When go to the doctor for a checkup, the first thing they do is take your blood pressure and pulse. Within minutes you know the most critical data to your physical health.
If only your financial vital signs were as easy to measure.
Among these signs, your income is the easiest to determine as most of us know it off the top of our heads unless you happen to be a business owner or partner.
Your net worth can be tallied with a little research on your investment accounts, mortgage and real estate. Your annual savings is still yet more difficult to determine.
Trumping all of these financial vital signs in its stealth is your annual spending. Most of us have only a rough approximation of how much we spend.
Why is annual spending so important? It is a prime determinant of whether you have reached financial independence or can retire completely. Financial independence is defined as having enough wealth so the return from your portfolio can support more than half of your expenses.
When you reach financial independence, you may decide to work fewer hours, change careers, go back to school, take a sabbatical or change roles to a less stressful position. You no longer need to continue with a work situation that leaves you hitting the snooze button Monday morning or ties your stomach up in knots.
While we are always in a position to be proactive about our careers, reaching financial independence opens up new possibilities as financial worry is removed from the equation.
Back to the spending. Some of you track it to the penny. Thirty years ago you kept a ledger, 20 years ago a spreadsheet, 10 years ago Quicken and now many use Mint.com. You can get a grip on your spending using these tools, but they take effort — which can be hard to sustain for more than a few months.
An alternative is the cash flow system put together by my colleagues at the Alliance of Cambridge Advisors. The key is having a separate working account for depositing your wages, business income and rental income, and a bill paying account for debit card transactions, checks and cash.
Make a rough estimate of your monthly spending and then transfer that amount every month into your bill paying account from your working account. You should start the bill paying account with two months of spending as seed money before you start the cash flow system.
Let’s say you estimate spending to be $8,000 a month. Start with $16,000 in the bill paying account and set up an $8,000 monthly transfer from the working account. Use the working account to pay taxes, extraordinary expenses and also to fund your non-retirement portfolio.
Once you run the cash flow system for a year, you have an accurate tally of your spending. In the above example, imagine after a year you have $25,000 left in your bill paying account. Simple math tells us that you spent $87,000 last year.
Not only is the cash flow system ideal for determining your spending level, it also decouples your spending from your earning. You’ll find as your income goes up that you need to make a conscious decision to increase spending under this system.
This will result in more “painless savings” that be used for education and retirement.
Through separating your spending and your earnings, and with an easy method to track what it takes to support your quality of life, not only will you know when you reach financial independence, but you’ll get there much faster.