Beyond The Headlines
The Profit: Who is Better Off?
If two people start with nothing, one is earning $100,000 a year, the other $50,000, but the first one is left with $5,000 after all taxes and expenses, and the second one with $10,000, which one is richer? One would need almost twenty years to save one year of expenses, the other four years. When it comes to personal finance, the concepts can get a bit confusing. Let me explain.
We join our clients on their journey at a point when they are financially comfortable. Whether through inheritance, business, or career success, they have accumulated enough wealth to set them apart from most people in their countries and the world. They are long past, or they never had to cut their maxed-out credit cards or had their internet or electricity disconnected because of a lapsed payment.
We start the conversation when our clients decide they want to see their nest egg last a lifetime or a family fortune serve many generations. It is refreshing to look at the underlying principles that might have become second nature but still need to be followed to achieve big-picture, long-term success – keeping the money.
When we analyze a business, we look at sales, costs, and profits, but the last item is the one that gets most of our attention. The example I shared of the two individuals with $100,000 and $50,000 salaries is no different than two businesses. The ranges can be even more extreme. One company can have $100 billion in sales and book $1 billion in profit. The other may have $5 billion in sales and $2 billion in profit.
$2 billion is more than $1 billion, no matter how much in sales it took to generate it. If anything, the higher the margin, profit divided by sales, the better the quality of the business. It usually means it has a stronger competitive position. Not getting too technical, but the actual cash flow after reinvestment in the business can tell us even more about the business. If a business needs only a small portion of the profit reinvested in the operations (new equipment, new facilities, etc.), and more left for the shareholder, the happier we are. Last but not least, if the reinvested capital earns high returns, it puts an additional smile on our faces.
Then you have the U.S. government or any government in the world. Somehow, many governments manage to even spend $150 on each $100 in tax revenue. You can’t run a household for too long this way. The governments get away with it by growing the outstanding debt. It’s the proverbial kicking of a can. If history teaches us anything, eventually, the government defaults on its debt, and one way or the other, needs to address the looming problem.
Sometimes it’s a manageable restructuring, other times, it’s a messy collapse, and since the government can be a big spender in some countries, the economic hit might be very pronounced. The most challenging situation happens when a country borrows most in another currency, usually the dollar. If the exchange rates collapse, too, the domestic tax revenue might never catch up with dollar payments.
I grew up in Poland, a country that technically defaulted on its dollar-denominated 1970s debt when I was one year old. The debts were settled, paid off, and partially forgiven when I was 14 (the mid-1990s). Many countries shared a similar path. It’s nothing new and will likely be repeated.
The U.S. has what we believe is a very privileged position; its debt is in its own currency, which happens to be the reserve and trade currency of the world. It’s got a lot more room to overborrow and overspend. There is some limit to it, and we are yet to see when and how we reach it, and it’s nothing to do with the ‘debt ceiling’ but with the investors’ willingness to buy and hold the U.S. government debt. It’s a privilege, NOT a right, but apparently, each country has to learn it again and again.
If the government wanted to set an example, they’d collect $100 in taxes, use $50, and return to you, the taxpayer, the $50 they didn’t use! The annual tax refund that many are excited about is the money you overpaid in taxes the year before. In the example above, the government collected more in taxes than it needed in a particular year. It doesn’t usually happen; I can’t actually think of an example.
Back to profits, though. Whether your household revenue comes from a salary, real estate assets, a business, a stock portfolio, royalties, and more, the top line is revenue. That amount needs to be taxed, and then all expenses follow. Usually, the rent, the mortgage, and your home is the biggest ticket item, and then transportation, food, medical expenses, education, and more. The labels are the same if you have a multi-million dollar household or a national median household, which is around $70,000.
Looking rich and being rich is not the same. A $100,000 household spending almost all they earn will obviously “look” a lot richer than a $50,000 household. All the visible proofs of wealth: a car, a house, and travel will differ. In our example, the first one saves or has a profit of $5,000 at the end of the year, the latter $10,000.
The concept of wealth gets even more interesting when you see it as how much a household makes, spends and saves, and actually possesses. Usually, the curiosity ends with the first question, and unless you talk about someone on the Forbes list, the last question doesn’t come up. It’s the middle, spending, and saving that makes all the difference, though.
Certain personal finance experts these days bring to our attention how spending more than we earn and growing debt is a source of stress and will eventually get us in trouble. Their advice is the same as a business or government would need. Cut spending, and look for ways to grow earnings. It’s a challenge not only for average household budgets. I spoke recently with a Great Depression era expert Nicki Woodard who studies the lives of the richest people of the era, Barbara Hutton, Doris Duke, Huntington Hartford, and others.
They were born to fortunes that were almost unimaginable to spend, yet many of them accomplished just that. On the one hand, there is no limit to spending; on the other, coming from a $30 million household and living in a $3 million household with a $30 million taste will get us to the same troubles over debt and overspending.
Charlie Munger, Warren Buffett’s wise business partner of few words but much wisdom, tells us to keep our expectations in check. I think it’s a piece of universal advice. The principles of personal finance are the same for a $70,000 household, a trillion-dollar corporation, and for the world’s largest economy. Spend less than you earn, save, and invest.
The governments won’t take this advice; they can always tax more, default, restructure, print money, and more. Corporations that want to have a loyal shareholder base eventually show discipline and profits. Individuals might have the least wiggle room here. At the end of the day, it’s your own quality of sleep, and somehow, we all sleep better when we have savings worth a few months of expenses and even better when we know we might not have to work for money another day in our life. The best truths are the most obvious but the hardest to embrace.
Next time you see a neighbor with a brand new top-of-the-line car, think of the profit of your household and theirs; you might still be closer to a better quality of sleep than your neighbor will ever be—just food for thought.
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