'With realization of one's own potential and self-confidence in one's ability, one can build a better world.' Dalai Lama
Add to this a solid, well thought out plan, and you've got a winning combination.
In all aspects of your life, you will do better if you have a plan. This need not necessarily be a full fledged detailed plan, but even a well thought out idea would do you good.
For example, suppose you were to plan a holiday. You wake up one day and you and your spouse decide that maybe it's time to take that vacation to Greece that you'll were thinking about.
Immediately, you start to plan.
You both will need leave from work.
The trip will cost roughly Rs. 1.50 lakhs. You already have say Rs. 50,000 idle in the bank, over and above your contingency fund. You need to add another Rs. 1 lakh to this. You decide to start a SIP into a liquid fund to set aside the funds each month.
Next August should be a good time to travel. You need to start looking into visa expenses, flight tickets and hotel bookings, sightseeing activities, and so on.
You narrow down on certain places or cities, you decide to spend a few days in each place... the details are exciting and you want to plan correctly so you have a wonderful vacation and build some excellent memories.
With realization of your own potential to plan things correctly and confidence in your ability to do so, you will give yourself a better vacation.
So why should your life be any different?
Look at how you planned the finances of your vacation. The first thing you did was estimate how much you would need. You then assessed how much you have already accumulated. You saw how much you would need to add and started putting the funds away.
So, your first step, was to assess where you stand today and where you want to reach.
Where your money is concerned, to do this, you need to first measure your financial health, and then determine how your money moves.
Measuring your Financial Health
When dealing with your personal finances, it is therefore important to start by knowing how financially healthy you are today. Generally most of us get a complete physical health check up once a year, especially after a certain age. This is done so that we know our health issues if any, and can treat any ailments before they cause any damage. Your finances are as important to you as your health, and deserve at least the same amount of care and attention.
Here we will cover 3 simple personal finance rules that you can start with, to see where you stand today.
- Debt to Income Ratio
Total monthly outgoings on liabilities (EMIs)
Debt to Income Ratio =
Total monthly income from fixed sources
Ideally, your debt to income ratio should not be higher than 30 - 35% as this means you are straining your income. This means you should not be spending more than 30 - 35% of your income on paying off your loans, including both the interest and the principal of the loan.
- Savings to Income Ratio
Total monthly savings
Savings to Income Ratio =
Total monthly income
Ideally, you should be saving at least 20% of your monthly income to save and invest. This does not mean you should put 20% of your income into a liquid fund or keep it as cash in the bank, but rather than your savings and investments both, should total up to at least 20% of your income.
So if you are earning Rs. 10,000 per month, you must save and invest atleast Rs. 2,000 per month. Of this, Rs. 500 might be your savings and Rs. 1,500 might be your investments.
Remember this figure is the minimum. If you can save and invest more, then do.
- Contingency Reserve
Contingency Reserve = 6 to 24 months of living expenses
You should set aside 6 to 24 months of living expenses as a contingency fund to be used only in times of emergencies. This should include any EMIs that you may have.
Once you implement these simple rules, you will find that your finances are more in your control and manageable.
Now that you have broadly assessed your financial standing today, you should move on to see how your money moves. What kind of spender are you, or what kind of saver?
Determining How Your Money Moves
This part of the article is fairly long, and hence for easy reading will be split into 2 parts, to be continued next Week.
Let's get started.
What are the financial habits, or lack of them, that have brought us to our current level of financial health? When you sit down to assess yourself, it is all really about only 2 things:
These 2 all important factors will determine whether you will be able to send your child to that excellent school, or buy the more beautiful house, drive the bigger car, take the longer vacations and retire those few years earlier.
- Are you living "within" your means or "below" your means?
By this, we mean is your level of saving the level that you require, or do you save that little bit extra – and invest it?
- What do you spend on and how much do you invest?
This means, is your expenditure primarily on luxuries or necessities?
And accordingly, are you investing as much as you can or are you spending the cash that could have been invested instead?
Let us go into this in some more detail...
Broadly, you have four important financial quadrants:
- Assets, and
Money tends to flow between the above quadrants.
Your income will fund your expenses and will also take care of the full or part purchase of any assets you may buy.
Part purchase of assets can be supported by taking on liabilities.
Your liability payments are in turn again funded by your income.
For all this to run smoothly, to generate wealth is to live within or preferably below your means by keeping an eye on your money flow.
For this, you need to first be aware of what your means are and what you are spending your money on. The use of a personal budget is the simplest and quickest way of assessing whether you are a spender or a saver. To successfully manage your personal cash flows, you will need a budget.
In our article next week, we will walk you through the 4 Simple Steps that will help you keep track of your monthly cash flows, bringing you one step closer to achieving your financial goals.