The whole world is going through tough economic times right now and a lot of people are struggling. So, I thought this week we would go back to fundamentals. I wanted to talk about the most important accounting rule, which is “Live beneath your means.” This is a much more complex idea than people think, and a lot of people make some unnecessary mistakes. I am going to be breaking it all down for you this video.
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When you look at the different money problems that people deal with, they almost always can be traced back to this one fundamental idea. Someone did not live beneath their means, and that led to money problems. They find themselves in a situation where they cannot pay their bills and that ultimately leads to bankruptcy. A lot of the activities accountants do is designed to address this major concern.
Let us start with the idea: “Live beneath your means.” The first issue you may have noticed is this is worded differently than what a lot of people say. Most people say, “Live within your means.” That is incorrect because it encourages some bad habits. It is not enough to simply live within your means, you need to live BELOW your means.
Let me explain what this looks like. Whether we are talking about a business or personal finance, you will have a certain amount of funds coming in as revenue, and a certain amount of funds going out as expenses. This is your cash flow. Your planned monthly expenses need to be lower than your revenue. The diagram on the screen is what everyone’s financial life should look like. Unfortunately, most people will plan to have their monthly expenses match their revenue, and a lot of people even exceed their revenue. Both situations inevitably lead to money problems.
What do I mean by monthly expenses? When you sit down to make a budget, everyone has a set of planned expenses by month. For a business, this will be payroll, rent, utilities, supplies, etc. This is the amount it costs to run your business. This needs to be below your revenue. What happens to the rest of the revenue? Well, to start with, it goes to profit, but there are also other things. There should be money for savings, capital expenditures to continue to invest in the business. You should have money set aside to jump on new opportunities, and contingency funds set aside to pay for unexpected expenses. This extra money gives you options in life.
You should see this financial dynamic happening in your business. Where the cost to run the business is below the revenue coming in. And all this extra revenue is then able to be used to make smart financial decisions and grow the business. And you should also have the same financial dynamic for your personal finances. If this is not happening, you need to do whatever it takes to make this happen. Either find a way to increase your revenue or decrease your expenses.
The reason why this works is uncertainty. Life is uncertain. No one knows what the future brings. If your costs are the same as your cash flow, as soon as the economy drops, your business is suddenly in trouble. You will not have any financial resources to survive. Just look at what happened this year with the pandemic. This is precisely why your financial business model needs this extra padding to allow for uncertainty.
Related to uncertainty is luck. A lot of successful businesspeople will talk about this important business concept. “In business, luck is more important than talent, hard work, or intelligence.” Luck will beat all these things in the business world. If you look at the stories of any successful business that has grown from a startup to a billion-dollar business, luck has a lot to do with it. These were entrepreneurs that were at the right place at the right time. Luck by its very definition cannot be manufactured. But you can increase your odds of being lucky. And the best way to do that is through time. The longer you can stay in business, the greater your chance of being lucky. This includes getting the big contract, landing a new client, hiring the right people, getting your big break. If you can just keep your doors open long enough, your odds of getting lucky increase. That is why finances are so important. Living beneath your means, is about maintaining strong finances, so you can be around to take advantage when a great opportunity shows up.
All this sounds simple, so why are there so many people out there not doing this? It takes a lot of self-discipline to see extra revenue coming in, and deciding not to spend it. A lot of people cannot do that. So it is your job as an accountant, to put reports in place to hold yourself accountable to ensure this happens.
Monitoring cash flow is the key. I see so few businesses using reports to monitor this. What most businesses do, is prepare an annual budget. They will sit down once a year in advance and plan out their expected revenues and monthly expenses. This is a great start but does not address the problem. The problem is that revenue is constantly changing and your expenses need to adjust with it in real time. What you should be paying attention to is your burn rates. What is your burn rate of cash each month? If revenue is changing, how can you adjust your burn rates to match? One way of doing this is called flexible budgeting. If you are interested in flexible budgeting, I have a white paper on the homepage of my website wolvesandfinance.com called “Supercharge your Business.” It is free and you do not have to sign up for anything. You can just download the PDF from the website.
When I work with a business, I spend a lot of time understanding burn rates, and ensuring the overall financial model fits this framework. Every business should strive to live beneath their means, or they risk running into money problems.
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Neither Zach De Gregorio or Wolves and Finance shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.