Developing a Personal Balance Sheet and Calculating Net Worth

Creating a personal balance sheet involves consolidating various assets and liabilities in one place to reflect an individual or household's financial position at a specific date.

Developing a Personal Balance Sheet i Key To Financial Planning

It is crucial to understand how things stand at a particular time, as shown by the balance sheet. Here's how assets and liabilities are typically categorized for an individual or household:

Assets:

• Physical assets like property and vehicles

• Financial assets such as investments in equity, debt, and mutual funds

• Cash, bank balances, and advances received, forming current assets

Liabilities:

• Loans, outstanding payments, and short-term debts like credit card dues

The difference between assets and liabilities determines the individual or household's net worth. Income plays a fundamental role in financial activities, covering current expenses and setting aside savings for future needs. Savings are crucial for stability, ensuring expenses are managed within income limits. While loans can bridge short-term imbalances, they should be used judiciously to avoid straining future finances.

Household savings are invested in assets, which can be physical (e.g., real estate, gold) or financial (e.g., bank deposits, equity shares). Physical assets are tangible and often serve as growth investments with value appreciation over time. On the other hand, financial assets represent claims to benefits and returns, with different liquidity features and regulatory controls.

The financial strength of a household depends on how assets are acquired. Loans used to buy appreciating assets contribute to long-term wealth, while leveraging to buy financial assets can be risky due to price volatility. Calculating net worth regularly (Assets - Liabilities) helps assess financial well-being and track progress towards financial goals.

Monitoring changes in net worth over time can reflect the value of assets and overall financial progress.

The Significance of Managing Cash Flow in Personal Finance

The foundation of the entire personal finance process lies in cash flow. It is crucial to maintain a proper balance between the timing and amount of income generated and the timing and amount of expenses incurred.

Cash flow management is key to your financial success

Timing is crucial when ensuring that income aligns with expenses. For example, a salaried individual with monthly income and expenses like utility bills and staff salaries demonstrates a balanced financial scenario. However, even a slight mismatch between cash flow can lead to the necessity of debt, which can be costly. If income arrives irregularly while expenses are consistent, a short-term financial gap may arise, requiring debt with added interest costs, reducing savings.

Efficient cash flow management provides financial control for families and individuals, instilling a sense of empowerment and confidence in handling finances effectively. This approach ensures a smooth household operation with funds readily available when needed.

Household Budget Preparation

Creating a household budget involves understanding the various sources of income and how these funds are utilized in a typical month. Here's how to approach preparing a household budget:

• Start by identifying the different income sources and listing the amounts received from each source to determine the total income. This can include regular income as well as irregular sources like investment returns.

• On the expenditure side, there are mandatory expenses that must be covered, essential living costs for daily needs, and discretionary expenses that can be adjusted if necessary.

• The variation between total income and total expenses reveals the savings managed by the household. Depending on the household, there may be one or multiple earners contributing to the income.

The income and expenditure statement reveals the surplus or savings created, offering insight into spending patterns and areas requiring effective financial management.

Budgeting and forecasting

The income of a household or individual must be sufficient to cover present expenses and save for future assets. By managing current expenses, it becomes easier to secure the financial future of the household. Understanding the income and expenses of the household is crucial for effective personal financial management.

The process of creating a budget involves the following steps:

• Firstly, list all regular and fixed incomes expected during the period and calculate the total.

• Deduct mandatory expenses from the total income to determine disposable income.

• Next, subtract essential household living expenses from the disposable income.

• Finally, list discretionary expenses and subtract them from the available income to determine the amount that can be saved.

Predicting or projecting involves anticipating and preparing for what lies ahead. This process involves analyzing current data and circumstances, and using this information to estimate future figures based on anticipated changes.

Supervising budgets and setting aside funds for savings.

Continuous monitoring of the budget is essential. If discrepancies are identified, corrective actions must be taken to adjust future budget figures. Persistent deviations from the budget indicate a need for improvement in planning through upcoming changes.

The ultimate goal of budgeting is to ensure a surplus after expenses, allowing for savings. These savings can then be allocated for future investments. Subsequent financial planning steps can only proceed if savings are accumulated.

There may be a slight disparity between the desired savings and the actual amount saved, which can be easily rectified. However, the real challenge arises when there is a substantial gap between the desired and actual savings. In such cases, a gradual approach is necessary to increase the savings level. Here are some steps that can help bridge the gap:

1. Set a target to increase the savings rate by a specific percentage, such as 10%, which is an achievable goal.

2. Once the initial target is met, establish a new target to maintain continuous efforts to boost the savings rate.

3. Focus on how savings are accumulated. Cutting out unnecessary expenses and reducing discretionary spending can effectively raise the savings rate.

4. Direct any large windfalls or lump sums towards savings to give a significant push to overall savings.

5. Avoid committing additional income to new expenses; instead, allocate it towards increasing the savings rate.

   
   

Efficient cash management is crucial for every budget, as it prevents any financial crisis by ensuring that there are sufficient funds to cover expenses when needed.

What is inflation?

In simple terms, you could have purchased 1 kg of Mango in 2013 for Rs 100, now the same quality mango comes for Rs 150, leading to a 50% increase in cost i.e. 5.5% per year cost increase, also called inflation.

Cost increase is a real pain for everyone

Why does this happen?

Demand-Pull

When too many people demand more because they could afford to spend more. As a result, the prices of products go up.

Supply Push

When the supply of products goes down. Supply-side factors could be due to the outbreak of war, poor weather, increase in labor prices, etc.

Is inflation good or not?

Is inflation good or not? A simple answer is that inflation should be there but at a moderate level.

High inflation will make the overall economy tremble. Everything will start to become expensive. The central bank will have to increase interest rates to tame inflation but the cost will be a sluggish, slow-growth economy.

Similarly, if the inflation is zero, the central bank will run out of policy-level level tools to boost the economy. A central bank can boost the economy by decreasing interest rates. But if the inflation is close to zero, RBI will not be able to boost the economy.

A good state is to have 3-5% inflation in the economy so RBI can manage inflation better.

As an individual, we can manage inflation by working on our skills. High inflation will not cause any problems for doctors, lawyers, consultants, etc. So invest time and effort to deal with inflation by acquiring high skills so that you can command better compensation or fees. This will easily take care of inflation scenarios.

The other option that helps in beating inflation is to allocate cash flows towards growth assets such as equities or real estate.