Last week we defined what a personal budget is, its purpose, benefits, types and why many people don’t budget. Today, we will discuss the principles of personal budgeting and its process.
Financial literacy: Before we take up today’s issues, it is important that we bring out the core around which everything in personal financial planning revolves. This is financial literacy.
Financial literacy is an individual’s cognitive ability to comprehend money issues and the skills required to manage contemporary and emerging personal finance matters such as investment opportunities, developing budgets, managing cash flow, etc. Financially literate individuals who apply their knowledge and skills wisely will have better chances of seizing opportunities and managing their finances than those who do not. Thankfully, we can develop financial literacy and skills over time through reading books, listening to podcasts and engaging with professionals. The scope of financial literacy is wide and can be captured rather simply as shown below.
The interest, ability and willingness to develop short- and long-term personal budgets is an indicator of the level of our individual financial literacy and money discipline. Financial literacy and the discipline that comes with it give us independence and confidence and help protect us from possible financial difficulties and consequential physical and mental health issues.
Principles of personal budgeting: There are a few crucial issues in budgeting that we should be aware of. These include:
- Know your revenues and income – Depending on what we do, we all have what we make as revenues and incomes on some periodic basis such as monthly salaries, quarterly commissions, annual dividend, etc. You need to know what you are currently making and what you may be making in the future.
- Know what your operating bills and any obligations are – We all have operating bills that must be settled. These may include grocery expenses, utility bills, transportation costs, school fees, etc. We may also have certain debt obligations that we will need to settle. You need to know what these bills and obligations are or may be during the budget period.
- Monitor assets and liabilities – Beyond revenues, incomes, operating bills and obligations, we need to understand various classes of assets we may have (or plan to acquire) and liabilities we may owe as well as their likely periodic returns, carrying costs or net impact on our wealth.
- Do only what you can afford to – A great financial philosophy and discipline is to ‘do only what we can afford’. However, we are often faced with situations when we just have to bear certain necessities that we probably cannot afford financially at the moment. Other times, we may need to borrow to seize certain opportunities. In both cases, we can positively consider taking on debts but we have to be clear about what the cost-benefits are and have a realistic repayment plan.
- Understand the time value of money – Our empirical experiences suggest the tendency for the same amount of money we may have to lose value over time, generally due to inflation. An upside is that ‘compounding’ is also real, which means if we can invest in an asset whose annual returns beat the rate of inflation, we can make substantial real gains over time.
- Be conservative – ‘Conservatism’ is a wise practice in both accounting and finance. It advocates that when deciding between conflicting reporting options, the alternative with a lower value {in the case of revenues and assets (except in case of a plan for say an acquisition)} or a higher cost (in case of expenses and liabilities) should be chosen. In addition, if there are uncertainties about incurring a loss or receipt of a gain, the loss should be recorded but the gain should be ignored until it occurs.
The personal budgeting process: The budgeting process is a reasonably simple one. It involves:
- Purpose and Period: The first thing to be clear of is the purpose and/or period you are drawing the budget for. I mean, drawing a shopping budget, which is within the scope of the month’s budget, is different from drawing an annual budget. So, you need to be clear about what the purpose of the budget is and the period it aims to cover. Whilst we should have a long-term plan and perspective on our finances, what is practical is to draw an annual budget and then monitor it on a monthly basis, tweaking it per emerging realities.
- Opening balances: We mostly don’t start with ‘zero’ balances for most of our accounts. We would possibly have some cash on hand and bank balances as well as various assets and perhaps some liabilities. We need to have our opening balances for each revenue, income, asset and liability account.
- Sources of revenues and incomes: You will need to bring out all inflows for the budget period such as pension payments, dividends, annual rental income, etc. The incomes and revenues that are ‘guaranteed’ such as salaries from your reputable employer should be captured as expected whilst those you aren’t sure of, such as dividends, should be estimated and treated conservatively.
- Capture all your outflows: You will also need to make estimates of all likely outflows for the budget period. These may include current expenses such as the earlier-mentioned grocery and utility bills. It should also capture what we can call as ‘capital payments’ such as the purchase of a vehicle and payment of annual school fees for the children due in the budget period.
- Research! We may have good estimates of what some bills such as utility and school fees might be. However, we may need to engage in some research for us to establish what some other costs and expenses might be. Estimates should be realistic.
Next week we will draw up a simple personal budget.
