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Financial Sustainability

How to stay solvent


Cover image credit: 1201 sn2 by thedailyenglishshow is licensed under CC BY 2.0.

We define financial sustainability (FS) as not running out of money, i.e., keeping your Net worth (NW) positive1 over a sustained period of time. The concept of FS is similar to what’s referred to in popular culture as “financial independence”, but a bit broader2.

NW, the most important quantity in personal finance, is not a static quantity, but rather it dynamically evolves over time. How it changes over time is primarily determined by what’s known as your “cash flow”, i.e., money that flows into your assets and your liabilities.

Original image from ClipartPanda.com

Your cash flow consists of two components, as shown in the figure:

  1. your income, which adds to your assets, and
  2. your expenses, which adds to your liabilities.

This implies that if your income is greater than or equal to your expenses, you’re financially sustainable. Now let’s look at each of the two components of cash flow more closely.

There are two main ways to generate income:

  1. in exchange for your time & labor, and
  2. making your money work for you.

The income generated through the first approach, which typically takes the form of a salary, is known as “active income3. As you can probably guess, the latter type of income is known as “passive income”. Passive income is directly proportional to the amount of money working for you, a.k.a. your “working capital”. In other words, the higher your working capital, the higher the passive income it can generate for you4. This is a fundamental principle of investment returns, and it is exactly what enables the rich to accumulate more riches without working as much.

Therefore if you want to be able to live off your passive income alone, you need to first have a sizeable amount of working capital. Unless you already have such an amount, e.g., through a substantial inheritance, you have to use the first option to generate sufficient active income to pay for your living expenses, and build your working capital. If you can’t generate sufficient income to pay for your living expenses, your situation is not financially sustainable, and that’s a recipe for financial stress.

It’s also important to remember that in many countries, passive income is usually taxed more favorably than active income5. This allows you to keep more of the passive income you generate than you would if you generated the same amount of active income. Thus, making your money work for you is much more advantageous than you working for money!

Now, let’s look at the other component of cash flow, viz., expenses. Conventional wisdom states that all your expenses can be classified into two categories: needs and wants. This is a false dichotomy, and it’s much better to conceptualize your living expenses as lying on a “reqs” spectrum.

Nonetheless, what remains true is that the lower your expenses, the lower the income level you need to sustain your expenses, which in turn means the earlier in your financial journey you can become financially sustainable. Since your expenses are more directly within your control than your income6, your total expenditure level is the most important factor that determines when – and if – you’ll attain FS.

In other words, maintaining a low expenditure level is the easiest way to achieve FS.

  1. or at least zero ↩︎

  2. The difference between financial sustainability and financial independence is that the former is deals with your total income whereas the latter only considers income not derived from your work. ↩︎

  3. so called since you have to actively work for it ↩︎

  4. in all practically relevant cases we’re aware of ↩︎

  5. e.g., you don’t need to pay payroll taxes, etc. in the US on investment income ↩︎

  6. since income is determined, among other factors, by the local supply and demand of your skill-set, the local cost of living, etc. which are not within your control, but you can decide what to spend your money and what not to spend it on ↩︎

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