It is important for everyone to understand basics of personal finances and also effectively use them.
Any individual has two types of income. Assured income as well as income which is not assured.
Assured income is one which will keep flowing whether you are personally working or not. For example, Rentals, dividends, royalties, Interest, etc.
On the other hand income which is not assured is one which stops flows the moment you stop working. For eg Paycheck, Bonus, etc ..
Similarly, there are broadly two types of expenses .Fixed and discretionary. Fixed expenses like, taxes, Debts, Insurance, household expenses, etc.
To achieve “personal financial freedom” we should be concerned about a Flow, which we can term as freedom flow. This is the difference between the Total expenses and the assured income. If the result is negative, then one can smell freedom. On the other hand if the result is positive, it implies continued imprisonment in the trap of debt.
There is a simple formula by which one can determine how long would a person take to achieve “personal financial freedom”.
N = Freedom Flow / AIOP x Plow back
Where, N = No of years required to achieve threshold of freedom.
Freedom Flow = Total expenses – Assured income
AIOP = Assured Income that can be generated as a percentage of the plow back. A 10% conversion is a good reference.
Plow back = (total income) – (total expenses). This is the money available for conversion to assured income.
To take an example, if for a person,
Assured Income = $ 25,000
Total Income = $ 1,00,000
Total Expenses = $ 85,000
AIOP = 10%
Then the plow back is $ 40,000.
So, as things stand, the number of years required to reach the threshold would be:
60,000 / .1x 40,000 = 15 Years.
Now, let us say the person is able to reduce his total expenses by 20% and improve his AIOP to 15%, then the number of years required for him to achieve threshold would be:
43,000 / .15 x 57,000 = 5 years.
Such is the power of this equation, which essentially means that we should
Keep the freedom flow as low as possible. Increase income and reduce expenses.
Maximize the plow back.
This formula, however does not take into account inflation. It is best to use this as an indicative tool rather than dissect it for accuracy.