Today, I am not writing a post on technology and instead writing something important about a different responsibility for those who are vying to be software freelancers. While I am writing this post as a software professional, this post applies to all freelancers. Part of the post applies to employees too. Today, I am discussing how not to ignore your finances and how to stay on top of them.
A. Know your monthly and yearly expenses
This is an important first step. Ideally you should have the answer ready from your job days, before you step into freelancing. The expenses should be a sum of both your business and lifestyle expenses. Business expenses are one-time or average yearly or monthly expenses for services like telephone, Internet, domain name, online hosting, stationary, commute, rent, electricity and subscription charges for technical magazines, journals or books purchased for learning. Lifestyle expenses are those related to food, clothes, hobbies and entertainment. You should record your expenses EVERY DAY in the evening around the time that you plan for your next day. If you do this everyday, month-on-month for 18 to 24 months, you will start recognising a pattern and have a sense of how much you spend every month / year.
Please remember that the aim is not to judge yourself and beat yourself up for unnecessary expenses. The aim is to accept your life as is and to make a financial plan for a freelancing career, one of the caveats of which is that no one will pay you at the end of every month like clockwork.
B. Know your future financial goals
Of course you have goals for your future and need the means to finance them. It may be for your marriage, further education, down payment for a house, world travel plans or the bootstrap fund to start a company in the future. You should figure out roughly how much you need and by when you need the money. Once you know these numbers, you can set up monthly or yearly contributions to each of these goals.
C. Your expected money outflow per month / year
From headings A and B, you now know how much of your earned income per month / year are ‘occupied’, i.e. they go either towards business expenses, lifestyle expenses or investments for future goals. You know that you need to earn at least that much every month / year.
D. Set a minimum income goal per year
Based on your expected outflow from heading C, you should have a minimum income goal for the year. You may not meet it or instead exceed it beyond your wildest dreams. But the objective is to have a number in mind that funds your lifestyle and your future financial goals comfortably and even leaves a little bit of surplus just in case.
If you have a number in mind, you will not slack off by avoiding too many projects. On the contrary, if you have already achieved your yearly goal, it gives you the option to say no to further projects and take a well-deserved holiday.
Let the number be realistic. Too much will overwhelm you and burn you out. A good rule is to earn 20 – 25% above your expected outflow (heading C).
E. Income, inflow, expense, outflow, profit, cash flow
Let’s say that a client X signs for up a project with you in January 2020 for a total value of ₹ 1,000,000. There will be an advance payment of ₹ 10,000 for the month. The next payment will be ₹ 30,000 on February 28, followed by another ₹ 30,000 on March 31, with a final installment of ₹ 30,000 on April 30.
The term income usually refers to the entire sum you will earn from the project. It does not account for the fact that some of the payment is in the future. The moment X signs the dotted line and pays you the advance of ₹ 10,000, your income is recorded as ₹ 1,000,000 in your accounting books.
Inflow refers to the actual amount received in a transaction. Inflow records only the money received and not how much you will receive in the future. So your inflow for January 2020 is only ₹ 10,000 from client X. Inflow will match income only in the next quarter after X has paid the whole sum.
Similar principles apply to payments. Let’s say your monthly Internet bill for ₹ 599 is due on Jan 15th. When you use your credit card, you have just recorded an expense. The transaction is purely a digital record with no money having flown from your bank account. Money leaves you only on the day when your credit card payment is due, which may be on Feb 10th. While the expense is recorded on Jan 15th, the outflow is only on Feb 10th.
Applying the two principles above, you can differentiate between profit and cash flow. Income minus expense equals profit. Your profit for January 2020 is recorded as ₹ 1,000,000 minus ₹ 599, which is ₹ 999,401, which appears massive. But the actual cash you have generated for January is your inflow minus outflow. Since you received only the advance, but on the other hand, paid for Internet with your credit card, your inflow is only ₹ 10,000, but also, your outflow is nothing. So your business generated a positive cash flow of ₹ 10,000. The cash that you have in hand is the most important aspect in your business. It frees up opportunities, allows you to meet payment schedules and keeps you afloat.
My trust lies with recording cash flow rather than profit, because it shows you how much you really have. But I do note down my income and expenses seperately, so that I can plan and pay my taxes well in advance, based on the fact that I know how much money I will eventually receive and pay during the year.
F. Know your tax obligations
Tax eats into your earnings like nothing else does. So you need to be aware of how much you owe and how you can reduce it.
As a software freelancer in India, you need to pay taxes only on your PROFIT and not on your INCOME. If I earn an income of ₹ 2,500,000 for the year, but I spend ₹ 500,000 for expenses like Internet, telephone, office space rent, online hosting and domain, etc. I need to pay taxes for only ₹ 2,000,000. Not only do you have to pay taxes only on part of your income, but sometimes the difference in taxable income usually bumps you into a lower tax bracket, e.g. from an income range that needs to pay 30% to a range that needs to pay only 20%.
Another benefit is that if your profit is 50% or more, i.e. if your total income is twice your expenses, then the tax department does not require that you produce proof of income or expenses. With a profit less than 50%, the tax department wonders what makes your operations so expensive. You may be summoned for an audit along with proof of every income and expense for the year. In our example, you have retained ₹ 2,000,000 of the ₹ 2,500,000 earned. So your profit is 80%. You just need to fill up one field on the tax form. The tax department will accept your tax filing cordially.
Another thing to keep track of is if any of your clients are already deducting tax from their end before paying you the dues. In this case, you get to reclaim those as a refund after accounting for your business expenses.
Goods and Services Tax, Service Tax, Value Added Tax (VAT)
These usually refer to the same tax, but is a tax levied on products sold or services offered. In India, GST (Goods and Services Tax), brought in new rules for taxation as against the outdated Service Tax. The rules for other countries keep changing every few years. I will refer to all these taxes as GST for this discussion.
GST is usually collected from your clients over and above the tariff you want to earn from them. The GST amount is then surrendered to the tax department during scheduled days in the year, whie you retain the tariff. The client can be informed whether GST is included or excluded from the tariff.
For example, software services in India are subject to a GST of 18%. So If I want to earn ₹ 100 from a client, I send him/her an invoice for a tariff ₹ 100, but I add another section that explicitly mentions the GST of ₹ 18. The total invoice adds to ₹ 118, that the client needs to pay. I surrender ₹ 18 to the tax department, while I get to keep ₹ 100. This is an example where I tell the client that my tariff is ₹ 100 EXCLUSIVE of taxes.
What if I do it another way? I send the client an invoice of ₹ 120 INCLUSIVE of taxes. If I divide the ₹ 120 into 118 parts, I get to keep 100 parts equaling ₹ 100.69, while I surrender 18 parts equaling 18.31. I could raise the bar a bit by charging the client ₹ 125 inclusive of taxes. In this case, I get to keep ₹ 105.93, while I pay ₹ 19.07 as GST. As you can see, the client doesn’t need to see what I earn and what he/she loses as part of tax. As far as he/she is concerned, my service costs ₹ 120 or ₹ 125 in his/her hands. It even lets us earn a few pennies more by rounding of a weird number such as 118 into a more familiar 120 or 125.
Please note that in India, payment of GST is compulsory if your total income for the year is more than ₹ 2,000,000 (₹ 1,000,000 if you are from a city like Shillong or Gangtok).
If you are not operating from India, you need to stay informed about the rules of service tax in your country and also the country to which you are providing services.
Finance is a very tricky topic. If you are a freelancer, you may not have enough to pay for a financial professional to take care of where and how your money flows. It works wonders if you educate yourself on finance, particular for rules in your country and those for the countries where you provide your service remotely. If you have been boggled about your finances in your freelancing career, now is the time to take control.