Why You Should Run Your Household Like a Business
If your household was a business, one sold on the stock exchange, would you invest in it? For most of us, the answer is probably no. We maybe don’t save enough money — spending every dollar we get, perhaps even a little bit more — so we’re not “profitable.” We’d be embarrassed to show people our balance sheets, cash flow, or profitability statements.
I suggest we need to start running our household finances as if it were a business. It’s not as outlandish an idea as you might think, as there are some big similarities between the two. We both have expenses. We both have assets and liabilities. We both have income. We both have taxes to deal with. We’re both trying to maximize “shareholder value.”
There is much that a well-run company can teach us about fiscal responsibility and profitability. Many of the structures and strategies of the business world would work well in managing our own household finances.
When it comes to personal financial planning, most people think of their balance sheet as the most important aspect of their financial life – they want to save as much money as they can so, in retirement, those assets will provide an income stream. But, I urge people to start thinking like a business.
Businesses know that cash flow is an important metric. They know that, without cash flow, they have no business. In our working lives, we sometimes take our cash flow for granted, because it comes in the form of a regular paycheck. When that paycheck stops in retirement, we will have to somehow replicate that cash flow. Cash flow gives us the ability to execute against the dreams for retirement. But it doesn’t happen automatically. You have to plan for it.
Vision or Mission Statement
Vision and mission statements help answer the core questions of why a business exists and what it is trying to achieve. They become a rallying point for employees, customers, stakeholders, and shareholders.
People who are successful at their household finances also often have some sort of a vision or mission statement, preferably one that’s written down, about what they want to accomplish over the next 20 to 30 years — new house, college for the kids, starting a business. Or, more importantly, what they want out of retirement. The more detailed those vision statements, the more likely they are to become a reality. Visualize, then execute.
Just as with a well-run corporation, we need to have good governance in our personal finance. A large part of good governance in the business world involves creating a board of directors. Corporations of any significant structure have a board of directors to aid the management team and hold them accountable for accomplishing their mission, goals and strategies. The board of directors is typically made up of people who have industry insights and background that will be helpful to management.
We need a similar board of directors in our households. They could be parents, friends, or professional advisers — such as accountants, attorneys, financial advisers, career counselors, even doctors. The board includes anybody who touches our lives in a way that has an impact on our success, financial and otherwise. Yet, it’s not enough to just have a board of directors – you need to meet regularly with them. Perhaps not quarterly, and perhaps not all at the same time, though there may be times when you want your attorney, accountant, and financial adviser all in the same meeting.
Well-run companies know that life is full of surprises. They therefore have people dedicated to risk management, insulating the firm from unexpected events, protecting its assets and its revenue. This often involves insurance.
We need similar risk management in our own financial lives. Our most important financial asset is our ability to earn an income. If something happened, the loss of our income would most likely put our families at risk. There are two ways to reduce this risk: Disability insurance in case we are injured or ill and can no longer work at our chosen profession; and life insurance, in case the worst happens.
Take no half measures here. It pays to understand your full human life value – how much it would take to replace the income you provide to your family over the course of your lifetime. A business would insure for the full replacement value of any asset it needs to protect, because to do otherwise would put the rest of the business at risk. Protect your own household by getting as much coverage as you can.
Every corporation expects to earn a profit, which is the difference between what is sold (revenue) and what it costs to make and sell it (expenses). Profit levels are monitored closely in the business world, and the stock price of a business goes up or down depending on whether the profit is expected to rise or fall over in the foreseeable future.
Every household needs to monitor its own profit margin, though in this case our profit is the amount of money we are able to save, where our expenses are less than our income. A rule of thumb suggests a savings goal of 15 percent of pre-tax salary is the foundation of a comfortable retirement. Whether that is the right amount or not, we would be well served to think of our savings rate as the profit for our households.
I wrote earlier about how businesses spend more time thinking about cash flow and their income statement than they do their balance sheet, but a strong balance sheet, where assets outweigh liabilities, is also important. A strong balance sheet provides businesses with a source of liquidity. They either have cash saved outright, or they can borrow against other assets to get the cash they need.
The same holds true with our household finances. Having a strong balance sheet gives us the leverage to overcome difficulties or take advantage of opportunities. This might come in the form of an emergency savings account in case we are laid off from our job, a rainy day fund we can use for a quick weekend getaway, or a home equity line of credit. We build up our balance sheet by showing a profit — saving some of what we earn.
Mind the Metrics
Once a business has everything in place, it then uses key performance indicators (KPIs) and other financial ratios to monitor the performance of the business. Are sales meeting expectations? How often does our inventory turn over? Are our expenses in line with our budget? Then there are the quarterly and annual reports, which tell the shareholders how the business is doing in generating revenue and profit.
Our households need similar KPIs we can use to monitor the health of our financial lives. We need to understand how much of our paycheck is going to pay interest on things like credit card debt. Or what our future savings looks like, and what our portfolios are earning. Are they on target for the goals we set for ourselves?
One key metric that is important for family life is ROE — Return on Enjoyment. With the money that you are saving, or spending, what return on enjoyment are you getting out of it? Mindless spending on things you don’t enjoy is a waste on many different levels. On the other hand, saving money without tying the savings into a larger vision or strategy may mean that you are postponing the joy you could have today for no good reason.
These concepts of cash flow, vision or mission statement, governance, risk management, profit margin, balance sheet, and KPIs are not strictly things that apply to business. We can easily use ideas from business to take a more structured and ultimately more profitable approach to our personal finances.