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Continuing with our look at financial systems, the next step, after you have clarified and identified where your money is going, is to find the area that needs the most work. This does not have to be an area where you are losing money or getting in debt, but an area that you can see will improve if you work on it. You want to choose an area that you can change pretty quickly, so that you can build momentum and then work on your bigger goals in your financial life.

For example, once I started keeping track of my expenses, I saw that in my financial system I was spending over $200 per month on coffee and pastries. I always thought that I might be spending a little bit too much in this area, but keeping track of the exact amount put a number to this hunch. It was now a fact. And I had to do something.

Then I analyzed the entire process that I went through in the morning that led to me spending this kind of money. I realized that the main driver for me going to Starbucks, or one of the alternatives, was that I was running short on time. By starting my day earlier, I would not have the same time pressure and could make my coffee at home or at the office.

Although I didn’t fully eliminate the coffee expense, I freed up about $100 per month, which is now going towards investing for my future.

You should do the same. Look at any area of your financial system and see where you can make small changes that can end up making a big difference. Don’t put ten or twenty things on your list and try to change them all at once, as it will be too big of a change to handle at once. Take one item from your list and analyze the entire process that you go through before and after making this purchase. Then consider putting part of this newfound money you’ve generated into some P2P loans on Lending Club.

Changing one item at a time will build up your confidence and the momentum to keep on changing other things. Eventually, you will have your personal financial system optimized and capable of carrying you towards your financial goals.

You do have written financial goals, right?

In an earlier post in this series, I made the point that personal finance can be viewed as a system, with money flowing into our system and money flowing out. Many times, the money leaving our system exceeds the money coming into our system. That’s called living on credit. Usually a financial system cannot sustain a prolonged period of living on credit. So the point of this post is for you to determine and clarify your financial system.

Now that the holidays have passed, spending usually goes back to “normal,” so keeping track of how your financial system works for one month will give you a pretty good picture of everything that’s involved. Get yourself a notebook or some other tool that you will use to keep track of your spending. I use my BlackBerry, which has a “Memo” program where I can quickly type in a transaction and its dollar amount. The BlackBerry is handy for me because it’s usually always with me. Find what works for you.

In tracking our transactions, we want to answer the following questions:

1. Where is the money coming from? And how much? Here you can list of any sources that you have had money come from in the past and expect to receive money from in the future. For most, our jobs will the number one contributor. You may also include part-time gigs, interest income, bonuses, child support, proceeds from P2P loans on Lending Club, or any other source that puts money into your life. Checks, direct deposits and cash all count. Don’t forget the small cash amounts!

2. Where is the money going? And in what amounts? First, I want you to write down five to ten categories that you can assign to your expenses. Examples of categories include: living expenses, food, transportation, entertainment, fees and miscellaneous. If you know you’re spending a lot of money on one product or activity, make a category for it. For me it was coffee, so I had a “coffee” category.

Once you have your categories, use the same process that you followed with your income, and write down every time any money leaves your life. If you are spending 50 cents on a bus ride, write it down. If you spend $75 on gasoline, write it down. You want every single transaction written down; nothing should be missed, especially those small transactions that add up to big bucks.

Many people, myself included, are at some level emotional about money. It’s not just green paper. Because money is so emotional, most of us misjudge how much we make, how much we spend and where that money is spent. When committing to one month of keeping track of your income and expenses, you will have hard facts about your money. You will be able to separate the emotions from it and then proceed to make decisions based on real facts that you gather, write down and analyze.

One of the big benefits of thinking of your financial life as a system is that you will respond instead of reacting to everything that happens to you financially. What is the difference? It can mean a lot to you financially.

A reaction is an action based on some kind of external action. A reaction has no plan and no thinking built into it. It can be called a “knee-jerk” action or a reflex. When the doctor taps you on the knee, you have no control over the reaction and your leg moves. Same thing happens when you are reacting to your financial life.

Some examples of reactions:

• There’s a sale going on at the mall and although you don’t need new clothes, you decide to go shopping

• Your car breaks down and it costs $500 to fix, so you put it on a credit card

When you don’t have a response or a system prepared to deal with everything that might come to you financially, you are forced to react. And many times this reaction will cost you a lot financially.

A response is a prepared action you have for anything that comes your way. A systemized financial life helps you by making sure you have a response for mostly everything. It helps you by allowing you to foresee anything that might go wrong and prepare for it ahead of time, so that the unplanned and unwelcome event does not ruin you financially.

Some examples of being ready with a response:

• Not spending all your money during the holiday season, knowing that the after-holiday sales will have a lot of bargains

• Putting away two to six months worth of life expenses in case you lose your job or get injured

• Planning ahead for major purchases so you’re not forced to use credit when buying them on a whim

Action: Look over your financial system to see where things might go wrong and prepare a response. This will keep you from breaking the bank when financial emergencies come up. It will also reduce the amount of stress you experience in your life, knowing that you have that cushion in case anything goes wrong on your way to achieving your goal to become wealthy.

One way to think of assets and liabilities is as vehicles or containers. They are either positive or negative. The positives are the assets, where you can build them up and they will bring more money into your life, while the negatives, which are the liabilities, require you to pay them and thus they are siphoning money away from you.

Assets – Assets are anything that brings money into your financial system once all of the expenses are counted. In this interpretation, a vehicle is not an asset because it takes money away from you each month, even if you have it fully paid off (because you still incur gas, insurance, maintenance and parking expenses). A rental property is an asset if you own it and it brings a net income every month to you. Money you lend out on person-to-person lending sites counts as assets also.

Assets can be broken down into two categories:

• Liquid Assets – If an asset can be turned into cash in a week or less with a minimal amount of loss of the asset, then it is a liquid asset. Checking and savings accounts, many mutual funds, and CDs are all examples of liquid assets.

• Non-Liquid Assets – These are assets that are not easily convertible to cash within a reasonable time period. A rental house, a business you own, and stocks in a startup are examples of non-liquid assets.

Liabilities – Liabilities are anything that takes money away from you, which is the outflow of money from your financial system. The official definition of a liability is: a financial obligation, debt, claim, or potential loss. The goal is always to minimize or eliminate as many liabilities as possible to keep the money for yourself and build up your assets.

Let’s look at the type of liabilities anybody out there can face:

• Permanent Liabilities – Taxes, groceries, utility bills, and transportation costs are examples of liabilities that cannot be eliminated. These liabilities will be with us for as long as we are part of this world. But they can be managed and optimized so you are paying as little as possible.

• Temporary Liabilities – These are expenses that have a deadline. Paying off your car, paying off your credit cards, and paying off anything else that takes money away from you each month is a temporary liability. You can choose to pay more towards it every month and there’s a date by which you will have paid the liability off.

Understanding that everybody has assets and liabilities in their lives and knowing how they work will help you to begin to lower or eliminate your liabilities and increase and acquire more assets.

In my first post, we determined that your financial life is in fact a system. Maybe a system in disarray, but we’ll look at that in the future. For now, let’s look at what makes up an “average” financial system. Here is what I’m assuming as a backdrop to this discussion: generating income of around $60,000 per year with the goal of retiring with $1.5 Million, and then putting that amount into a very safe investment generating 5% per year to produce approximately $75,000 per year in retirement. To see how to achieve that goal, let’s start by looking at the “processes” in everybody’s financial life.

Processes - You can think of processes as any type of movement of money, assets or liabilities. The processes of an average financial system are:

Money Inflow – Some examples include depositing a paycheck, receiving interest earned from a person-to-person loan on Lending Club, cashing a tax refund check, and having a friend return the $20 she borrowed. Money flowing into the system, coming to us, is part of this Inflow process.

• Ongoing – There is no 100% guaranteed ongoing income, but some things come close. Your salary is one example, where although you might lose it with one job, you can still find other employment, and the income is pretty stable. Other ongoing income can be interest earned on an investment that goes on for years.

• Limited – This could be that bonus that you got at the end of the year or the valuable baseball card you sold on eBay. Anything that happens infrequently and in an unpredictable manner falls into this category.

Money Outflow - Buying coffee, paying rent, having taxes taken out of your paycheck, paying for a parking ticket, investing in a mutual fund or letting a friend borrow some cash are all part of the Outflow process. This process encompasses any money that is going away from you.

• Ongoing – There are certain outflows of money that you can’t stop, including paying taxes, buying groceries, paying your power and gas bills, and so forth.

• Limited – Limited money outflows are expenses that can be stopped. Paying off the car stops the car payment. Other limited outflows include buying a computer or paying off a loan. Another example is lending out some money in p2p loan portfolios on Lending Club or making other types of investments.

Realizing that the flow of money in and out of your life is where you have the most control, it makes sense to break this process down, analyze it and change it if needed. In this way, you can make sure you keep as much money as possible.

Next, we’ll look at assets and liabilities as part of the financial system.