- Run the Numbers is one of the most popular parts of our show, and it makes sense.

Money is always best understood through specific examples rather than vague concepts.

So y'all are in for a treat today.

Meet Adrian.

He's been feeling a little anxious about the state of his money and his graciously allowing us access to all his financial information.

And today, we're gonna run all the numbers together to assess his financial health and get him on track for success.

Let's do it.

(excited music) - But before we get into it, we need to talk about the biggest roadblock that can sabotage us from the start.

Feelings.

A Nobel Prize winner found that 90% of the financial decisions we make are emotional and only 10% based on logic.

And that makes sense when you consider that our brains evolved way before things like money came on the scene, let alone credit cards and spreadsheets.

Financial stress has been scientifically proven to hamper your cognitive abilities and do wild things like decrease gray matter in areas associated with memory and learning.

So make sure that when you attempt an audit like this, you're rested, fed, and in a grounded place.

Also, pro tip, set 20-minute timers for yourself.

So you can take five to 10-minute brain breaks.

There's no need to rush.

All right, Adrian, you got your breathing exercise in?

Let's go.

(lively music) - First up, let's figure out our cash flow capability.

This is the current average gap or lack thereof between income and spending.

Adrian is in his late 20s and works at a mid-size company making $75,000 a year gross salary.

After logging into his checking account, we see that after taxes and insurance, he's left with 2,520 per paycheck.

He gets paid every two weeks, so we'll take that number times 26 pay periods divided by 12 months, making his average monthly take home pay $5,460.

Now let's figure out where all that's been going.

- We'll start by adding up his essentials and debt payments.

These are things that he'll have to pay for even if he loses his job.

Here's a breakdown of his housing payment, average utilities, cell phone bill, groceries, transportation expenses, essential prescriptions, and car insurance.

For Adrian, they come to $2,350 a month.

Most banks and credit cards these days offer a basic breakdown of expense tracking, so just look at the last three months to get an average of the numbers that fluctuate like groceries.

Now, when it comes to debt, he has a $200 car payment and $100 payment for some student loans.

So in total, 2,650 of his 5,460 has been accounted for, but where's the remainder of his income going?

- In my experience, it's relatively easy for people to rattle off their essential expenses, but unless you have a holistic expense tracker that you regularly engage with, the rest can be tough to nail down.

But don't worry, I've got a trick.

Instead of trying to figure out the rest of your expenses, let's account for savings first.

Every month, he sends $500 into a savings account, but he's been pretty consistently dipping into it to replace a tire or go on a vacation.

In this situation, the best thing to do is to look back at the last six months and see how much his savings account has grown.

Turns out it was $2,500 six months ago and it's $5,000 today.

That means his account has grown by $2,500, breaking down to about $416 of net savings on average per month.

- Now, it's a common mistake to exclude credit card information when calculating your expenditures, and unfortunately, 50% of Americans hold outstanding credit card debt.

So if his savings account grew by 2,500, but his outstanding credit card balance grew by 1500 over that same period, that would mean he would only be saving $166 net, not 416.

Thankfully for him, that's not the case.

Now we know his income, essential expenditures, debt payments, and savings.

The rest has to be his average discretionary spending.

That leaves us with 2,394 a month that's headed out the door for things like restaurants, household goods, gifts for family subscriptions, vacations, etc.

The next step is plugging these three numbers into a few health assessing ratios.

- Let's start with his savings rate.

Right now, it's $416 a month.

Divide that by gross monthly pay of 6,250 and you get a 6.6% savings rate.

Most financial professionals suggest 20% of gross pay as a healthy goal of savings, which for him, would come to around 1,250 a month.

To get there, he'll need to cut 834 extra dollars from his spending or find a way to make a little more money to create that level of gap.

So he's not there but the good news is that he is living within his means.

- The next ratio to check is essentials to income.

A lot of people focus on debt to income, but I tend to find that a very narrow number and it doesn't give you a holistic idea of your overall financial health.

What's cool about this number is that it can help answer whether your financial stress stems from income or spending issues.

Let me explain.

At the moment, his essentials and debt payments are coming to 48% of his income.

Whenever I see people stressed about money or not saving the amount they think they should, they tend to beat themselves up and blame it on their discretionary spending like eating out too much.

But there's more at play here.

Of all the areas of your budget, your essentials are what you have the least control over.

You don't set how expensive the rent is in your area.

You don't set grocery, gas or utility prices or control if your parents could help you with college, - If you run this number for yourself and realize that your essentials come closer to the 55 to 60% mark or above, that means an income problem might be at play, AKA, your area's cost of living is more expensive than your salary can keep up with.

So your time and mental effort are likely better spent asking for a raise than buying different yogurt at the grocery store.

It's especially typical to see these kinds of numbers and high cost of living areas like New York City or Austin.

That's why it's so tough for many who live in those kinds of places to build long-term wealth.

However, if essential spending ends up coming to 30 to 40% of your income and you're still stressed, most likely, you've got a spending related issue.

While that might not be the most fun thing to learn about yourself, it is a relatively straightforward problem and more within your power to adjust.

- So what are we taking away so far?

- Well, he's living within his means and saving about six to 7% of his income.

Thankfully, his essential spending is healthy based on where he lives but if he wanted to move to a bigger, nicer apartment, he'd possibly need a roommate to keep his ratio in check.

- Exactly.

So we do need to make a few adjustments to spending to get a bit closer to that 20% savings goal.

Thankfully, he finds a few subscriptions to cross off the list and feels confident that he can be a bit stricter with his grocery dining out and clothing budgets, which gets him to a cash flow gap of $1,000 a month.

Progress is definitely better than perfection in this area, and it's better to cut in a sustainable way rather than swing the pendulum too far.

But now it begs the question, what we do with that $1,000?

Looks like it's time to put on our hard hats and lay some foundation.

- Unfortunately, laying foundation is the least exciting part of building a house, but if you skip it, you'll always be one unlucky gust of wind away from having things crumble around you.

So let's check that each layer is fully in place before we get to the fun stuff like investing.

Our first layer consists of putting one month of expenses in a separate savings account as an emergency fund.

Thankfully, Adrian currently has $1,500 in his checking account and $5,000 in savings.

So he's got that on lock.

Time to move on to layer two, get on track for commitments.

Every year, Adrian goes across the country to visit his family for Christmas and he's committed to being in a friend's wedding.

Between those two things, that will claim $100 a month of savings.

So the remaining $300 is free to move on to step number three, get out of debt.

- Adrian currently has $25,000 student loans at 3.5% and $2,500 left on a car loan at 8.9%.

Now, if he didn't make any spending adjustments, he wouldn't be able to get anywhere very fast.

But now that he's closer to that 20% savings mark, he could be debt free in a couple years.

Now this is the part where I remind you that these steps are a rule of thumb and it's okay to flex a bit based on your personal preferences.

For example, he's not interested in getting out of those student loans super fast given their low interest and the current state of the economy.

So he decides to skip paying off the student loans faster to move ahead.

After all, he's a little anxious to start saving into his 401k.

Once the car is paid off, it's time to lay the last layer of foundation by bulking up that emergency fund to three months of expenses.

Finally, it's time to get after investing free and clear and focus your energy on building up a beautiful financial house.

- So in review, the three steps to a proper financial audit are, one, analyze your current cash flow picture and figure out where all that money has been going.

Number two, calculate your savings to income and essentials to income ratios to assess your financial health.

Finally, check to see if your foundation has any cracks and focus extra money on shoring it up one layer at a time.

- In our experience, most financial stress comes from lacking cash flow clarity and experiencing analysis paralysis over what to do with extra money.

Hopefully, this exercise gives you the confidence to know where you are now and the tools to pave a clearer path towards your financial goals.

- And that's our two cents.