|Rediff India Abroad Home | All the sections|
How to plan your finances
BS Bureau | August 19, 2003
You may know how to read company balance-sheets, but have you ever tried to read your own personal balance-sheet?
If you've answered yes, try this quiz:
If your answer is no, welcome to the world of personal financial planning. And you'd better start now, for the later you start, the more difficult it will be.
Let's start with a question: if you need a certain amount of money -- say Rs 10 lakh (Rs 1 million) -- at the end of say 10 years, would it be easier to accomplish this goal by starting to save today, or in 2012? Obviously, today.
Because you have more time to accumulate the money, you can save a lower amount every year to reach Rs 10 lakh. If you begin in 2012, you have just a year to save it.
To be sure, financial planning is not rocket science. But it does require some simple arithmetic abilities. The rest of it is easy if you are disciplined. There are five steps to financial planning:
Step 1: Review you current financial status. This means figuring out your assets and liabilities.
Step 2: Work out your income and expenditures. All incomes, all expenditures.
Step 3: Clarify your long-term financial goals. This means defining why you need blocks of money -- for buying your Mercedes, marriage/education of a child, retirement, whatever.
Step 4: Plan a roadmap on how to get there: Priorities your goals, assess your saving abilities, and zero in on the investment avenues that suit your financial status best.
Step 5: Start saving and investing. But review the plan every year.
So how does one begin assessing one's current financial status? This is where some spreadsheet knowledge (Microsoft Excel will do fine) helps, since you can enter the numbers in columns and rows and the programme will do the calculations for you.
But even if you don't have a spreadsheet, you can always do the numbers on a plain sheet of paper.
Step 1 is crucial, since it will tell you what is possible immediately. Start first by listing your assets and their estimated current market values.
We are not talking about utensils and cupboards here, but assets that can be easily encashed, sold or liquidated.
Typically, at this stage we would include things like shares, bonds and mutual funds you own, bank deposits and balances, your flat and car, plus any valuables like jewellery, and the current surrender values of life insurance policies.
Let's say these add up to Rs 15 lakh (Rs 1.5 million).
Then start listing your liabilities. If you have taken a loan to finance your sister's wedding, the value of the unpaid balance would figure here as outstanding liability.
If you have run up a large credit card bill that you are repaying only in bits and pieces, add that amount too. Similarly for any home or car loans you have taken. Let's say these ad up to Rs 12 lakh (Rs 1.2 million).
On a spreadsheet, if you have listed your assets in one column and liabilities in another, you will know your net worth immediately - your assets minus liabilities. It will be Rs 3 lakh (Rs 300,000).
This is what you will be left with if you were to sell all your assets and repay your creditors. Why is this important for financial planning?
Knowing your net worth tells you how you can rearrange your existing assets to yield more income or prepay the liabilities that are costing you too much.
Step 2 is estimating your income and expenditure. This is what will give you an idea of how much you are saving now and what you may need to do about raising income or cutting spending to increase savings, if necessary.
Back to the spreadsheet. On one side list your current sources of annual income - salary (net after taxes), dividends, interest on fixed deposits, rental income, etc. If you and your spouse are doing this jointly, list the sources of both partners' incomes.
Then there's expenditure. This is the hardest part of the exercise. Most people know how much they earn, but very few people know where the money goes.
Ideally, what you should be doing is track you expenses daily for three months - using a separate spreadsheet. List them under broad heads like house rent/mortgage instalments, children's school fees, electricity, water and telephone expenses, insurance premiums, vegetables and groceries, conveyance and car expenses, eating out, payments to people employed by you (maid servants, drivers, car cleaners, etc), and miscellaneous.
After three months, split these expenditures into two categories: those easy to control and the rest. Controllable expenses are things like annual vacations costs, conveyance costs, miscellaneous expenses, etc.
Not so controllable are things like school fees, rentals, insurance, electricity and water charges.
A caveat: Nothing is actually beyond control, but the difference between what you can control and what you can't is something you have to define.
Rentals are controllable if you are willing to move to a smaller flat or a distant suburb. Insurance costs are controllable if you surrender a money-back policy and opt for pure life insurance.
But this is partly subjective. Once you have done this, adding up the incomes and subtracting the expenditures will give you your current annual saving ability.
Which bring us to step 3 - estimating your financial goals. Most of us have ideas about buying a bigger house, taking a vacation abroad or saving up a particular sum for retirement.
Let's say you want to save up Rs 5 lakh for a trip abroad with your family. And you want to do it five years from now.
That's goal one. Goal two could be financing your son's MBA/study abroad, 10 years from now, for which you estimate another Rs 5 lakh (Rs 500,000).
You have to work backwards from your goals to figure out how much you need to save, given a certain rate of interest or return on investment.
For example, if you assume that your investment will give you annual returns of eight per cent, to save Rs 5 lakh five years from now you will have to invest Rs 6,800-and-odd every month.
You must do similar sums for the other Rs 5 lakh financial goal -- you son's education. Let's assume you invest assuming a return of six per cent in a safe and steady avenue.
In this event, you need to save around Rs 3,000 every month for the next 10 years. Taken together, this means you have to save Rs 6,800 plus Rs 3,000 every month for the next five years, and Rs 3,000 for another five years.
Step four is about deciding which goal is more important, and which ones you will take absolutely no risk of failure.
For example, if going abroad is important, but not as important as your son's higher education, this means you are willing to be accept that you will put off going abroad if you are not able to accumulate enough money for it, but there is no question about not saving for the second goal.
This automatically tells you where you are willing to take risks and where you are not. In the case of the MBA education plan, you will therefore work out safer avenues of investment; in the case of the trip abroad, you may be willing to take more chances with your investment.
You could put money in instruments like equity funds, since returns here could be higher or lower depending on market movements. It also means you may reach your target savings earlier or later.
That's why step five involves both acting on your priorities and reviewing them regularly.
What this means is this: if you have invested in a gilt fund and it shows lower returns than expected, you may need to reallocate the fund to another avenue that could improve your returns.
You will obviously take this decision after consulting some experts, but constant review and reallocation is central to financial planning. It's your job.
In a nutshell