How the self-employed can set their personal finances in order

Entrepreneurs have a wide business and social network. They often blindly rely on this network to buy high-cost financial products through distributors without doing their own research.

Running a business, growing it and making real money out of it is extremely hard. Entrepreneurs have to face countless challenges, take tough decisions and relentlessly strive to keep the money rolling in and alongside, manage people. They are independent, ambitious, intuitive and aggressive risk-takers.

Yet, when it comes to managing their personal money, many of them fail to act with the desired prudence. This is particularly true of owners with small and medium-sized businesses. A certain air of confidence with which they take business decisions resonates in their personal financial lives. They are certain of having ticked all the boxes correctly. However, it is seldom true.

Where they usually go wrong

The most common tendency is mixing business cash flows with personal cash flows. Typically, the money invested in the business generates profits, which is redeployed in the business as the aim is to scale up. But due to a lack of clarity about the quantum and timing of reinvestment, there is a propensity to hold on to the money, with the effect that personal investments are irregular and not commensurate with the income earned from the business. Worse, as there is no proper demarcation between personal and business funds, sometimes even personal investments are untimely redeemed to invest in the business.

It is an unfortunate truism that many such businesses operate in a cash-heavy environment, with many off-the-books transactions. To avoid tax, this unaccounted business money usually is channelled into illiquid assets like real estate and physical gold. There is no decent exposure to growth assets like equity, which has consistently been proved to be the best asset class to beat inflation over longer periods of time.

Sticking with the equity theme, despite investing in their own business, many entrepreneurs fail to understand equities as an asset class. They do not realise they are investing in companies that go through different business and economic cycles, just like their own enterprise. Their mindset is more returns-oriented rather than investing in fundamentally solid businesses which have the ability to create long-term wealth.

That brings up other investments. Entrepreneurs have a wide business and social network. They often blindly rely on this network to buy high-cost financial products through distributors without doing their own research. An investment approach focused on high returns is haphazard; they would be better served going by structured goal-based planning.

Entrepreneurs are go-getters and always ready to take big risks in their business. However, they are unable to take a bird’s eye view of the impact on their personal finances. In unfavourable times, it is their personal wealth that bears the brunt due to lack of contingency planning in the business.

What needs to be done

Having separate accounts for personal and business spending is the obvious solution. But it is easier said than done. What is required is a complete change in mindset. It has to be understood that business and the business owner are two separate entities. In this context, a more pragmatic starting point would be to target building the personal net worth year by year. Net worth is the difference between what one owns (assets) and owes (liabilities).

Listing personal assets and liabilities to create a net worth statement would be an eye-opening activity. For this purpose, business assets and liabilities like office space, warehouse, commercial loans, etc, should be excluded from the statement. The proper valuation of the business will have to be assumed to be what it would realise were it to be dissolved or sold off. This takes the business value out of the picture. Only the net income coming out of the business is to be considered and invested regularly to grow personal wealth.

It is also imperative to remember that personal net worth is meant for the family and to meet its financial goals. As far as possible, it should not be touched for business purposes.

The personal net worth statement gives the entrepreneur a reference point to measure progress towards wealth accumulation and evaluate financial stability to tide over future uncertainties. It can help an entrepreneur have an honest assessment of where s/he stands financially. Regular tracking will automatically encourage the discipline of treating both business and personal finances as separate. Knowing one’s personal net worth is the key!