
Gas $120.00
My Misc. $130.00
Entert. $65.00
Dogs $10.00
Misc -
Christmas $500.00
Total Variable $935.00
Total Exp $1,792.59
Net Income $2,307.41

The next step involves paying off any unnecessary debt. You have probably heard the terms "good debt" and "bad debt" before. For our purposes, good debt would be any debt that generates positive cashflow into our income statement. For example, a $100,000 loan on an apartment building that puts $200 a month of cash flow into the income column is considered good debt in our paradigm.

Bad debt is debt that does not deliver cash flow into the income column and typically serves to drain it through expenses.   Examples of this include cars, retail debt, rent-a-furniture and negative cash flowing real estate. Again, this is the picture of the middle class.  

Additionally, Warren Buffett and Berkshire Hathaway weigh-in on the subject of debt via their investment philosophy: Buffett invests in companies that typically have the ability to retire long-term debt in one to three years from earnings.  Thus, on the subject of leverage, it is best to remain conservative with little to no debt; I have 80 billion examples to back up this argument. 

Returning to our picture of Financial Independence, it is best to augment cash flow while diminishing expenses in order to expedite the process.  A person with $1,000 a month in cash flow and $1,500 a month in expenses could simply reduce their expenses by $500 a month and reach financial independence.

Here is the personal financial plan as prescribed by Dave Ramsey that assist in managing and lowering expenses:

1) Save up $1000 in an emergency fund

2) Pay off all debts smallest to largest

3) Maximize an emergency fund at 3 to 6 months of expenses

4) Start investing in retirement plans and mutual funds

5) Pay off the house

6) Advanced investing

The retirement of bad debt frees up much needed income necessary to build the asset column to a critical mass of financial independence.

4.) Buying Assets

I've posted many blogs that go into detail on buying Assets. Check out these subject blogs on this site:

• Real Estate
• DIFCOO
• Dividends
• Buffett Stock Investing
• Why You Should Turn Your Hobby Into a Small Business

Some great books that serve as the corner stones for the framework of financial independence:

• Mary Buffett, Buffettology
• Robert Kiyosaki's Rich Dad Poor Dad
• Adam Brownlee, Building a Small Business That Warren Buffett Would Love
• Thomas Stanley The Millionaire Next Door
• Dave Ramsey, Total Money Makeover or Financial Peace

5.) Financial Independence

Again, an individual with passive income equal to or greater than expenses, has reached financial independence.