Financial independence #3 – Understanding cash flows

Now that we have understood the Active and Passive income categories, we need to look at our cash flows needed when we have reached a state of FI. For this purpose we will be using the Extended money equation, that I had outlined in one of my earlier posts. We will be using a variant of the same which is given below:-

AI + PI = RME + RAE + DME + DAE + IRE

  • In the FI state we are assuming that Active income is not needed, so AI = 0 in this state. In other words the Passive income ( PI ) should take care of all expenditure.
  • Regular monthly expenditure ( RME ) will be Rent / EMI, Groceries, Utilities, Schooling etc.
  • Regular annual expenditure ( RAE ) will be insurance premiums, Property taxes, Maintenance, Donations etc.
  • Discretionary monthly expenditure ( DME ) will be entertainment, eating out etc
  • Discretionary Annual Expenditure ( DAE ) will be Vacations, Clothing etc.
  • Indulgences Related expenditure ( IRE ) will depend on the family.

Now in the state of FI, it will make sense to minimize the above to the extent possible without compromising on the lifestyle one is used to. The reason is this – higher the PI needed, higher is the asset base required to generate that PI. Therefore, if we want to achieve the state of FI earlier we need to see how the above parameters can be controlled. Fortunately, a lot of this will happen naturally as you will see from the following:-

  • Achievement of FI will normally coincide with the children leaving home for college. This will normally bring down the expenses in RME, due to their schooling and other costs going away. Yes, there are college expenses, but those are normally taken as a separate goal and funded differently.
  • RAE will reduce as in the state of FI, life insurance is not really required any more.
  • DME and DAE will also reduce because of children factor and lower level of activities as we grow older. After all we will look for lesser entertainment, vacations and dining out at 50 plus years, as opposed to when we are in our 30s.
  • Same logic for IRE will have it at a lower level.

I had done an analysis of my expenditure over the years and saw that my expenses had risen from 1988 (when I started work) through 2012 ( when my daughter started her college). It then stayed at pretty much the same level for another 2 years and went down after my son joined his college in 2014. Note that I an NOT talking of the total expenditure, but only the ones related to the above terms in the equation. Their college education related expenditure was funded separately as 2 goals and that money available is now used for the same.

From a planning perspective, we can therefore look at the below conditions when working out the level of PI needed:-

  1. As investment for goals are made out of AI, which we do not want to depend on now, it will be important to ensure that all investment levels for goals are at a stage where it can grow to the required amounts naturally, i.e without any additional investments in the FI period.
  2. PI should be funding at least 70 % of your peak expenses adjusted for inflation if you have 1 child, and at least 60 % if you have 2 children. As we want to be conservative let us take 70 % as the desired level.
  3. With the above conditions let us now look at my own example:
    1. Peak RME = 50 K, Peak RAE = 2 L , Peak DAE = 2 L and Peak DME = 1 L
    2. Total expenditure was 11 lacs and at 70 % it came to nearly 8 lacs
    3. For FI I needed to generate an annual PI of at least 8 lacs.

So, if I had financial resources that could be arranged in a manner, so as to generate a PI of 8 lacs a year, I could call myself as Financially independent.

There are some other things to being a FI too, from my perspective, which I will discuss in the next post.

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