Personal Financial Planning: An "How-To" Guide (part 14)

Cash In/Cash Out: 

Preparing and Using Budgets

by

Charles Lamson

Many of us avoid budgeting like the plague. After all do you really want to know that 30 percent of your take-home pay is going to restaurant meals? Yet, preparing, analyzing, and monitoring your personal budget are essential steps for successful personal financial planning.

Once you define your short-term financial goals, you can prepare a cash budget for the coming year. Recall that a budget is a short-term financial planning report that helps you achieve your short-term financial goals. By taking the time to evaluate your current financial situation, spending patterns, and goals, you can develop a realistic budget consistent with your personal lifestyle, family situation, and values. A cash budget is a valuable money management tool that helps you:

1. Maintain the necessary information to monitor and control your finances
2. Decide how to allocate your income to reach your financial goals
3. Implement a system of disciplined spending---as opposed to just existing from one paycheck to the next
4. Reduce needless spending so you can increase the funds allocated to savings and investments
5. Achieve your long-term financial goals

Just as your goals change over your lifetime, so will your budget as your financial situation becomes more complex. Typically, the number of income and expense categories increases as you accumulate more assets and debts and have more family responsibilities. For example, the budget of a college student should be quite simple, with limited income from part-time jobs, parental contributions, and scholarships and grants. Expenses might include room and board, clothes, books, auto expenses, and entertainment. Once a student graduates and goes to work full time, his or her budget will include additional expenses, such as rent, insurance, work clothes, and commuting costs. Not until retirement can you expect this process to perhaps begin to simplify.

The Budgeting Process

Like the income and expense statement, a budget should be prepared on a cash basis, thus, we call this document a cash budget because it deals with estimated cash receipts and cash expenses, including savings and investments, that are expected to occur in the coming year. Because you receive and pay most bills monthly, you will probably want to estimate income as well as expenses on a monthly basis.

The cash budget preparation process has three stages: estimating income, estimating expenses, and finalizing the cash budget. When estimating income and expenses, you should take into account any anticipated changes in the cost of living and their impact on your budget components. If your income is fixed---not expected to change over the budgetary period---increases in various items of expense will probably cause the purchasing power of your income to deteriorate.Worksheet 1, "Annual Cash Budget by Month: An Excel Template," has separate sections to record your income and expenses and lists the most common categories for each.

Estimating Income

The first step in the cash budget preparation process is to estimate your income for the coming year. Include all income for the coming year: the take-home pay of both spouses, expected bonuses or commissions, pension or annuity income, and investment income---interest, dividend, rental, and asset (particularly security) sale income. When estimating income, keep in mind that any item you receive for which replacement is required is not considered income. For instance, loan proceeds are treated not as a source of income but as a liability for which scheduled repayments are required.

Note also that, unlike the income and expense statement, you should use take-home pay (rather than gross income) in the cash budget. Your cash budget focuses on those areas over which you have control---and most people effectively have limited control over things like taxes withheld, contributions to company insurance and pension plans, and the like. In effect, take-home pay represents the amount of disposable income you receive from your employer.

Estimating Expenses

 The second step in the cash budgeting process is by far the most difficult: preparing a schedule of estimated expenses for the coming year. This is usually done using actual expenses from previous years (as found on income and expense statements and in supporting information for those periods), along with predetermined short-term financial goals. Good financial records, as discussed in an earlier post, make it easier to develop realistic expense estimates. If you do not have past expense data, you could reexamine old checkbook registers and credit card statements to approximate expenses, or take a "needs approach" and attach dollar values to projected expenses. Pay close attention to expenses associated with medical disabilities, divorce and child support, and similar special circumstances.

Regardless of whether you have historical information, as you prepare your budget be aware of your expenditure patterns and how you spend money. After tracking your expenses over several months, you can study your spending habits to see if you are doing things that should be eliminated (like going to the ATM too often or using credit cards too freely).

You will probably find it easier to budget expenses if you group them into several general categories, rather than trying to estimate each item. Worksheet 1 provides an example of one such grouping scheme, patterned after the categories used in the income and expense statement.

Initially, your expense estimates should include the transactions necessary to achieve your short-term goals. You should also quantify any current or short-term contributions toward your long-term goals and schedule them into the budget. Equally important are scheduled additions to savings and investments, because planned savings should be high on everyone's list of goals. If your budget does not balance with all these items, you will have to make some adjustments in the final budget.

Base estimated expenses on current price levels and then increase them by a percentage that reflects the anticipated rate of inflation. For example, if you estimate the monthly food bill at $350 and expect 4 percent inflation, you should budget your monthly food expenditure at $364, $350 + $14 (4 percent X $350).

Do not forget an allowance for "fun money," which family members spend as they wish. This gives each person a degree of financial independence and helps provide a healthy family budget relationship.

Finalizing the Cash Budget

After you estimate income and expenses, finalize your budget by comparing projected income to projected expenses. Show the difference in the third section as a surplus or deficit. In a balanced budget, the total income for the year equals or exceeds total expenses. If you find that you have a deficit at year end, you will have to go back and adjust your expenses accordingly. If you have several months of large surpluses, you should be able to cover any shortfall in a later month. Budget preparation is complete once all monthly deficits are resolved and the total budget balances.

Admittedly, there is a lot of "number crunching" in personal cash budgeting. As mentioned earlier, personal planning software can greatly streamline the budget's preparation process.

Smart.sites Use the Family Budget Calculator at https://www.quicken.com/budget-calculator to compare how budgets vary by family type and area of the country.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 71-74*

END

Smart.sites

Use the Family Budget Calculator at https://www.quicken.com/budget-calculator to compare how budgets vary by family type and area of the country.