I think the income or p&l statement which catalogs earnings and expenses is more telling about a person’s financial situation on a day to day basis than the balance sheet which is where you calculate your net worth. The balance sheet is more useful when you are considering buying or selling assets. So for example, if you were to buy on credit, the seller/creditor would consider your income statement to see if you made enough money to make payments. If you were paying cash, the seller would consider your balance sheet and net worth to see if you had enough money.
Here’s my statement of income. To retain a little bit of privacy I have normalized all numbers to my gross wage income which I in turn have normalized to units of $100. Despite being financially independent, I am still “gainfully” employed. In fact, one of my unsolved problems is that retirement is generally for people in their 60s and 70s. Even mainstream “early retirement” is for people in the 40s and 50s. However, I don’t see myself playing golf all day with a bunch of 40 year old geezers , so I still pretend to have an ordinary career.
Another benefit of normalizing to my wage income is that it provides a meaningful way of comparing your numbers to mine since most readers are presumably still working.
income (revenue): $100
(if your gross income is $40,000, multiply all numbers by 400)
Thus before I pay for living expenses, general expenses, taxes, etc. I have $100 dollars coming to me.
cost of living (expenses): $30
Cost of living in the upper parts of Silicon Valley (that’s a specific as I am going to get) are pretty high, so 30% of my income goes towards food, rent, insurance, gas, … In the midwest this number would be cut in half! Living on the coasts is very expensive. I was in sticker shock for months when I moved here. My first piece of advice to those who want to save money is to NOT live on the coast and move inland ASAP. When we lived in the midwest cost of living was about half of what it is now.
The next item of the list is depreciation. Things wear out and have to be replaced some day. Thus a small amount is continuously budgeted for eventual replacements. House owners would include maintenance costs here. Since we rent, the rent is included in expenses above. We own a car however. The car is by far the largest contribution to this account. I would like to get rid of the car for that reason. It would not be beyond me to haul 40lbs of groceries in a large back pack for a few miles. I have done so before. I approximated my depreciation expenses by estimating the value of my stuff and dividing by 10 years of straight line depreciation. I expect my stuff, car, TV, clothes, to last 10 years. Naturally, the longer one makes things last, the cheaper they get. This is why I always prefer to buy quality. Computers are more tricky to evaluate. Some last 5 years or more. Others die quickly. Computers are cheap these days, so I just ignored them in the calculation.
I think I can safely say that my amortization costs are 0. It’s not like I’m a brand name or try to maintain a fashionable wardrobe. If you do, I think this would need to be included in amortization. I’m not an accountant though. This is just a game to me. Yes, I have no life.
Subtracting my cost of living expenses and depreciation from my wage income leaves my
operating income: $68
Operating income (EBIT for the accounting geeks) is my wage income minus everything that is required to maintain me as an employee if someone else paid my taxes. It is my net contribution to society as a worker.
The next item on the list is interest payments. I don’t pay interest.
However, for people in credit card debt, particularly those who make minimum payments, this can be a major expense. It can easily add 20% of the cost of living expenses above.
Other people pay me interest though. I also earn dividends, etc. Capital gains are harder to estimate. I use a more conservative long run figure of 8% of my invested assets. Sometimes it’s more, sometimes it’s less.
investment income: $34
Note that $34 exceeds my cost of living expenses of $30. Realistically speaking, expenses would rise about 4% with inflation (a hidden tax on money), thus 4% out of the 8% of my investment income should go towards growing principal. Otherwise inflation would eventually make my fixed income worthless. Many retirees have this problem which is why we are all a bunch of fiscal and monetary conservatives. Half of $34 is $17 which is below my cost of living expenses ($30). Thus I can not maintain financial independence while living in overly expensive California unless of course I use a more optimistic figure of 12%. I sincerely doubt that such returns will be possible in the US in the coming decades, but this discussion show why your rate of return is very important. NB! If I were to quit my job, I would move to a state without state income taxes, thank you very much.
Speaking of taxes. A full 25% of my wage income goes towards taxes. This is not counting sales taxes (those are included in expenses). Some of these taxes are also taxes on investments. This shows why minimizing taxes is a great idea. It is not efficient for the economy as a whole to have a ton of tax lawyers or yourself working on this problem but that is the way the governments we have elected have decided to set things up, so I just deal with it.
Adding investment income and subtracting taxes, this leaves me with a bottom line net earnings profit margin of 77% of my gross wage. Another way of thinking about this is that I save 77% of my gross wage income (where else would it go). This is possible since the investment income supports it. Still a savings rate of 77% is very very high. A very high net earnings percentage is the key to early retirement! I have consistently maintained it in that range for the past 6 years. If you get a number here closer to 40%, expect to spend ten years or more working towards retirement. If you use the widely recommended 15%, expect to spend 30 years or more working.
Net earnings (bottom line): $77
So incidentally, if I was a company what would I sell for on the stock market on a price earnings basis. Well, first you have to decide whether I am a value company (P/E ~ 10) or a growth company (P/E ~ 20). Then you take my wage income, multiply by that number and multiply by 77%. That would be my market cap if I was evaluated like a company. Funny!
Originally posted 2007-12-25 08:35:00.