If your life was a business, would it be profitable? Recently I began thinking: What if I organized my personal finances like a business? For one, I would need to make a lot of changes.
I don’t have an MBA, but I know a few basics about running a business.
- A business should be profitable
- Income – expenses = profit
- It takes capital to make money
- A business must be sustainable in both the short term (cash flow) and long term (return on investment)
How do these principles translate to personal finance? Let’s take them one at a time.
A business should be profitable. Nobody wants to invest in (or work for) a company that loses money. So why do would you want to live your life losing money? Unfortunately, we do it all the time by living above our means and going into debt.
If we can learn to save a percentage of our income rather than going into debt we, as individuals, become “profitable”. How do we do it?
Income minus expenses equals profit or loss. The exact same holds true in personal finance, and it is how we determine whether we are living below or above our means.
One difference I see between business and personal finances is that in business, you think of making more money than you spend (having revenue exceed expenses). In personal finance, however, we most often hear about spending less than we earn.
That’s because we fall into the trap of thinking that our incomes are fixed and that the only way to be “profitable” in life is to cut expenses. For most of us working for a salary, that seems to be the case.
For those that truly want to be successful however, it helps to think the other way around. Yes, there are times we need to cut expenses to see a profit. Businesses do it all the time. But we need to think about the other side, too. How can we generate more income for ourselves?
Can we get a raise? Move into a higher-paying career? Start a business on the side?
Any CEO worth his or her salt would never look at only cutting expenses to make a profit. The CEO would want to increase revenue as well. We should do the same.
It takes capital to earn revenue. Most business start with a certain amount of capital, provided by investors, to produce and market their product or service.
In our personal lives, capital often doesn’t mean money. Most often, our capital is our time, skills, and education. What can we offer to others that will earn us income?
In order to make more money, we can always consider increasing our capital, whether it involves working more hours or going back to school to acquire new skills.
Of course, the truly successful will put financial capital to work, too, investing in stocks, real estate, or even business ventures.
This is also where debt plays a role in our personal finances, just as it does in business.
Businesses use debt to build their capital – products, facilities, and employees – that in turn will earn them revenue. Investors bet that the revenue the business will generate will be great enough to repay the debt and generate a return for both the investors and business owners.
Businesses don’t go into debt just to buy the flashiest building on the block like we might take out an auto loan to get a hot new sports car. If a business can’t justify how a loan will help them earn more money, no bank is going to give it to them.
The business will get the building that will best serve their purposes. The pragmatic person, also will buy a car that will serve our transportation needs to get to work (and earn income), and nothing fancier.
Personally, debt is smartly used to pay for education and real estate that may appreciate. While a car will depreciate, if we need a car to get to work and have no other way to pay for it, an auto loan is acceptable.
Other examples of when debt might be OK are if we need a new suit for a job interview or a plane ticket to network with potential employers.
In these situations a smart CEO would carefully examine whether the expense and the interest that will be paid on the debt are worth the potential benefit.
So should we.
A business must be sustainable in both the short term (cash flow) and long term (return on investment). If a business has $1M to start and spends all of that $1 million to develop a product that can easily make them $3 million in a year, will they be successful?
If the business spends the entire $1 million on its product, how does it expect to pay to market and sell that product? How will it afford an office, a warehouse, and to pay employees to sell the product?
Similarly, if a business opens up with a great marketing pitch but fails to take the time to ensure a high quality product and good customer service, it may earn a lot of money very quickly, but it won’t be in business very long.
How do these lessons apply to our personal finances?
For example, we might be tempted to spend $25,000 to go back to school to earn a degree that will easily double our salary. But can we afford to live on a monthly basis while we are in school? Will we be able to afford to live while we find the higher paying job?
Conversely, if we find ourselves with a windfall – maybe a bonus or cash prize – we can’t all of a sudden live like we earn that much money every month. Nor can we afford not to contribute to retirement savings. We will find ourselves living large until we can no longer work, only to find ourselves very, very poor.
These are just a few of the ways I thought about running our personal finances like a business. Can you think of any others? Have you tried this?