Be Efficient with Capital Through – The Emergency Fund

Personal finance experts throughout the land will tell you that you need to have an emergency fund. Today I am going to discuss the reasons behind having an emergency fund and what we can do to optimize it.

The purpose of an emergency fund is to act as a risk mitigation tool.

An emergency fund is a form of self-insurance. If you need to use it you are sure glad you had it, but if you don’t need to use it you would have been better off doing something else with your money.

There are a huge number of risks people and businesses face each day that warrant keeping an extra bundle of money in a very liquid form (cash). The most commonly cited example I hear from people is that they are keeping 3 to 12 months worth of expenses in cash in case they lose their job. I think this is a great reason to keep some extra cash around to pay for everyday living expenses while you figure out where you are going next.

Too much Emergency Fund

I’ve had a few people ask me what the drawbacks of having a much bigger emergency fund is. The answer is that having extra money sitting around in the form of cash is not productive. There are far more efficient things your capital can do for you (i.e. investments) rather than sitting in a bank account collecting the minuscule interest that a bank will pay for your cash deposit.

Some of the best interest rates for bank cash deposits I have seen are currently around 1%.

Too Little Emergency Fund

Let’s say you have zero emergency fund. What happens when you need to pay an extra car repair bill you didn’t plan on? Since your car mechanic doesn’t accept homemade cookies as payment (I do) you’ll have to pay him with some form of a loan. Let’s say you use your credit card, but you aren’t able to pay the balance at the end of the month because you don’t have any leftover cash. This means you are going to be paying interest on whatever the cost of the repair is.

The average interest rate of credit cards is between 15% and 22%.

The Goldilocks Zone for Emergency Fund

The Goldilocks Zone is the amount of money where you strike a balance between your lost opportunity on the money that only makes 1% in a bank account and the amount of money you have to pay a high interest rate on because you don’t have the liquidity needed to cover expenses in an emergency.

No single answer is correct for everyone. Let’s look at some factors to consider that can help guide you towards the best decision.

  • How secure is your current income? If your current company is posting great profits and you are a valuable part of that team you might consider holding a smaller emergency fund. This isn’t a set it and forget it situation though. If circumstances in your company change, you need to be aware and give yourself additional cushion.
  • How easily could you find new source of income? If you have skills that are needed by many businesses you might consider again reducing your emergency fund.
  • How old is your car? Your house?
  • Do you have any concerns with your health or your family members’ health? How old are you? What are your health risk factors?
  • Look back at your old income statements and see how often you have large  unexpected spikes in expenses.

Do you have a smaller or larger emergency fund? Have you thought about why? Let me know if the comments.

Measuring Efficiency with Money

This week I’m excited to start talking about the efficient use of capital. The efficient use of money is a topic that I think gets far too little lip service in everyday conversation.

How you use your money is a direct reflection of either your mission, vision, or values.

I want to begin by discussing a few tools that can be used to measure the efficient use of money.  On some level everyone has a SMART goal related to using money more efficiently.  The Specifics, Achievability, Relevance and Time bounds of the SMART goals vary slightly for every person, but Measurement is the same.  Therefore, I want to focus on a couple of tools used for money and the “M” of the SMART goal, Measurement.

  1. The first tool is called an income statement.

An income statement is a measure of all the money you earned in a certain amount of time subtracted by all the money you spent over that same time period.

Prepared and reviewing an income statement has two primary effects:

  • Makes you aware of all the places you are earning money as well as spending money.

Being aware of where you are spending money can quickly alert you to spending that is not in alignment with your values.  Being aware can also help you identify opportunities for improvement.

  • Tells you if you are making a profit or going further into debt.

Earning more than you are spending means you are making a profit. Spending more than you are earning means you are digging yourself a hole. I will let you figure out which one is better.

  1. The second tool is called a balance sheet.

A balance sheet is a measure of how much you are worth at a certain point in time. It is calculated by adding up the value of everything you own, these are called your assets, and then subtracting the amount of money you owe, these are called your liabilities. The difference between these two numbers is how much you are worth, called your net worth. In accounting terms, it is also called owner’s equity.

The income statement and balance sheet are two financial documents that help us measure the current state of our finances (money) as well as help measure any future improvement. I have been creating a personal monthly income statement and balance sheet for almost a decade now.  I find them extremely helpful with understanding where my money is and where it is going.

Do you have questions about how to get started with using or creating these tools? Do you use them in your personal or business life? Let me know in the comments and if you haven’t already subscribed please do so over on the right.

Origins of the SMART Goals

In a previous post I talked about setting SMART goals to help you achieve better efficiency in your life. Today I’m going to talk about where your SMART goals should come from and a framework for the rest of this blog. SMART Goals stem from an organization or person’s mission, vision, or values.

Mission statements, vision statements, and values are typically used by organizations to establish where the company is heading and to determine why the organization exists in the first place. Missions, visions, and values are established for the organization to use as a guidepost. If you aren’t familiar with the difference between mission statements, vision statements, and values here is a quick summary:

Mission Statement: Describes what the organization or you do.

Vision Statement: Describes how the organization or you see the future.

Values: A judgement of what is important.

Mission statements, vision statements, and values establish a purpose and provide a foundation through which an organization or you function.  Once a mission statement, vision statement, or a value is established one can determine how to proceed.

You can think of mission statements, vision statements, and value statements as forming the base of a pyramid.  From the base of the pyramid goals, strategy, and then tactics emerge. Pyramid

 

Goals are your desired result. Strategy is a plan designed to achieve one of your established goals.  Tactics are a specific action you are taking as part of your larger strategy

You must “climb” the pyramid in the hopes of obtaining a successful result.  Although there is only one mission statement, vision statement, and set of values that form the basis for what you do, there can be an unlimited amount of goals, strategies and tactics that are derived from your base. Here is an example of how the pyramid can be used:

Mission, Vision, or Value: One of my values is efficiency.

Goal: My SMART Goal is to efficiently save X dollars for retirement by a certain date

Strategy: One of my strategies for saving X dollars for retirement will be to reduce my overall tax liability.

Tactics: One of my tactics to reduce my overall tax liability will be to use my company 401(k).

In my future posts I’ll be getting into the trenches and discussing strategies and tactics you can use to improve your efficiency.

Do you have a personal mission statement, vision statement, or set of values? I would love to hear about it in the comments below.

Measure Measure Measure

If you can’t measure it, you can’t improve it. Peter Drucker

This is a famous quote in the six sigma and quality circles that I hang out with. I get invited to some pretty awesome parties.

When I first started working as a process engineer I got to witness an interesting phenomena.

A new boss high up in the process department had been hired, and he was very interested in knowing and improving our daily throughput. Every time he was around he would ask us how the throughput was going. He requested new reports that prominently displayed our daily throughput. When we had a good day on throughput he would congratulate us on our hard work.

However, the truth was before the new boss started we were already doing everything we could to get more throughput.  Since he had started we actually hadn’t changed anything.

As time wore on I expected no improvement in throughput, but I was wrong. The new boss kept asking everyone about throughput and slowly we started to get more throughput. Nothing drastic, but sure enough I could pull up the data and there it was. We were doing 3 or 4 percent better than a several months before. I couldn’t figure out how we had pulled off a little better performance until one day I was out talking to an operator and he told me about how he had switched out one piece of equipment for another one to try to increase throughput. The new equipment gave us a little better throughput in one area, but it ended up causing a bunch of other maintenance issues.

A few months down the road we got a new boss who didn’t care much about throughput. Instead he wanted to know all about availability and maintenance issues. Once again not much change initially but over time as the new boss let everyone know how important availability and maintenance issues were. Slowly everyone made all the small adjustments to improve the availability and maintenance issues and the data showed we were doing a little bit better in availability and maintenance. The funny thing is that the throughput also slowly slipped back to where it used to be.

My story illustrates two important points about measurement.

  1. Measurement makes you aware of where you used to be and where you are now.
  2. You need to measure the correct things. (HINT: throughput and availability were both poor choices in isolation)

Have you ever started measuring or tracking something and quickly found ways to improve? Leave a comment and let me know.

Jeff N. was the winner of last week’s drawing for “The Goal: A Process of Ongoing Improvement”. Thank you to everyone who registered.

The Three Inputs to Efficiency

Earlier this week I talked about goals or the outputs of the efficiency equation.  This post I will be talking about the inputs to the efficiency equation. There are two ways you improve efficiency over time: (1) to get more outputs with the same inputs and (2) to get the same outputs with less inputs.

Anything you do can be considered an input; thus, there are infinite inputs that can be examined. For the purpose of simplicity I’m going to categorize all inputs as either Time, Capital (Money), or Skill.  Inputs within each category have their limits.  For instance, there is only so much time, money, or skill an individual possesses.

Time: Every single person has 1,440 minutes to use every day. The people who make the best use of those limited minutes will reach their goals more easily than those who choose to waste that valuable time.

Capital: Unless you are like my hero Warren Buffet, you also have a limited amount of capital and money to deploy towards reaching your goals. Making sure that each dollar you have works as hard for you as you do for it is important to making your life efficient.

Skill: Skills are knowledge, techniques, or abilities we use to achieve our goals. We learn to use skills starting at a very young age. Supply and demand will determine how valuable your skills are in the open market. The more difficult and rarer your skills are the most valuable they will likely be.

I should also mention that these inputs are all linked to each other. TriangleYou can use money to buy additional time or skills. You can use your skills and time to earn capital. When evaluating whether you are becoming more efficient you need to look at the whole picture and not just one aspect. For example, if I want to reduce the amount of time it takes me to mow my lawn I could just hire a lawn maintenance service and reduce my total time spent; however, I would be paying a bill for the service, ignoring the money and capital aspect of inputs equation.

Don’t forget I’m giving away one copy of “The Goal: A Process of Ongoing Improvement” to a randomly selected subscriber to my website. You have to be registered by 8 pm PST on Sunday to be eligible for the drawing. Add your name and email off to the right to be entered.