We hope you agree that getting your personal finances in order before you set up shop makes a lot of sense. But you have so much to do and so little time! Where to begin and what to do?
To start a business, you need to save enough money to get started. This article lists some important financial tasks you should complete.
1. Assess your financial position and goals
Where do you stand in terms of retirement planning? How much do you want to have saved to pay for your children’s educational costs? What kind of home do you want to buy?
These and other important questions can help shape your personal financial plans. Sound financial planning isn’t about faithfully balancing your checkbook or investing in stocks based on a friend’s tip.
Rather, smart financial management is about taking a hard look at where you are, figuring out where you want to go, and making sure that you’re prepared for occasional adverse conditions along the way — a process, incidentally, that isn’t unlike what you’ll be doing when you run your own business.
2. Measuring your net worth
The first step in assessing your financial position is giving yourself a financial physical. Start with measuring your net worth, a term that defines the difference be- tween your financial assets and your financial liabilities.
Begin by totaling up your financial assets (all your various bank accounts, stocks, mutual funds, and so on) and subtracting from that the sum total of all your liabilities (credit-card debt, auto loans, student loans, and so on).
Note: Because most people don’t view their home as a retirement asset, we’ve left your home’s value and mortgage out of your net worth calculations. (Personal property — furniture, cars, and so on — doesn’t count as a financial asset.) However, you may include your home if you want, especially if you’re willing to tap your home’s equity to accomplish goals such as retiring.
Now, don’t jump to conclusions based on the size of the resulting number. If you’re young and still breaking into your working years, your net worth is bound to be relatively low — perhaps even negative. Relax. Sure, you have work to do, but you have plenty of time ahead of you.
Ideally, as you approach the age of 40, your net worth should be greater than a year’s worth of gross income; if your net worth equals more than a few years of income, you’re well on the road toward meeting larger financial goals, such as retirement.
Of course, the key to increasing your net worth is making sure that more money comes in than goes out. To achieve typical financial goals such as retirement, you need to save about 10 percent of your gross (pretax) income. If you have big dreams or you’re behind in the game, you may need to save 15 percent or more.
If you know you’re already saving enough, or if you know it won’t be that hard to start saving enough, then don’t bother tracking your spending. On the other hand, if you have no idea how you’ll start saving that much, you need to determine where you’re spending your money.
3. Telling good debt from bad debt
- Good debt refers to money borrowed for a long-term investment that appreciates over time, such as a home, an education, or a small business.
- Bad debt (also called consumer debt) is money borrowed for a consumer purchase, such as a car, a designer suit, or a vacation to Cancun.
Why is bad debt bad? Because it’s costly to carry, and if you carry too much, it becomes like a financial cancer. If the outstanding balance of all your credit cards and auto loans divided by your annual gross income exceeds 25 percent of your income, you’ve entered a danger zone, where your debt can start to snowball out of control.
Don’t even consider starting a small business until you’ve paid off all your consumer debt. Not only are the interest rates on consumer debt relatively high, but the things you buy with consumer debt also lose their value over time. A financially healthy amount of bad debt — like a healthy amount of cigarette smoking — is none.
4. Reducing debt
If you have outstanding consumer debt, pay it off sooner rather than later. If you must tap into savings to pay down your consumer debts, then do it. Many people resist digging into savings, feeling as if they’re losing hard-earned money.
Remember that your net worth — the difference between your assets and liabilities — determines the growth of your money. Paying off an outstanding credit card balance with an interest rate of 14 percent is like finding an investment with a guaranteed return of 14 percent — tax-free.
If you don’t have any available savings with which to pay off your high-interest-rate debts, you’ll have to climb out of debt gradually over time. The fact that you’re in hock and without savings is likely a sign that you’ve been living beyond your means. Devote 10 to 15 percent of your income toward paying down your consumer loans.
If you have no idea where you’ll get this money, detail your spending by expense category, such as rent, eating out, clothing, and so on. You’ll probably find that your spending doesn’t reflect what’s important to you, and you’ll see fat to trim. (This process is similar to budgeting and expense management in business; not being able to manage your personal expenses may be a telltale sign of your inability to manage a business.)
While paying down your debt, always look for ways to lower your interest rate. Apply for low-interest-rate cards to which you can transfer balances from your highest-interest-rate cards. Haggling with your current credit card company for a lower interest rate sometimes works. Also, think about borrowing against the equity in your home, against your employer-sponsored retirement account, or from family — all options that should lower your interest rate significantly.
If you’re having a hard time kicking the credit-card habit, get out your scissors and cut up your cards. You can still enjoy the convenience of purchasing with plastic by using a Visa or MasterCard debit card, which is linked directly to your checking account. The major benefit of using a debit card rather than a credit card is that you can’t spend beyond your means. Merchants who take Visa or MasterCard credit cards also accept these companies’ debit cards.
5. Buying insurance
Before you address your longer-term financial goals, you need to make sure that you’re properly covered by insurance. Without proper insurance coverage, an illness or an accident can quickly turn into a devastating financial storm.
Buy long-term disability insurance if you lack it. This most-overlooked form of insurance protects against a disability that curtails your greatest income-generating asset: your ability to earn money. If anyone depends on your employment income, buy term life insurance, which, in the event of your death, leaves money to those financially dependent on you. Make sure that your health insurance policy is a comprehensive one. Ideally, your lifetime benefits should be unlimited; if the policy has a maximum, it should be at least a few million dollars.
Also check your auto and home policies’ liability coverage, which protects you in the event of a lawsuit; you should have at least enough to cover twice your assets.
For all your insurance policies, take the highest deductible you can afford to pay out of pocket should you have a claim. Of course, if you have a claim, you’ll have to pay more of the initial expense out of your own pocket, but you’ll save significantly on premiums. Buy insurance to cover the potentially catastrophic losses, not the small stuff.
6. Planning for the long term
In coauthor Eric’s experience as a financial counselor, he has seen many examples prove that earning a high income doesn’t guarantee a high rate of savings. The best savers he knows tend to be goal oriented; in other words, they earmark their savings for specific purposes.
If you know that you’re an undisciplined saver, you may consider adopting the technique of designating certain savings or investment accounts toward specific goals. After all, if you’re feeling tempted to buy a luxury car, it’s a lot harder to take money out of an account earmarked for Timmy’s college education than from a general savings account.
Perhaps because it’s the farthest away, retirement is the most difficult long-term goal to bring into focus. Retirement is also much tougher to plan for than most goals because of all the difficult-to-make assumptions — inflation, life expectancy, Social Security benefits, taxes, rate of return, and so on — that go into the calculations.
Use a good retirement planning workbook or program. Check out the resources online from T. Rowe Price or Vanguard. These retirement planners can help you transform a fuzzy dream into a concrete action plan, forcing you to get specific about retirement issues you may not have thought about and opening your eyes to the power of compounding interest and the importance of saving now.
Goal-specific saving is challenging for most people given their many competing goals. Even a respectable 10 to 15 percent of your income may not be enough to accomplish such goals as saving for retirement, accumulating a down payment for a home, saving for children’s college expenses, and tucking away some money for starting a small business.
So you have to make some tough choices and prioritize your goals. Only you know what’s important to you, which means that you’re the most qualified person to make these decisions. But we want to stress the importance of contributing to retirement accounts, whether you use a 401(k), SEP-IRA, or IRA. Not only do retirement accounts shelter your investment earnings from taxation, but contributions to these accounts are also generally tax deductible.
As for the money you’re socking away, be sure to invest it wisely. Doing so isn’t as difficult as most financial advisors and investment publications make it out to be. (Some make it sound complicated in order to gain your confidence, business, and fees.)
What’s your reward for whipping your finances into shape and staying the course? Although it’s true that money can’t buy happiness, managing your personal finances efficiently can open up your future life options, such as switching into a lower-paying but more fulfilling career, starting your own business, or perhaps working part time at a home-based business when your kids are young so that you can be an involved parent. Work at achieving financial success and then be sure to make the most of it.
7. Shrink your spending
Do all you can to reduce your expenses and lifestyle to a level that fits with the entrepreneurial life you want to lead. Now is the time to make your budget lean and entrepreneurially friendly.
Determine what you spend each month on rent, mortgage, groceries, eating out, insurance, and so on. Your banking records, your credit-card transactions, and your memory of cash purchases should help you piece together what you spend on various things in a typical month. The best way to track your expenses is to pay either by credit card, debit card, or check. Cash doesn’t provide you a paper trail to reconcile your expenses at the end of the month.
Beyond the bare essentials of food, shelter, healthcare, and clothing, most of what you spend money on is discretionary — in other words, luxuries. Even the dollars you spend on the so-called necessities, such as food and shelter, are usually only part necessity, with the balance being luxury.
If you refuse to question your current spending or if you view all your current spending as necessary, you’ll probably have no option but to continue your career as an employee. You’ll never be able to pursue your dream!
Overspending won’t make you happy; you’ll be miserable over the years if your excess spending makes you feel chained to a job you don’t like. Life is too short to work at a full time job that doesn’t make you happy.
8. Build up your cash reserves
Shrinking your spending is a means to an end — that end being the ability to save for a rainy day. In the embryonic years of your business, you’re going to see your fair share of rainy days; you may even experience years predominated by rain.
Your wherewithal to stick with an entrepreneurial endeavor depends, in part, on your current war chest of cash. At a minimum, you should have three to six months of living expenses invested in an accessible account, such as a money market fund with low operating expenses. If you have consumer debt, after you finish paying off your debt, your top financial priority should be building this account.
The bigger the war chest, the better; if you can accumulate a year’s worth of living expenses, great!
9. Stabilize income with part-time work
One way to pursue your entrepreneurial dreams — and not starve while doing so — is to continue working part-time in a regular job at the same time you’re working part-time in your own business. If you have a job that allows you to work part-time, seize the opportunity. Some employers even allow you to maintain your benefits.
When coauthor I was planning to start my financial counseling business, I was able to cut back his full time job to half-time for four months, using my time away from my regular job to start my financial counseling business.
In addition to the monetary security you get from a regular job, splitting your time allows you to adjust gradually to a completely new way of making a living. Some people have a difficult time if they quit their regular full time job cold turkey and start working full time as an entrepreneur.
If you’re not interested in keeping your current job, you can completely leave that job and line up a different form of work that will provide a decent income for at least some of your weekly work hours. Consulting for your former employer is a time-tested first “entrepreneurial” option with low risk — just one of many reasons why you should endeavor to leave your current job without burning bridges in the process.
Another option to working part time is to depend on your spouse’s income while you work on beefing up your own. Obviously, this option involves sacrifice from the love of your life, so be sure to talk things through with your partner to minimize misunderstandings and resentments.