PFM Chapter-4 (Global)

Chapter 4: Budget and Emergency Fund You will learn how to prepare your client’s budget, how to align it with cashflow statement, networth and analysing the requirements of a client’s emergency fund Household budget is very important for any individual to plan their expenses in such a way that out of income, he is able to create surplus. The surplus thus created will be invested to meet future goals. Making household budget brings discipline in spending. Budget allocates future personal income towards household expenses, debt/loan repayments (EMI) and investment. Many unexpected expenses like medical emergency, loss of job, car breakdown also come up, if planning and budgeting not done, will lead to borrowings from friends or approaching banks for personal loans. Therefore keeping some money in savings account, Liquid funds of Mutual Funds etc. can help meeting these expenses. Households who get a fixed monthly income can plan their budget easily as income and expenses are known to them. More precautions need to be taken by families getting an irregular income. Households with an irregular income should keep two common major consequences in mind when planning their finances: 1. Spending more than their average income, 2. Running out of money even when income is on average. A household needs to estimate their average (yearly) income and spending, which will be relatively constant, needs to be maintained below that amount Learn to Make a Budget in Six Steps 1. Collect your financial information Before you start making household budget, collect all your financial statements, including:  Bank statements  Investment details  Recent utility bills  Credit card bills  Receipts from the last three months CFP Level 1 - Module 1 - Personal Financial Management - Global Page 1

You should have access to any information about your income and expenses. One of the keys to the budget-making process is to create a monthly average. The more information you can have, the better. 2. Calculate Your Income How much income do you get each month? If your income is in the form of a regular salary, where taxes are automatically deducted by employer and paid to Income tax department, then using the net income (or take-home pay) amount is fine. If you are self-employed , your income may not be fixed but it may vary every month, you need to be very careful while making budget as some months’ provision needs to be in cushion. Have realistic assumptions about your income and expenses need to be planned. 3. Make a list of monthly expenses Write down a list of all the expenses you expect to have during a month. This list could include:  EMI (Home loan, Car Loan etc.)  Rent (If staying in rented accommodation.  Insurance Premium (Annual, divide by 12 to keep monthly provision)  Groceries  Utilities  Entertainment  Personal care  Eating out  Baby-sitting charges  Transportation costs  Travel  Provision for Miscellaneous expenses  Savings/ Investments Use your bank statements, receipts, and credit card statements from the last three months to identify all your spending. 4. Identify fixed and variable expenses Fixed expenses are those mandatory expenses that you pay the same amount for each time. It Include items like EMIs, House rent payments, car payments, internet service, regular childcare, salaries of maids. If you pay a standard credit card payment, include that amount and any other essential spending that tends to stay the same from month to month. If you plan to save a fixed amount or pay off a certain amount of debt each month, also include savings and debt repayment as fixed expenses. CFP Level 1 - Module 1 - Personal Financial Management - Global Page 2

Variable expenses are the type that will change from month to month, such as:  Groceries  Gasoline  Entertainment  Eating out  Shopping etc. If you don't have an emergency fund, include a category for \"surprise expenses\" that might come up over the month and disrupt your budget. Start assigning a spending value to each category, beginning with your fixed expenses. Then, estimate how much you'll need to spend per month on variable expenses. If you're not sure how much you spend in each category, review your last two or three months of credit card or bank transactions to make a rough estimate. 5. Sum up your monthly income and expenses If your income is higher than your expenses, you are off to a good start. This extra money means you can put funds towards areas of your budget, such as investing for various goals or paying off debt. If you have more income than expenses, consider adopting the “50-30-20” budgeting philosophy. In a 50-30-20 budget, \"needs,\" or essential expenses, should represent half of your budget, wants should make up another 30%, and savings/investments and debt repayment should make up the final 20% of your budget. If your expenses are more than your income, that means you are overspending and need to make some changes. 6. Make adjustments to expenses If you're in a state where expenses are higher than income, find areas in your variable expenses you can cut. Look for places you can reduce your spending—like eating out less—or eliminate a category—like cancelling your gym membership. If your expenses are very high compared to your income, only reducing variable expenses will not help. You will have to reduce some of your fixed expenses and think of increasing your income as well. Aim to have your income and expense columns to be equal. This equal balance means all of your income is accounted for and budgeted toward a specific expense or savings goal. CFP Level 1 - Module 1 - Personal Financial Management - Global Page 3

How to Use Your Budget After you have set up your budget, you must monitor and continue to track your expenses in each category, ideally every month. Recording what you spend throughout the month will keep you from overspending and help you identify unnecessary expenses or problematic spending patterns. Take a few minutes each day to record your expenses, rather than putting it off until the end of the month. If you're not confident that you can budget your money, adopt the envelope system where you divide cash for spending into separate envelopes for different spending categories. When an envelope becomes empty, you'll have to stop spending in that particular category. As you use your budget, keep an eye on how much you have spent. Once you have reached your spending limit in a category, you will either need to stop that type of spending for the month or move money from another category to cover additional expenses. Your goal in using your budget should be to keep your expenses equal to or lower than your income for the month. Some tips on budgeting Once you have set up a basic budget, customize it according to your financial situation and goals. 1. If you work on commission based projects, be aggressive in saving to help cover periods when the market is slow and your revenue is low. 2. Divide your monthly income by weeks, and keep the cash you planned to spend in remaining weeks in a separate account until you need it. 3. Pay with a credit card only if you will have the money to pay it off at the end of the month. Otherwise, you will owe interest which is quite high. 4. Adjust your budget monthly if you find you overestimated or underestimated your expenses. Keep an eye on large expenses that only occur every few months, such as insurance payments. 5. If you tend to overspend in certain categories, use budgeting hacks such as switching to a cash-only budget. 6. Once your expenses are lower than your income, budget towards investing for your financial goals before you increase your spending. 7. Take time to learn other financial skills to improve your financial literacy and make your money work harder for you. 8. Become Financially Intelligent 9. Limit the budget period to one year. This allows goal setting for a manageable time frame. 10. Keep it simple and short. Avoid too much detail, which can make it confusing and hard to follow. The miscellaneous category can provide funds for the occasional discretionary cash purchase that doesn’t seem to fit elsewhere (just don’t overuse it). 11. Draft a budget that fits with the client’s income situation. Some clients have income that fluctuates substantially during a 12-month period. In this situation, two budgets could be prepared—one with anticipated income and another with a more conservative estimate that reflects situations such as receiving fewer commissions or less income from investments. CFP Level 1 - Module 1 - Personal Financial Management - Global Page 4

12. Keep it flexible. Expenses will not always follow an always-predictable path. Flexibility allows the client to deal with emergencies, opportunities, and difficulties that may arise. 13. Avoid information that does not aid the process. For example, it doesn’t matter if food was purchased at one grocery store or another — it’s all food. 14. Design the budget with specific goals in mind. 15. Budgets should be consistent in form and content from year to year. If the categories constantly change, you cannot measure progress. This does not mean that the categories should not change when warranted, just that they should normally be consistent. 16. Budgets are not only guides to spending and saving, they are tools for self-evaluation. When the client’s reality doesn’t match the plan, the differences must be evaluated. If the differences more accurately reflect normal spending patterns, the budget should be modified accordingly. 17. When designing the budget, keep in mind things that may be different in the future. Areas of change might include expected changes in income, changes in the status of family members, changes in activities, and changes in personal goals. These variables will affect the resulting budget. 18. Following a budget and maintaining the required records to determine whether the client is living within the budget is not always easy. It sometimes can feel intrusive, but the financial rewards are significant. Performa of a budget INFLOWS 2017 2018 2019 After Tax salaries 8,00,000 900,000 10,00,000 Dividend income 85,000 1,00,000 Interest income 20,000 35,000 50,000 TOTAL INFLOWS 8,20,000 10,20,000 10,60,000 OUTFLOWS Savings and investments (SIP) 1,60,000 150,000 2,10,000 Fixed Outflows EMI (Home loan) 20,000 20,000 20,000 EMI (Car loan payments) 16,000 16,000 16,000 Insurance premiums 15,000 15,000 15,000 Variable Outflows Food 80,000 80,000 80,000 Transportation 12,000 12,200 12,400 Utilities/household expense 95,000 99,750 1,04,750 Clothing/personal care 36,000 36,000 37,000 Entertainment/vacation 23,500 25,000 30,000 Medical/dental care 15,000 35,000 25,500 Miscellaneous 32,000 32,000 32,000 5,04,500 5,20,950 5,82.650 TOTAL OUT FLOWS 3,15,500 4,99,050 4,77,350 NET PROJECTED INFLOW CFP Level 1 - Module 1 - Personal Financial Management - Global Page 5

Financial Ratios After you have reviewed a client’s budget, you will want to evaluate whether the client is living in a financially-sustainable manner. Several financial ratios can help with this. Liquid Assets to Net Worth To learn how much cash (or equivalent) a client should have, relative to overall net worth, and financial professional can use this ratio. A healthy ratio is at least 15 per cent. Savings Ratio The savings ratio shows the percentage of gross income a client is saving for his or her future. A financial professional would normally want to see a minimum ratio of 10 per cent or higher. This general rule of thumb does not consider goal-achievement. Instead, it’s focused on savings habits that promote general financial well-being. Debt to Assets Ratio The debt to asset ratio measures liquidity with a focus on the client’s ability to repay debts and remain solvent. The ratio is calculated by dividing total debt by total assets. Look for a ratio of 50 per cent or less. Debt Service Ratio The debt service ratio is related to the debt to asset ratio. In this case, it divides annual debt repayments by annual net income. The result shows a client’s ability to service or repay debts. A reasonable target is 35 per cent or lower. A ratio of 45 per cent or higher is too high. Values between those two points identify the need for caution. Basic Liquidity Ratio Liquidity refers to the ability of an asset to be converted quickly and easily into cash. The basic liquidity ratio shows the number of months a client could continue to meet expenses from existing cash and cash equivalent assets (as well as other relatively liquid investments) after a total loss of income. The basic liquidity ratio divides liquid assets by monthly expenses: CFP Level 1 - Module 1 - Personal Financial Management - Global Page 6

This is also known as the current ratio when it is used to evaluate whether a business has enough liquidity to pay bills. When using the ratio with individuals, it can be referred to as an emergency fund ratio. This ratio indicates about money available with client to take care of emergency needs. Normally a ration between 3 to 6 months’ of expenses is recommended for a young person. This ratio should be more for people in old age or retired people. This ratio also should be more for a person not having consistent income. Emergencies can do substantial loss to any budget. A sudden requirement of a large amount of money to meet an emergency can ruin an otherwise sound financial plan. An emergency fund is one well-regarded solution to keep things on track Special Needs and Goals Some clients may approach Financial Planner for normal financial goals like buying a house, buying a car, investing for education of children, retirement planning, marriage of children etc. Some clients may have some special goals as follows:  Planning for short term vacation which was a dream  Planning for expenses related to divorce and remarriage  Planning to have sufficient amount of money for a chronic illness of family member  Planning for the needs of special children  Any other special need which has cropped up suddenly Every need will require customised solution. Planning for special needs will require separate funding; therefore professional financial planner has to make sure that in addition to providing for basic financial goals, these needs are also taken care of. For funding purposes, it’s possible that some expenses may already be budgeted. Food, for example, is likely already in the budget. However, any specialized nutritional requirements may need special attention. There will almost certainly be additional medical expenses that must be added to the budget. Most likely, this will require some give and take. Add to the medical budget and reduce one or more other areas. Once again, it may be possible to increase inflows through insurance coverage or other external funding resources, a frank and open discussion will help guide the process to a successful conclusion. The Envelope System The envelope system is a way to track exactly how much money you have in each expense category for the month by keeping your cash inserted in envelopes. At the end of the month, you can see how much cash is left by taking a quick peek in your envelope. Is not it very easy? If you feel that you overspend on say “Eating out” category every month, envelop system will be very useful as you can fix the amount of expense for a month and keep it in envelop. The envelope system is a great tool to help you stop overspending! CFP Level 1 - Module 1 - Personal Financial Management - Global Page 7

How the Envelope System Works One of the reasons we overspend is because there’s no one telling us when to stop. That’s where the envelope system comes in. It’s definitely going to help you stick to your budget. Here’s how it works: 1. Think of the budget categories that need a cash envelope. It’s a good idea to use the envelope system for items that tend to break your budget. Think of things like groceries, restaurants, entertainment, gas and clothing. You need to decide which budget categories get an envelope, but here are a few to think about:  Groceries  Restaurants  Health  Parlour  Car maintenance  Personal  Entertainment  Gifts 2. Estimate your budget amount. If you know you tend to overspend on things like baby showers, birthdays and other gifts, you need to look at limiting that to a certain amount for the month. If you buy unnecessary groceries also leading to more cash outflows, figure out how much you want to spend on them and then stick to it! Make sure you and your spouse are on the same page with the budget amounts, or if you’re single, run the amounts by your accountability partner to get their input. 3. Create envelops and fill cash and write category. Let’s say you’ve budgeted Rs.5,000 a month for groceries. When you get your first salary of the month, take out Rs.5000 from your bank account and put the cash in an envelope. On that envelope, write out \"Groceries.\" When you get your second salary, do the same thing again, and put that Rs.5,000 in the envelope. That’s your Rs.5000 food budget for the month. It is so simple 4. Spend only what you’ve put in each cash envelope. Don’t forget: When your money is gone, it’s gone! If you want to go to the store but don’t have enough money, see the fridge for leftovers. Do a pantry check! Dig through your pantry to see what you can find to make dinner without having to hit the grocery store. This is a great way to really get intentional about your spending! Advantages to Using the Envelope System CFP Level 1 - Module 1 - Personal Financial Management - Global Page 8

 It keeps your expenses on track.  It helps in having discipline.  It holds you accountable.  It makes it pretty hard to overspend. Emergency Fund and Funding Vehicles An emergency fund is a vital corpus that you must keep aside to take care of emergencies. It is a fund that you can fall back on at the time of unexpected and unplanned situations, and not for meeting your monthly household expenses. So, you must design it specifically to meet unanticipated financial shortfalls that may come across. You should be in a position to meet unexpected expenses is the reason why an emergency fund should be liquid. You should always keep liquidity in mind when you are choosing where to park your emergency fund. You should be able to withdraw the money when you need it and without any delay. At the same time, you need to ensure that you do not get punished in the form of an exit load or pre-withdrawal penalty. The value of the amount invested should not go down either and must deliver reasonable return. Where to park your emergency fund? Since liquidity is most important in case of emergency fund, you can choose any of the following avenues to park your money:  Savings Account  Flexi Deposit Account (Savings cum Fixed Deposit account)  Liquid funds of Mutual Funds (Investment gets redeemed within a day) Sometimes emergency may come in the form of loss of job due to accident etc. One should also buy accident insurance policy to enable him to get weekly amount from Insurance Company. In such type of emergency, existing investments may be encashed. The primary focus of an emergency fund is defensive. Clients often do not like to hold money in an emergency fund because cash and cash-equivalent instruments earn very little. However, an emergency fund is like an insurance policy. Until someone needs it, it seems like a waste of money. However, having the funds in place when an emergency strikes makes the fund worth having. Emergency funds, like an insurance policy, are only effective when they are in effect – you can’t start an emergency fund or purchase an insurance policy to handle the emergency after it strikes. The policy – and emergency fund – must already be in place to be of any value. CFP Level 1 - Module 1 - Personal Financial Management - Global Page 9

Building Cash Reserves (Savings) One of the most important financial planning questions to be discussed with client is how much money to have in a cash reserve. The general rule of thumb is to build up three to six months of expenses in an emergency reserve. Some people keep on adding more amounts to their savings account, the surplus amount needs to be transferred from cash/savings account to assets generating higher return as savings account provides very low rate of interest. If there is less cash than required for emergencies, money needs to be provided from monthly salary to build cash reserve.  Understanding your need This is the first step in understanding how much money you need for a cash reserve. Since most transactions are done electronically today, many families really don’t know how much their family spends on fixed and variable expenses every month. Once you calculate this amount (let’s say Rs.50, 000 a month for example) then you can multiply that number by the rule of thumb of three to six months and that is a good place to start. The real question I find in the planning process is, “how much money in the bank will allow you peace of mind to go to bed at night?” Of course, since most marketable securities are liquid within two business days, you don’t want too much in the bank or you will just safely lose pace to inflation.  Determine where to keep your cash When most people think of cash reserves, they think of how much money to keep in their savings account. Savings accounts are accessed with the help of ATM Cards; it may happen that you keep withdrawing cash reserve as it is easy money. So, make sure that cash reserve is fixed in some account; it can be flexi deposit account, fixed deposit account or Liquid fund of a Mutual Fund so that you need to apply it for encashment (redemption). If you have kept money in savings account, you need to have discipline to keep it safe.  Build up by saving If you do have disposable income as a family, one step to build up the cash reserve is to set up a systematic savings plan.  Build up cash by selling some investments If you can’t save on a monthly basis, consider getting your reserves filled up quickly by selling your investments. Once investments are redeemed to build cash reserve, do not touch that money Income Generation Income generation relates to cash flow management. Every aspect of financial advice involves the inflow of cash. When income decreases or stops, a lot of financial strategies become unworkable at least for a temporary period. One of the most important role of a financial planner’s job is securing the client’s financial situation through adequate insurance coverage. Disability income insurance coverage often plays a key financial role. CFP Level 1 - Module 1 - Personal Financial Management - Global Page 10

One way of increasing income is to change job for better prospects and income. Changing job may have following drawbacks  Loss of existing benefits, either temporarily or long-term  Possibility of a lower-level benefits package  Loss of built-up sick leave (This will not be an issue in some territories, but in others, the accumulation of sick-leave time can create a significant safety net in the event of an illness or disability.)  Risk that the new employer’s financial stability may not be as sound as the previous employer, leading to potential loss of income if the company closes or reduces staff  Potential that the new job might not work out, leaving the job changer with an income loss A client may also consider becoming an entrepreneur to try to gain additional income The biggest potential impact of becoming entrepreneur is the loss of a steady income stream. Unless the client already has a strong customer base, he or she may face a period –where he may be without income or less income for few months. Even in situations where the client believes the move to being a business owner will generate increased income over time, he or she should be prepared to address any initial income shortfall. This can potentially impact the entire client’s savings and cash reserve plans, and would likely require a substantial reworking of any existing financial plan. Financial professionals should discuss the risks of slow or no positive cash flow, and whether the client has a sufficient financial safety net in place to cover both business expenses and potential loss of income. Along with loss of regular income, comes the loss of employer-provided benefits. Again, the significance of this will vary, but in many cases, employer benefits have great value. Many employers provide health care, disability and life insurance, and retirement benefits, in addition to others. Where this is true, most or all of these benefits will need to be replaced by the entrepreneur. The cost of providing these benefits should factor into the business’s ability to generate positive cash flow. Initial and on-going funding is likely to be the biggest part of any financial discussion. Passive Income / Unearned Income All income does not come from employer. One income-generating method may be to structure an invested portfolio in such a way that it produces income Two primary options exist for an income-generating portfolio – capital utilization and capital preservation (or conservation). Capital utilization option uses existing capital and earnings to generate income. Since capital and return are both used for withdrawal, it requires less capital. The big downside is that capital will decrease, and can eventually be depleted. Let’s assume the objective is to generate Rs.6,00,000 income annually in addition to existing income CFP Level 1 - Module 1 - Personal Financial Management - Global Page 11

Working through the calculations shows the capital required for each approach. With the capital- utilization approach, assume all capital gets consumed over a 20-year period. For capital preservation, no capital gets consumed. We can assume a six per cent return for both calculations, with no inflation adjustment. Following are the financial calculator keystrokes. Capital Utilization CASIO FC 200V  20 N  6I  600000 PMT (annual)  PV =-6881953  P/Y=1, C/Y=1 A portfolio targeted to generate Rs.600000 income per annum for 20 years at the end of each year, assuming a six per cent return, will require Rs.6881953 capital. At the end of 20 years, the capital ac Let us do this with the help of Excel. Go to fx, Select Financial and select PV (Present Value) Present Value= Amount invested or to be invested. Feed the values as shown below: CFP Level 1 - Module 1 - Personal Financial Management - Global Page 12

Capital Preservation Capital preservation means you do not withdraw principal or amount invested while withdrawing to meet household expenses; you only withdraw interest/ return 600000 ÷ 0.06 = 1, 00,00,000 (Rs. 1 crore) In the calculation of capital utilisation, an amount of Rs.68.82 lakhs invested will give an amount of Rs.6, 00,000 for 20 years and the whole money will exhaust. With every withdrawal, he withdraws principal and interest both. In capital preservation, amount invested is large and a person will be able to withdraw Rs.6, 00,000 till he wishes to and amount invested will remain, assuming there is no change in interest rate. Capital utilisation will require less capital but there is risk of outliving number of years initially planned, 20 years in this case. A large enough portfolio would allow an individual to allocate sufficient resources to produce a sizeable amount of income. Using the capital preservation method would further allow a reallocation of those resources if that became desirable. Personal financial management is the foundation of a client’s financial plan and helps determine financial well-being. As previously mentioned, many potential clients have not given enough consideration to a financial management plan or a strategy for achieving related goals. We have already covered goals and desirable outcomes for a financial management plan. In the next chapter, we will consider strategies to achieve and maintain a client’s financial well-being. Let us take one more example to understand Capital Utilization and Capital Preservation: Mr. Mehta is retiring soon and will get an amount of Rs.60, 00,000 as retirement corpus and he will get small amount of pension per month. He approached a financial planner and asked for his recommendations regarding investment of his corpus. While having discussions, they spoke about this concept of Capital Utilization and Capital Preservation. Mr. Mehta wishes to understand both the options as to how much amount can be made available annually at the end of every year. He will then match the amount receivable with his requirement in both cases. The calculation in case of Capital Utilization will be done for 25 years’ time horizon in mind. Money will generate a return of 8% p.a. Capital Utilization Method: Calculation as per calculator: CASIO FC 200 V  -6000000 PV 8 I  25 N  P/Y=1, C/Y=1 Solve PMT= 562072.67 (Rs. 562000 p.a.) Page 13 CFP Level 1 - Module 1 - Personal Financial Management - Global

Solution with the help of Excel: Capital Preservation method: = 6000000*.08 = 480000 p.a. 480000/.08= 6000000 In this case he would like to withdraw only interest, he is not touching principal and he can keep withdrawing Rs.4,80,000 till the time he is alive and principal amount will be enjoyed by family after his death. He will have to take decision what amount is comfortable for him i.e. whether he is ok with withdrawing Rs.480000 per annum at the end of every year. If he wishes to withdraw more than this amount, he will have to choose capital utilization. CFP Level 1 - Module 1 - Personal Financial Management - Global Page 14