Foundation — Cash flow management, the household budget and the personal balance sheet

3.1 Why cash flow management matters

"The cash flow is the STARTING POINT of the whole personal finance process. The TIME and the AMOUNT of income that is generated and the TIME and the AMOUNT when this is spent as expense is CRITICAL to ensure that there is a PROPER BALANCE maintained between the two."

"The TIME of the cash flow becomes critical because the INCOME HAS TO BE AVAILABLE WHEN EXPENSES CROP UP. A very good example of a balance... is that of a SALARIED individual who gets a MONTHLY income in the form of salary and whose expenses are also due MONTHLY like payment of ELECTRICITY, TELEPHONE BILL, SALARY TO HOUSEHOLD STAFF."

"Even a SLIGHT MISMATCH between the cash flow can lead to the NEED FOR DEBT which is COSTLY. If there is a situation wherein the income comes in at UNSPECIFIED TIME INTERVALS, but the expenses are EVENLY SPREAD OUT then this can lead to a short term mismatch. This has to be met through debt, which comes at a cost in the form of interest. The interest becomes an EXTRA OUTGO, which REDUCES THE SAVINGS FURTHER."

The consequences the chapter draws out:

• "Cash flow MISMANAGEMENT can become a SOURCE OF TENSION for the individual and family. This can DISRUPT NORMAL LIFE AND PEACE in the family... This can further lead to HEALTH PROBLEMS if the tension persists over a period of time."
• "Cash flow management ensures that there is a CONTROL over the finances... There is a SENSE OF EMPOWERMENT that this gives, because there is CONFIDENCE that things are being handled in a proper manner. It also makes for SMOOTH RUNNING OF THE HOUSEHOLD as funds are available as and when required."

3.2 Preparing a household budget

"Preparing a household budget entails an understanding of THE SOURCES FROM WHICH THE HOUSEHOLD RECEIVES INCOME, and the APPLICATION OF THESE FUNDS IN A TYPICAL MONTH."

"start with the various HEADS OF INCOME... Some of it might be REGULAR in nature while there might be heads like INVESTMENT INCOME that is NOT REGULAR and which comes INFREQUENTLY."

The three expense heads

Table 3.1 — Monthly Household Budget of ABC Family

Surplus in hand versus savings — the key distinction

"The DIFFERENCE between MONTHLY SURPLUS IN HAND and SAVINGS is to be noted. The monthly surplus in hand is calculated AFTER MANDATORY DEDUCTIONS, such as contributions made to PROVIDENT FUND and NATIONAL PENSION SYSTEM. THESE ARE ADDED BACK to the monthly surplus in hand to ARRIVE AT THE SAVINGS."

So savings (Rs 34,000) = PF contribution (Rs 9,000) + investments (Rs 18,000) + surplus in hand (Rs 7,000) — the PF is a saving even though it never reaches the household's hands.

"Let us assume that 6 months expenses need to be covered. Monthly expenses to consider are Rs 79,000 (regular expenses) and Rs 12,000 (loan servicing) i.e. Rs 91,000."

3.3.1 Cash management

"On paper there could be a situation wherein there is some savings or surplus that is being seen, but this has to MATCH WITH THE ACTUAL CASH FLOW because the income and expense figures HAVE TO BE BACKED BY ACTUAL CASH."

The Sunita example: "Sunita earns Rs 50,000 a month... In reality there is something more that needs to be seen and this is whether the FULL AMOUNT of Rs 50,000 has been RECEIVED every month. It could be that there are several components to Sunita's salary, let us say, Rs 15,000 of various REIMBURSEMENTS that need to be CLAIMED. If in a particular month this figure has NOT BEEN CLAIMED, then the ACTUAL CASH INFLOW would be JUST Rs 35,000. This can throw the entire calculation out of control and there could be a CASH CRUNCH."

"On the expense side too... If TOO MANY EXPENSES COME RIGHT AT THE START OF THE MONTH then the overall cash balance could run low... Too many expenses right in the first few days of the month can also lead to a problem IF THE INCOME IS DELAYED FOR EVEN A FEW DAYS."

The two remedies:

• "a SURPLUS AMOUNT would always be MAINTAINED IN THE BANK OR IN CASH"
• "the creation of a SEPARATE FUND set aside for this purpose. This is DIFFERENT FROM AN EMERGENCY FUND that is used to tackle INCOME DISRUPTION. This separate fund just helps to tackle some SHORT-TERM CASH MISMATCH."

3.3.2 Income and expenditure statement

"gives a view of the FINANCIAL FLOWS for an individual or household for a SPECIFIC TIME PERIOD... this could be a year or month."

"There is a SLIGHT DIFFERENCE between the income and the expenditure statement AS COMPARED TO THE CASH STATEMENT because there can be SOME ITEMS IN THE INCOME AND EXPENDITURE STATEMENT THAT HAVE NOT BEEN RECEIVED OR PAID YET."

Two examples the chapter gives:

• "Salary: An individual might be receiving their salary on the FIRST OF THE NEXT MONTH. However, the income and expenditure figure would include the figure IN THE PREVIOUS MONTH since this PERTAINS TO the previous month."
• "Credit card: expenses made using a credit card but the payment for this could be DUE LATER when the free credit period is over... Still, this would have to be included in the expenditure statement FOR THE PERIOD IN WHICH THE EXPENSE WAS ACTUALLY MADE."

"The income and expenditure statement shows the extent of the SURPLUS OR SAVINGS that is generated and this can also give an idea about WHERE THE MONEY IS ACTUALLY GOING and WHAT NEEDS EFFECTIVE CONTROL."

3.4 Budgeting and forecasting

"Income has to be REGULAR AND STABLE to be able to be assigned to expenses. The income is FIRST used to meet MANDATORY expenses such as REPAYMENT OF LOANS AND PAYMENT OF TAXES. The REMAINING income is NEXT used to meet ESSENTIAL expenses... DISCRETIONARY expenses, such as those on ENTERTAINMENT AND RECREATIONAL ACTIVITIES, are NEXT met... The EXCESS income available is the SAVINGS."

"However, meeting goals and future needs CANNOT BE DONE IF SAVINGS IS AD-HOC. Prudent financial management requires that a DEFINED LEVEL OF SAVINGS SHOULD BE TARGETED that is essential to meet goals."

The four steps to making a budget

1. "LIST AND TOTAL the REGULAR AND DEFINITE INCOMES that will be received in the period."
2. "LIST AND DEDUCT the MANDATORY EXPENSES from the total income. WHAT IS LEFT IS THE DISPOSABLE INCOME."
3. "IDENTIFY ESSENTIAL LIVING EXPENSES of the household and DEDUCT from the disposable income."
4. "LIST THE DISCRETIONARY EXPENSES and deduct it from available income TO ARRIVE AT THE SAVINGS."

"The INCOME CANNOT BE EXPANDED BEYOND A CERTAIN LEVEL. The FOCUS SHOULD BE ON MANAGING THE EXPENSES to enhance savings. If the mandatory expenses are too high, it may be because of the PRESSURE FROM LOAN REPAYMENTS. A DEBT RATIONALISATION EXERCISE with a financial planner may help reduce the burden. DISCRETIONARY expenses and living expenses to some extent are areas where a household can focus on CUTTING BACK OR POSTPONING."

The six conditions of forecasting

"Forecasting or projecting is the ABILITY TO LOOK AHEAD AND PLAN FOR THE FUTURE."

1. "involves PREDICTING THE FUTURE SITUATION that is expected to arise... the final forecast will be based on the CONDITIONS PREVALENT AT THAT POINT OF TIME"
2. "There has to be a SPECIFIC BASIS on which forecasting is done. It is NOT JUST A RANDOM EXERCISE"
3. "The various EVOLVING CONDITIONS are taken into consideration. This makes forecasting a DYNAMIC EXERCISE"
4. "There are several ASSUMPTIONS... these need to be looked at closely. Assumptions CAN ALSO CHANGE along with the change in overall conditions"
5. "There might be a need for SEVERAL EXPERTS OR EXPERT OPINION... as ONE PERSON MIGHT NOT KNOW ABOUT ALL THE AREAS"
6. "There has to be some EXPERIENCE present for the person making the forecasts. The more one does it, THE BETTER IT GETS"

"The forecast also has to be SEEN IN THE CONTEXT OF WHAT ACTUALLY HAPPENS so that the REAL SITUATION IS UNDERSTOOD and DEVIATIONS IF ANY ARE PLUGGED."

3.5 Monitoring budgets and provision for savings

"The process of monitoring involves RECORDING THE ACTUAL INCOME AND THE EXPENSES that have arisen... The ACTUAL FIGURES WHEN COMPARED TO THE BUDGET PLAN will give an idea of HOW ROBUST THE BUDGET PLANNING ACTUALLY WAS. It is NOT LIKELY that every item... will end up with the same actual figure, thus the VARIATION WITNESSED GIVES A BETTER PICTURE of the strength of the budgeting process."

The conveyance example: "if there is a provision of Rs 4,000 a month for conveyance and the average conveyance expense comes to Rs 6,000 for a few months then it is clear that EITHER the budget figure HAS TO BE RAISED OR the individual has to CHANGE THE MODE OF CONVEYANCE to reduce cost."

"There can be an END OF THE MONTH monitoring... but the effort also depends on the kind of RECORD KEEPING that is taking place. If there is a REGULAR NOTING DOWN OF EXPENSE, then even a MID MONTH REVIEW can be made."

Closing the savings gap — the five steps

"a person could have a savings of Rs 15,000 per month but if the goals require an investment of Rs 30,000 a month then this is NOT ENOUGH." When "the gap between the actual and the desired savings is HUGE", a step by step approach is needed:

1. "A TARGET of raising the savings rate by a specified percentage might be set. This could be something like 10 per cent which is NOT TOO DIFFICULT to achieve."
2. "The target once achieved would result in a FURTHER TARGET being set. This will ensure that there are CONSTANT EFFORTS."
3. "ELIMINATION OF WASTEFUL EXPENDITURE and CUTTING DOWN ON DISCRETIONARY EXPENSES are a good way to raise the savings rate."
4. "LUMPSUM OR LARGE RECEIPTS should be DIRECTLY DIVERTED TOWARDS SAVINGS."
5. "HIGHER INCOME SHOULD NOT BE COMMITTED TO SOME ADDITIONAL EXPENSE but this should be LEFT FREE FOR CONTRIBUTION TO THE SAVINGS RATE."

3.6 The personal balance sheet

"A balance sheet shows the FINANCIAL POSITION of the individual or household in the form of ASSETS AND LIABILITIES AT A PARTICULAR DATE."

"Assets... will include PHYSICAL assets like property, car etc. and FINANCIAL assets like investments in equity, debt and mutual funds. There might be some ADVANCES received by them along with their CASH AND BANK BALANCES which would form CURRENT ASSETS. On the liabilities side the various LOANS plus other payments outstanding including SHORT TERM DEBT LIKE CREDIT CARD DUES."

The Lakshmi example

"The net worth is the total assets of Rs 36,22,000 reduced by the total liabilities of Rs 12,07,000 (Rs 12,02,000 + 5,000) giving the amount as Rs 24,15,000."

The chapter's own analysis of Lakshmi: "As compared to the value of the house, the INVESTMENT FIGURE IS STILL A BIT LESS and these are also NOT MUCH INTO GROWTH ASSETS like equity and equity oriented mutual funds. The amount lying in the bank is ALSO NOT VERY HIGH. On the other side the NET WORTH FIGURE IS RELATIVELY LOW BECAUSE MOST OF THE ASSETS HAVE BEEN ACQUIRED THROUGH LOANS and a large part of these are still outstanding."

3.7 Creating a budget and savings plan — the seven steps

• a. "GATHER all the relevant details about the various sources of income and expenses... unless this is present the budget would NOT REFLECT THE TRUE SITUATION"
• b. "CHECK to see that SOME AREA HAS NOT BEEN MISSED OUT... The WIDER THE COVERAGE of the areas, the better the budget will turn out to be"
• c. "BASE the budget figures on either ACTUAL EXPENSES that have been made IN THE PAST or if this has changed, then the kind of expense that are LIKELY"
• d. "There has to be some element of CHANGE in the various figures based on the TIME PERIOD. For example, when VEGETABLE PRICES show a SEASONAL SPIKE a higher amount needs to be allocated. A month in which there are a couple of BIRTHDAYS in the family might need a higher allocation for discretionary expenses"
• e. "There has to be a CONTINGENCY FIGURE that is present... this feature would ensure that the budget REMAINS ROBUST"
• f. "The amount of savings needed would have to be achieved through the CURTAILMENT OF EXPENSES WITHIN LIMITS. So, the REQUIRED SAVINGS FIGURE BASED ON THE GOALS needs to be present"
• g. "There has to be a PROPER ALLOCATION of the savings amount and this should be done BEFORE THE FIGURE IS SPENT ELSEWHERE. This is why there has to be a DIRECT TRANSFER to the various investments, so that the amount AUTOMATICALLY GOES EACH MONTH"

"Make the savings plan a PART OF THE FIXED FIGURE in the budget."

3.8 Contingency planning

The emergency fund

"An emergency fund needs to be THE FIRST GOAL towards which a household or individual should save as a protection against the possibility of loss or reduction of income."

• "The fund should be ADEQUATE TO MEET THE EXPENSES FOR SIX MONTHS, in the event the regular income is not available"
• "should be HELD IN LIQUID ASSETS, to enable EASY ACCESS"
• "If INCOME SECURITY IS HIGH, the fund can also be held in a LADDERED WAY, with the equivalent of around THREE MONTHS' expenses being held in LIQUID assets, and the rest... in LESS LIQUID assets BUT WHICH GIVES BETTER RETURNS"
• "If the emergency fund is USED then efforts must be made to REPLENISH IT AS SOON AS POSSIBLE"
• "The ADEQUACY... should also be PERIODICALLY REVIEWED. It should be done ANNUALLY or WHENEVER THERE IS A LARGE ADDITION, SUCH AS AN EMI, to the monthly expenses"

Holding patterns between spouses

• "ensure a HEALTHY DISTRIBUTION BETWEEN BOTH SPOUSES of the holdings of the family's assets and liabilities. For example, in some investments, one partner will be the FIRST HOLDER, while the other may be a JOINT HOLDER; the holding pattern can be REVERSED in some other investments"
• "In the case of DOUBLE INCOME families, the holding pattern can be CLOSELY ALIGNED TO THE SOURCE OF INCOME. Investment made out of incomes of one partner can be held with that partner as the FIRST HOLDER"
• "keep the SALARY ACCOUNT of each partner DISTINCT (with the other partner as JOINT HOLDER). This account is to be used ONLY FOR INVESTMENTS, or to TRANSFER FUNDS TO ANOTHER JOINT ACCOUNT that is used for meeting household expenses. Such SEGREGATION of investment flows and household expense flow helps in BETTER EXPENSE MONITORING, as well as INVESTMENT RECORD KEEPING AND TAX RECORD KEEPING"
• "When a HOUSING LOAN is taken, the partners can be JOINT OWNERS of the property as well as JOINT BORROWERS for the loan"