To lead a decent life one needs money. Financial planning deals with this money management.
An individual or a family must have sufficient money to meet their current expenses and also future expenses.
But from where this money will come?
People generally work to generate income. There are people who work for salary.
There are people who has their own business.
No matter what ever is ones profession, to lead a decent life ones source of income must be predictable.
Generally, people focus too much on their immediate needs.
In this process, people fail to foresee the future requirements.
These requirements may be future now, but when it arrives, they become unavoidable.
Few examples of such requirements are:
- Medical emergency,
- Higher education for child etc.
Plan for future needs
It is essential for people to have a financial plan in place for such future requirements.
One cannot afford a delay to start arranging for finance for such future needs.
There is a typical peculiarity of most future needs, all of them are extremely capital intensive.
Hence it becomes even more imperative to plan “very early” for their realisation.
A delay will only ensure that sufficient funds are not available at the right time.
So the first step of financial planning is to set aside a preplanned amount towards fulfilment of future needs.
But what one should do with this set aside amounts?
These amounts should be used to accumulate assets.
These assets in turn helps in capital appreciations or additional income generation.
A “complete financial plan” not only deals with capital appreciation or income generation.
The scope of financial planning is much wider:
- It ensures emergency fund creation.
- It deals with adequate life insurance coverage.
- Evaluates what saving is essential to fund all needs.
- Plans the purchase of specific assets.
These assets in turn helps to manage all current and future needs
Financial planning is a process which makes people aware of the present and future.
It identifies all present and future goals (needs).
It then does a scrutiny on ones income and expense pattern to understand if the person is saving enough on not.
Selection of right investment products (assets) & its systematic inclusion in investment portfolio is also a part of financial planning.
Before we go deeper into the meaning and implementation of personal financial planning, lets know about following terms:
- Liabilities &
- Net Worth
For a person who wants to improve his personal finances, must know and use these terms in a right way.
People often confuse between asset and liability.
There are majority living in this world who know only income and expense.
But in order to improve ones finances, one must focus hundred percent on building a decent net worth.
Like big companies manage balance sheet, individuals must manage their net worth.
#1. Asset Accuumulation
All financial transactions has its origin in income.
A person whose income is high, will spend more and also save more.
A person whose income is low, will spend less and save less.
No matter whatever is ones level of income, a portion of income is used to fullfill current expenses.
The balance portion is set aside as savings.
These savings are essential to manage future needs.
When person is earning more than he/she is spending, their finance is said to be in order.
But it may happen that even for such people, financial dis-balance may creep in.
Such short term imbalance can be managed by resorting to bank loans.
But if a person has to resort to “high debt” to fund their current needs, its an indication that, at some point in the past, the financial planning was not done.
One must plan for what? Asset accumulation.
Ideally, people must accumulate assets with objective to sell them in future when need comes.
Systematic purchase of assets over a period of time comes in the purview of personal financial planning.
There are two types of assets:
- Physical asset (real estate, gold etc)
- Financial assets (bank deposit, stocks, mutual funds etc)
Traditionally people love physical assets as they are things that people can see and feel.
The feel of ownership is more dominant in case of physical assets.
This is one reason why physical assets are always in demand.
Hence, they provide excellent inflation hedge for the investors.
Financial assets are instruments that are bounded by strong government regulations.
Hence information available related to these financial products are very reliable.
These information (like stocks data) people can use to evaluate these types of assets in a much better way.
#2. Minimise Liability
Ideally people must buy assets from their savings.
But more often than not, people resort to bank loans to buy assets.
Loans substantially decrease the potential return of an asset.
There are some assets which are very difficult to buy solely on basis of savings (like a house property).
In such cases availing a loan becomes necessary because acquiring a house property requires a huge one time investment.
As a rule of thumb, even the costliest of asset purchase must be funded as below:
- 50% financing from savings and,
- 50% from loan.
If this rule is maintained, liability management becomes easier.
So next time when you go to buy your car, make sure that you make 50% down-payment and balance is loan.
#3. Be aware of your Net Worth
Financial health of people is estimated by calculating their net worth.
The calculation of net worth is done by this formula:
Asset – Liability = Net Worth.
Target should be to keep improving ones net worth month after month.
This can only happen if one increases his assets base and decreases the loan of liability.
The overall purpose of financial planning is to assure growth of ones Net Worth year after year.
Purchase of more and more assets in ones portfolio will assure net worth increase.
#4. Financial Planning for future needs
Generally people look for experts advice for personal financial management.
I think its better to take advice of experts when it comes to money management.
But I will suggest my readers to do a small home work before approaching an expert.
Preparing a rough financial plan for oneself will give a great deal of clarity to an individual.
Once this rough plan is in place, talking to a financial advisor will become more effective.
Answering the following questions for SELF.
This can take you a long way into depths of financial planning.
#4.1) What is my Financial Position?
To understand ones current financial position, it is important to evaluate following things:
- Quality of income.
- Quality of net worth
If a person scores high in ‘quality of income’ and in ‘quality of net worth’, it means that his financial position is good.
What means by high scores? Lets read more…
#4.1.1 QUALITY OF INCOME (Grades Required: 90%)
One may be earning very handsomely, but still he may get poor grades in terms of “Quality of Income”.
Similarly, an average earning person may fare very well in quality of income. How?
There can be 2 source of income:
- WORK INCOME – Salary income or income from business
- PASSIVE INCOME – Income from assets (rent, interest, dividend etc)
A financially dependent person in more dependent on income from work income.
The reason why such people are called dependent because, if for any reason they cannot continue working their income will stop.
This is undesirable.
A financially independent person in free.
His source of income is more from passive income.
The reason why such people are called independent because, they can generate passive income.
This passive income in turn supports their cost of living.
Passive income is a this type of income will continue to yield even when you are asleep.
A good financial planning motivates people to increase their passive income as much as possible year after year.
So, first a person must understand how dependent he or she is on work income.
Suppose a person total monthly expense is Rs 100,000.
Out of these Rs.100,000, Rs.45,000 are those expense which are unavoidable.
If the person generates Rs.15,000 from passive income, he is only 33% independent (15K/45K).
To earn high grades in quality of income, the person must be at least 90% independent.
#4.1.2 QUALITY OF NET WORTH (Growth Required: min 12%)
Net Worth = Asset – Liability.
Ideally a person must keep liability to zero.
As a rule of thumb asset liability ratio must be greater than two (2).
Generally people track their performance of investment portfolio.
But I will suggest people to keep a track of their Net Worth.
When a persons net worth is growing at a rate more than 12% per annum, it can be considered good.
I will advice my readers to main their asset liability chart in an excel sheet.
A typical net worth must look like this:
#5) Set Goals and achieve it…
Identification of financial goal must be done with care.
There are three components for any goal:
- Clear Description of Goal
- Associated Value to the Goal
- Time in hand before realisation of the goal.
A typical example of goal listing is as below:
|SL||DESCRIPTION OF GOAL||PRESENT VALUE||TIME|
|1||CAR PURCHASE||6,00,000||3 YEARS|
|2||HOME LOAN CLOSURE||35,00,000||5 YEARS|
|3||HIGHER EDUCATION||25,00,000||12 YEARS|
Future Value = Current Value x (1 + Inflation Rate) ^ (time in years)
This way the future value of goals will be as follows (inflation@ 6% p.a.):
|SL||DESCRIPTION OF GOAL||FUTURE VALUE||TIME|
|1||CAR PURCHASE||7,15,000||3 YEARS FROM TODAY|
|2||HOME LOAN CLOSURE||35,00,000||10 YEARS FROM TODAY|
|3||HIGHER EDUCATION||50,31,000||12 YEARS FROM TODAY|
|4||RETIREMENT||3,20,00,000||20 YEARS FROM TODAY|
In order to fund future goals one can do the following:
- Sells accumulated assets
- Take loan
If one has sufficient assets to fund their future goals, this is a ideal condition.
But it takes time for assets to build.
Hence it is imperative that one must start early the process of asset accumulation.
Now, in order to accumulate assets worth as indicated above one must select a suitable investment vehicle.
Based on the time horizon and value one needs to gather, following investment option should be preferred:
|SL||DESCRIPTION OF GOAL||FUTURE VALUE||VEHICLE|
|1||CAR PURCHASE||7,15,000||BALANCED FUND|
|2||HOME LOAN CLOSURE||35,00,000||BLUE CHIP MUTUAL FUND|
|3||HIGHER EDUCATION||50,31,000||DIVERSIFIED EQUITY FUND|
|4||RETIREMENT||3,20,00,000||DIVERSIFIED EQUITY FUND|
Potential investment return that one can earn on above investment vehicles are as follows:
|1||BALANCED FUND||12% P.A.|
|2||BLUE CHIP MUTUAL FUND||15% P.A.|
|3||DIVERSIFIED EQUITY FUND||16% P.A.|
|4||DIVERSIFIED EQUITY FUND||16% P.A.|
With the above reasonable assumptions, lets use my SIP Calculator to calculate what monthly contribution will be required to build the corpus:
|SL||DESCRIPTION OF GOAL||FUTURE VALUE||POTENTIAL RETURN||TIME||MONTHY CONTRIBUTION|
|1||CAR PURCHASE||7,15,000||12% P.A.||3 YEARS||16,557|
|2||HOME LOAN CLOSURE||35,00,000||15% P.A.||10 YEARS||13,286|
|3||HIGHER EDUCATION||50,31,000||16% P.A.||12 YEARS||12,506|
|4||RETIREMENT||3,20,00,000||16% P.A.||20 YEARS||21,269|
This table will highlight, how a monthly contribution of Rs.63,618 at an average return of 12.66% will help in achievement of goals:
|Year||Monthly Contribution||Average Return of Portfolio||Appreciated Value of Portfolio||Redemption from Portfolio|