Personal Financial Planning – The Scope (II)
Last week, we commenced the presentation of the scope of personal financial planning and management, which we presented as essentially being the broad activities that the subject covers. Today, we will conclude by taking up the following: Liquidity and Cash flow: Last week, we took up revenues, incomes, expenses, surplus/savings and investments. But as we […]
personal financial planning – the scope (ii)
Last week, we commenced the presentation of the scope of personal financial planning and management, which we presented as essentially being the broad activities that the subject covers. Today, we will conclude by taking up the following:
Liquidity and Cash flow: Last week, we took up revenues, incomes, expenses, surplus/savings and investments. But as we know, it is possible for us to generate revenues and incomes but not have cash (that is to be liquid). This may happen, if, for instance, we work for the month at our place of employment or we execute a contract for a client and we don’t get paid on time. In each case, we can register in our records that we have earned the ‘revenues’ but do not yet have the cash, which in this case, will be represented by a receivable as the asset that we hold instead.
These situations can portend difficulties to the state of our personal finances because we need liquidity to settle our own obligations and make desired investments, except if we choose to take loans to do that. (Taking loans in itself simply makes cash available to enable the borrower to do what they need to.) But even if we take the loans, we will still ultimately need to pay back our creditor.
A positive cash flow indicates that our cash inflows (represented by revenues, sale of assets, and sometimes debts, etc.) cover our cash outflows (the first line being our living expenses. But some argue that we should first reward ourselves by savings/investments before taking on expenses. We will get to this later). The surplus can then be applied towards savings, investments, etc. Positive cash flow makes it possible for us to seize opportunities, pay our taxes, handle emergencies, level out the irregularities in our revenue streams, etc. Liquidity and cash flow should therefore be understood and taken seriously if we are to be successfully on top of our personal finances and thereby avoid going into financial distress with possible untoward consequences to our physical and mental health.
Profitability and Wealth Creation: For corporations, finance revolves around matters like capital structure, profitability, liquidity, investment decisions, risk management, dividend payout, etc. In many similar ways, personal finance revolves around to what extent the revenues and incomes we generate and earn cover our expenses; what are the sources of our revenues and cash; to what use we put our revenues and cash; what our investment preferences and risk inclinations are, etc.
Profitability or the surplus of our revenues over our expenses is what gives us the best opportunity to gradually build wealth through investments over time. It makes it possible for us to learn what works and what does not without taking on risks that might ‘bring down the house’. The keys are consistency, caution and wisdom. Obviously, taking on debt is another pathway to building wealth, but it comes with the additional risks that our surpluses don’t pose.
Debt: Another important factor in personal financial planning and management is debt and our mindset and approach towards it. We can borrow from different sources and for different purposes. Debt can be put to beneficial uses but could also be sourced and used wrongly with devastating consequences. Generally speaking, we can take loans if our plan is to put the proceeds into income-generating activities that will repay the principal and any borrowing costs such as interest and other agreed charges, as well as leave a positive net return for us. It, however, happens that sometimes we borrow to cover our personal living expenses. Whenever we have to do that, we should also ensure that we have expected sources of inflow that will make it possible for us to repay the loan as per the terms we agreed with the creditor. What we can borrow for, from which sources, the processes and etiquettes of borrowing will be taken up in due course.
Risk-Return Management: Two closely related factors in personal financial management are risk and return. Basically, and in a general sense, risk refers to the probability of the occurrence of an undesired event. Specifically in financial management, risk is defined as the chance that the outcome of (return on) an investment will differ from what was expected. In other words, it is the possibility of losing part or all of the expected return and/or part of or all of the initial investment made.
For example, you could check the historical performance of a company and establish that over the past ten years, it has always paid dividends to its shareholders, which may be part of the basis you may decide to invest in the company by buying some of its shares. Despite the historical performance, there is, however, still the possibility that over the coming years, the company may fail to pay out dividends entirely or pay only a fraction of what it used to.
Understanding our personal risk affinities and the likely risks associated with any investment that we are considering vis-à-vis our expected returns on the investment is crucial to our ultimate financial success. One of the things that I should state here is that risk is widely misunderstood and you often hear people talk about ‘business is risk’. This suggests that we should take risks in our businesses and investments almost recklessly. This is not the right understanding of risk in business and investments. Instead, what is important is to identify and understand specific risks in our transactions, investments and businesses and try to take measures that will eliminate, mitigate, or manage each as may be appropriate. We will take this in greater detail later.