This story first appeared in the November 2015 issue of Entrepreneur. To receive the magazine, click here to subscribe.
Thanks to many years of modeling financial statements and analyzing performance ratios, I tend to think like a CFO when it comes to my personal finances. This means I have a comprehensive understanding of the ripple effect that good or bad financial decisions will have on my net worth.
One role of a CFO is to ensure profitability, despite fluctuations in revenue. This starts with the essential task of identifying the proper balance between fixed and variable costs. When managing your personal income, you must do the same.
I always put at least 20 percent of my take-home pay into savings; it’s a nonnegotiable expense. To do this, I limit my fixed overhead to no more than 45 percent of my income. Allocating at least 35 percent to variable costs (food, entertainment, clothing, vacations) enables me to control my expenses and consistently meet my savings goal. It also prevents me from having to dip into my savings account if my income changes.
However, it is possible to save too much. A business that allocates too much of its retained earnings toward growth is often starved for cash and forced to rely on alternative-and expensive-ways to fund its daily operations. The same can happen to you: Poor cash management will inevitably force you to rely on credit cards. Given that the average card charges 15 percent interest, this will undermine any return you’ve generated by your rigid need to save.
While properly managing your income is essential to building wealth, you must also maximize the way your money works for you. I recently decided to leave California and move back to Texas. Beyond personal considerations, the move made sense from a business perspective, offering more affordable travel costs, lower taxes and a new client base.
I had planned to put my California house on the market and liquidate its equity, which has nearly doubled over the past three years, and I was set on purchasing a far less expensive home in Texas with the cash. The idea of being mortgage-free was enticing. But upon further reflection, I realized that sacrificing the opportunity to leverage up a highly appreciating asset with a 3.25 percent mortgage-not to mention the potential for rental income-was not financially prudent. I decided I would be crazy to liquidate.
So take a hard look at your assets (and debts) and ask yourself if you’re putting each of them to their best use. Consider how restructuring your liabilities could expand your assets.
I am certain that thinking like a CFO has saved me from making costly mistakes at home. You can-and should-do the same.