The first step in developing an effective financial plan is to understand your income and expenses. While this may seem elementary (and it is), most clients I work with have never correctly and completely tracked their cash flows. Many don’t know how to balance their checkbook, and almost none have tracked cash flows over a long enough time period to fully understand their financial picture. It’s very difficult to build an actionable financial plan without first completing the budgeting process.
To build a budget, we first need to gather data. It is a very good idea to create a spreadsheet in Excel or another spreadsheet program so you can track all income and expenses over time. If we are starting from scratch, we can use our current month’s data. The spreadsheet should contain a column for the current month — June for example, and all data for June should be entered into the spreadsheet in a single column under the June 2013 heading.
For those who earn a fixed amount each month, the income portion of the budget is fairly straight-forward — simply write down the net amount earned, after taxes and other deductions during the month. This becomes more important for those who do not earn the same amount each month, who have inconsistent income, and/or those who earn commissions or bonuses periodically. By tracking income over the course of a year, we can get a reasonably good idea of total net income, which can then be used in the budgeting and forecasting process of the comprehensive financial plan
For married couples, partners and/or those with multiple sources of income, each income source can be entered as a separate line item in the spreadsheet to accurately track the details of each income source month by month.
After all income sources have been identified and accurately entered into the spreadsheet, we can begin to address the expenses portion of the budget. I prefer to divide expenses into two broad categories: mandatory or nondiscretionary expenses and nonmandatory or discretionary expenses. Mandatory expenses are those expense items that we must pay each month. These include housing (mortgage or rent payments), utilities, car payments, gasoline, food, insurance, etc. I typically place mandatory expenses in a section just below income within the spreadsheet.
Discretionary expenses are those expenses that we don’t have to incur. These expenses include things like entertainment, vacation expenses, eating out, coffee at Starbucks, etc. I usually place discretionary expenses in a section below mandatory expenses in the spreadsheet.
Discretionary expenses are where the action takes place within the budget. These are the expenses that offer the best opportunities for improvement in our financial situations. Discretionary expenses can be reduced or in some cases eliminated, which can free up cash that can be used to pay down debt or save for investments, a home, college expenses, etc.
Within the discretionary expenses section, I like to prioritize these expenses, placing those that the client feels are the hardest to reduce or eliminate first, followed by those that will be easier to reduce or eliminate, in order, from toughest to reduce or eliminate to the easiest.
The process of prioritizing expenses is very subjective and is specific and personal to each person. One person’s easiest expense to reduce or cut may be the hardest for the next person. For this reason, each person should first write down all expenses and then evaluate each expense, thinking about how easy or hard it will be to reduce or eliminate each. Once all expenses have been evaluated, they can then be entered into the spreadsheet in their prioritized order.
Once all income and expenses have been entered into the spreadsheet, and the expenses are divided between mandatory and discretionary, and the discretionary expenses have been prioritized from hardest to reduce or eliminate to easiest, it is time to create a budget. The budgeting process is also a very specific, personal endeavor. Each person must create a budget that is viable over the long term, meaning it is realistic in the sense that it is something the person can stick to over time.
The budgeting process is very similar to dieting; every person is different, and we all have varying levels of discipline, time, focus, etc. A successful budget must reflect the ability of the individual to adhere to the spending changes required to meet the targets specified within the budget, again over the long term.
To create a budget, we use the actual income and spending data we have gathered and entered in our spreadsheet. I like to add a column in the spreadsheet directly to the right of the current month’s column so it is easy to compare the actual spending with the target spending amounts. We first look at all income sources to see if there is any way to increase income — can we work overtime, take on more projects, increase commissions and/or bonuses, etc.? Generally, it’s not an easy or simple thing for most people to increase income, but we need to consider any opportunities to do so.
The next step in the budgeting process is to review our discretionary spending items, one by one, evaluating each to see if we can reduce or eliminate them. If we have prioritized these expenses properly, those toward the bottom of the spreadsheet should offer the best opportunities for reductions or eliminations. Those toward the bottom should also offer the largest potential reductions/eliminations.
By working through all expenses one by one, we can set target spending levels for each expense. Targets for all income and expense items should be entered into the spreadsheet in the column to the right of the current month’s information. I also like to total the income items and the expense items for comparison. For example, if we are using June 2013 data, we want a total for all June 2013 income, a total for June 2013 mandatory expenses, and a total for June 2013 discretionary expenses. The budget column should also contain totals for the same categories for comparison.
We should also take the difference between the total income and the total of all expenses, so we can see if we are cash-flow positive or negative for the month and by how much. The same should be done for the budget — total income less all expenses — to see what our projected net cash flow should be if we hit all budgeted (target) amounts.
It is advisable to be realistic about how much expense reduction or elimination we target in our budget. We can adjust the target amounts for reductions/eliminations over time, as we grow more comfortable with the process.
Each month, we need to track all income and expenses, entering the following month’s data into the spreadsheet and comparing the results to the budget. If we are consistently missing the budgeted targets, we either need to adjust the budget or work harder to meet the target in the budget. Assuming that the net cash flow projected in the budget column is positive, we should make progress toward our long-term financial goals, if we can hit our budgeted targets each month. That cash can then be used to pay down debt, invest, save for long-term goals such as buying a home or paying for college expenses.
There are many other aspects to the budgeting and financial planning process, but this simple approach can go a long way toward putting you on the right path toward achieving long-term financial goals.