Thursday, June 10, 2010

Basic Accounting Principles - The start to financial freedom

The first step towards achieving financial independence is being in control of your finances. Understanding where you are at is vital to enable you to shape your actions so that you are moving towards achieving your financial goals.

It is important to note that wealth is not measure in terms of money, it is measured in terms of time. How long can you survive without going to work

1. Income

In simple terms, income is money that goes into your pocket. There are three two types of income, passive, earned and portfolio income.

Earned income is income earned as a result of your work. You need to work to earn this income, if you get sick or are unable to work due to any reason you get no income. This is the most common type of income that most people have. This is what keeps most people poor.

Passive income is income that you get without doing anything. Once you setup the passive income sources the only thing you need to do is sit back and watch the money coming in. Nevertheless you need to work hard to setup your passive income stream. Some examples of passive income include, real estate income, dividends from shares, passive income from the internet, income from vending machines, interest you earn from investments and others.

Portfolio income is income generated from paper assets such as shares or bonds.

What you really want is to have various sources of passive and portfolio income.

2. Expenses

Expenses is simply many that goes out. Bills, interest expenses, payments for your house, car or anything that takes money from you.

3. Cash Flow

Cash flow refers to the sources of income coming in and then going out as expenses. You want to be in control of you cash flow, you need to know how much money comes in and how much goes out, you need to ensure that you are always in a positive cash flow scenario.

Cash flow is the most important aspect of your finances, without cash flow you cannot do anything, you cannot invest in building your passive income sources and even worst, negative cash flow means that you spend more than what you earn. You need to turn this around as soon as possible.

4. Budgeting

You need to take control of your expenditure to ensure that you spend less than you earn. This is called cash flow. This means that at any point in time you know how much money is coming in and how much is going out. That knowledge will enable you to take control of your finances.

If your budget shows that your income is lower than your expenses then you need to reduce your expenses or increase your income. Doing both is the best option.

In terms of reducing your expenses, take a hard look at the money going out and find places to cut. There are also many sites on the internet with useful tips on how to reduce your expenses.

Increasing your income, that is everyone's target isn't it? The most straight forward way to increase your income is to get a second job. I don't think anyone wants to do that, you work hard during the day, the last thing you want is to get a job on the weekend or at night time. This will take you away from your family, you will get tired, it can be just too hard.

Another job doesn't need to be a torture. Think about something you like, if you have a hobby or your favourite past time activity. Now think about how much you know about it. You probably know a lot. A straight forward way to make money is to use the knowledge you have and tutor people about it. You are probably thinking, how am I going to get someone that will pay for this? Well, that is a good question, a good starting point is to create a website. If you are not technology savvy you can find many templates for websites and even some free hosting. Put adds on your website (you get paid every time someone clicks on an ad on your blog. Create a community and watch people coming to your site and asking for tips. This can provide you with tutoring opportunities or some very interesting and rewarding passive income through the advertisement on your site.

Just look on the internet and you will find many ways to produce income, the key is to do something, don't sit around thinking that it is too hard or that will never work. You will never know if you don't try.

5. Assets

Asset is anything that puts money in your pocket. Think about it, do you have any assets? Assets will generate income, if you have enough income from your assets you probably have a healthy, positive, cash flow. If you don't have any assets your are fully dependent on your daily job, if that goes you are in real trouble.

One of the most big misunderstandings regarding assets is your own house. Unless you are making money from your own house, it is not an asset. You have to pay for it so it does not put money in your pocket, it takes money from you. Don't misunderstand me. I am not saying that you should not own your own house, I think you should. If you pay rent your are certainly paying someone else's mortgage. You don't want that. You want your own house. Just be clear, it is not an asset.

6. Liabilities

Liability is anything that takes money out of your pocket. Liabilities take money from you. Examples of liabilities is money owed to credit card companies, car loans, personal loans, tax.

Liabilities generate expenses that are related to those liabilities, the loan payment for example.

Your credit card debt is a liability. Credit card is the worst type of liability. It task your money even as you sleep. Every night the credit card company calculates and accrues interest on your debt, it grows as you sleep.

Debt is not always bad. Any debt you acquire to buy assets is a good thing. A debt to buy an investment property is a good debt, to generates cash flow that should pay for the mortgage and it gives you an asset.

All of these terms are not just theories, when you combine these figures and create your financial statement you start to get a picture of exactly where you are.

If all of your income is passive income and it is going out as expenses to pay your debts then you are in real trouble.

A typical scenario of a middle-class family is as follows:

  • Assets - none
  • Liabilities - mortgage debt, car loan, credit card balance
  • Income - only earned income from day job
  • Expenses - expenses going out as payments to cover your liabilities
The scenario above is unfortunately very common. If you are in this situation you need to get rid of bad debts and move on to create assets.

Take action, do your financial analysis and understand where you are at today. Use this to make decisions that will take you closer towards achieving financial independence.

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