At least once a week, someone will contact me with this question:
How do I know when I'm financially independent?
Honestly, this is a math question which can be boiled down to a simple number. I call that number your Financial Independence Score, or FIS, which unambiguously answers the queston.
HOW TO CALCULATE YOUR FINANCIAL INDEPENDENCE SCORE IN 5 EASY STEPS
Want to find out how financially independent you are?
Easy! Do the following ...
Step 1: Add the income hitting your bank account for last month which was generated from sources not requiring your direct labor. This qualification is important. You are adding your passive income not your total income.
So, include dividends from publicly-traded stocks, dividends from privately-held businesses in which you don't work, rental income, interest received, and royalties for inventions, software and creative works produced by you more than 1 year ago.
Call this total X.
Do not include your salary, wage, consulting fees, profits from businesses which rely on your active involvement because these sources of income require your direct labor. You should only include passive income in X.
Step 2: Add all your personal expenses for last month.
Include groceries, drink, restaurants, repairs, maintenance, electricity, gas, water, telephone, internet, lawn moving, snow plowing, clothes, homewares, beauty and grooming services, medical, dental, pharmaceuticals, gas, car insurance, car repairs, public transport fares, school tuition, publications, subscriptions, stationery, leisure activities, gifts, legal, accounting, tax preparation fees, association dues, charitable donations, bank charges, property taxes, vacations and anything else you spend.
Call that total Y.
Step 3: Repeat this process so you have X and Y for the most recently completed month and the two months before that. For example, if its June, you should calculate X and Y for May, April and March.
Step 4: Now add your three X numbers together and call that A and then your three Y figures and call that B. So, A should be all your passive income from the last three months and B should be all your living expenses for the last three months.
Step 5: Calculate A divided by B multiplied by 100. That's your Financial Independence Score. The formula is FIS = A ÷ B x 100.
SOME ACTUAL FIS CALCULATIONS
Let's calculate some real-world Financial Independence Scores, from Entrepreneurs Life subscribers. Last names are withheld.
Peter's FIS Calculation
Peter has a 9 to 5 job but, because he is unmarried and has no children, has managed to squirrel away savings of $15,000 at 2.15% interest. He has no stocks, privately-held businesses or royalties.
From his cash deposit, he earned interest of $26.13, $26.21 and $26.88 for August, September and October respectively.
His monthly living expenses were $3,880, $3,072 and $3,316 for August, September and October respectively.
A is $79.22. This is the sum of the last three months interest received on his $15,000 deposit.
B is $10,268, his living expenses for the last three months.
Peter's November FIS is 1% ($79.22 divided by $10,268 times 100).
Cynthia's FIS Calculation
Cynthia has bought and rented houses since she was 23. At 47, she's now has a meaningful real estate portfolio of seven properties, four of which are fully paid.
Rental income from her portfolio was $19,600 for each of July, August and September.
Her monthly living expenses including large mortgage payments on the leveraged three properties were $24,293, $26,422 and $21,900 for July, August and September respectively.
A is $58,800. This is the sum of the last three months rent received on her seven properties.
B is $72,615, her living expenses for the last three months.
Cynthia's October FIS is therefore 81% ($58,800 divided by $72,615 times 100).
Robert's FIS Calculation
Robert is a wheeler-dealer entrepreneur with fingers in a number of pies. He works long hours in his own business. This enabled him to generate profits which he reinvested into an index fund, three retail properties, one commercial office and a small portpolio of startups as an angel investor. One of Robert's previous businesses was a software company which he sold 80%. In that deal, he negotiated a 1% royalty fee on all future software licences.
Index fund dividends were $5,072 in May.
Rent on the three retail properties were $7,200 per month for each of March, April and May.
Rent on the commercial office was $2,800 per month for each of March, April and May.
The portfolio of privately-held companies produced dividends of $500, $4,800 and $1,200 in March, April and May.
He earned $580 in royalties from the software.
Robert's monthly living expenses of $7,000 for each of March, April and May.
A is $42,152. This is the sum of the last three months index fund, property, small business investments and royalties.
B is $21,000, his living expenses for the last three months.
Robert's June FIS is therefore 201% ($42,152 divided by $21,000 times 100).
Calculate your FIS now. Don't skip this. Trust me. Do it. You're going have your eyes well and truly opened. It's necessary.
WHAT YOUR FINANCIAL INDEPENDENCE SCORE MEANS
Your FIS tells you what percentage of your living expenses is covered by your passive income over a 3 month rolling period. Put another way, it tells you how much of life's expenses are paid without you having to work!
As you make decisions about your finances, your FIS will change. It will change dramatically if you have a major financial event or transaction in your life like selling your business. Measure your FIS monthly. Invest. Reinvest. Track and monitor. If you want to know how the experts invest, take Intelligent Investor, my free short course on investing.
Here's summary of what your FIS result means:
0% to 5%: Government Welfare Client
Welcome to the world of most people. If your FIS is in this range by retirement, you'll need to dramatically cut back your spending and you'll need family, charities and the government to help you out. They won't be able to help you enough and things will be financially dire. Remember, the Government is terrible debt. You can't rely on programs to save.
6% to 25%: Dependent
If your FIS is in this range by retirement, you'll be living in poverty. It's a given you'll have to dramatically cut back your spending but, worse, no government program will be able to subsidize you. You'll only be able to rely on family and charity to help out. You'll be a financial dependent, like a child.
26% to 75%: Self-Funded Hardship
An FIS score in this range at retirement means you'll have a lifestyle shock. You'll have to reduce your monthly expenditure by approximately half. Retirement will be self-funded but a miserable penny-pinching situation.
76% to 95%: Self-Funded
You're in an interesting position if your FIS score in this range. At the lower end, judge whether you can lift your score further by taking a slight lifestyle haircut. If you're at the lower end and already live frugally, keep building your passive income.
96% to 100%: Self-Funded Comfortable
Good news. Nearly all of your living expenses are covered by income sources independent of your direct labor. All you need to do is make a few cuts to your monthly spend and you're financially independent.
Over 100%: Independent
Congratulations! You are financially independent. I'm not saying you're a ultra high net worth individual or a high net worth individual or even affluent. I'm just saying you can cover your living expenses without having to work. Assuming your investments remain strong, you'll be in this wonderful position. Beware though. Financial independence is not a permanent state and things can change. You need to protect your passive income and recalculate your FIS monthly. Never take your eye off the ball.
In the three examples I provided, Peter's FIS of 1% indicates he'll be in bad shape come retirement time. He's nowhere near financial independence at this stage. The good news for him is he is in his 20s and has time on his side.
Cynthia's FIS of 81% puts her in good shape at age 47. If she keeps on this path, she'll be financially independent.
Robert is a powerhouse with a FIS of 201%. He is financially independent but vigilant to ensure he stays that way.
TIPS ON INCREASING YOUR FINANCIAL INDEPENDENCE SCORE
All good in theory, right?
But how do your improve your FIS in practice?
There are many paths to financial independence. Here's what I recommend:
Calculate your Financial Independence Score. Mine is 239%. What's yours? Does this worry you? Are you ready to improve your financial independence and need accountability to achieve it?
Let me know your thoughts in the comments section below or contact me directly.