Personal Financial Planning – The Process
Over the last two weeks, we introduced the scope of personal financial planning. Today, we will introduce the activities involved in personal financial planning before taking each up in greater detail over the coming weeks. Financial literacy: Financial literacy is the cognitive understanding of all matters that impact and are impacted by our personal financial […]
retirement plans
Over the last two weeks, we introduced the scope of personal financial planning. Today, we will introduce the activities involved in personal financial planning before taking each up in greater detail over the coming weeks.
Financial literacy: Financial literacy is the cognitive understanding of all matters that impact and are impacted by our personal financial decisions. Some of these include economic, political, cultural and definitely financial matters. Being financially literate means the individual is able to read, understand and draw pragmatic conclusions from economic, political, and cultural factors as they relate to matters of their personal finances such as cost of living, spending, savings, investments, debt management, etc.
Success in financial planning and management is built on financial literacy. Being financially literate involves understanding what is happening both locally and in the global economy. We see how insecurity in one part of our country can affect food prices in the country and even the West African subregion in not dissimilar ways that wars in near and distant parts of the world can affect our businesses and personal lives locally.
The benefits of being financially literate include personal ability to make better financial decisions, building effective money management skills, success in the attainment of short- and long-term financial goals, less financial stress and anxiety, etc.
Budgeting: A budget is a plan and tool for the coordinated use and monitoring of different financial resources to cover expenditures of different purposes over a projected period. At a personal level, a budget will typically capture all income streams that will be applied to cover various expenditures such as grocery purchases, payment of utility bills, loan repayments and even investments.
It is important to realise that budgets are not only for corporations and governments. As individuals, we need budgets to help us keep perspective and focus and enhance our chances of achieving our financial goals. Budgets help put us in control of our finances; reduce wasteful spending to the minimum possible by creating awareness about what we may be doing; make positive changes possible in our financial lives; enhance our chances of paying our bills and meeting financial obligations; prepare us for emergencies and reduce stress while building confidence. It is important to note that a budget should be goal-driven, flexible, and realistic (even if it should force a reasonable level of discipline).
Cash Flow Management: As mentioned previously, businesses can be profitable but not have positive cash flow. This is essentially because the principle of accrual in accounting allows for the recognition of revenues without actual payment being received. Generally speaking, however, this is not common in personal finance because income sources such as salary and property rent are recognised by individuals when they receive the payment. Nevertheless, individuals can still risk falling into a negative cash flow position due to several possibilities such as a mismatch between when the salary and property rent are received and when actual payment of bills such as utilities, debt servicing, etc. fall due. When an individual projects the possibility of a negative cash flow for a particular period, it behoves on them to make plans as to how to cover the gap.
Personal cash flow refers to the projection of the net of cash inflows and cash outflows that we expect over a future period. The various individual cash outflows are summed up and taken out of the sum of total cash inflows. This is mathematically shown as:
Where NCF is the net cash flow over period i=1 to n; and CIFi and COFi are the individual cash inflows and cash outflows for individual subperiods i respectively. Personal cash flow management is the crucial foundation to financial stability, balancing of income and expenditures, and ensuring that both short- and long-term financial objectives remain on our radar and are ultimately achieved. Managing cash flow requires a detailed understanding of how much money we earn (and receive in cash) along with how much we expend taking into consideration the timings of individual inflows and outflows.
Net worth: Ultimately, the purpose of personal financial planning and management is to make it possible for us to be on top of our finances in the short run and build wealth in the long run. Staying on top of our finances means meeting our daily requirements and obligations such as feeding, transportation, clothing, servicing our debts, etc. Building our wealth means growing our assets that will continue to provide income and further asset growth.
Now one of the key financial statements that corporations draw and monitor closely is the statement of financial affairs or the balance sheet. This is a statement of the total assets owned and total liabilities owed by the corporation. At a personal level, the parallel to a statement of financial affairs or balance sheet is the statement of net worth. The statement of net worth is basically the list of total liabilities and total assets of the individual. The personal net worth itself is calculated as:
Where NW, TA and TL are respectively the net worth, total assets and total liabilities.
Assets include current, savings and bank deposit balances, motor vehicles, securities, such as stocks and bonds, real estate, etc. Liabilities include debts like personal overdrafts, car loans, bills and taxes that must be paid, etc. If TA is greater than TL, the person has a positive net worth. Persons with substantial net worth are known as high-net-worth individuals. On the other hand, if TA is less than TL, the person has a negative net worth, meaning that their assets cannot cover their liabilities. Regular and periodic monitoring of our net worth is key to assessing how well we are doing financially.