A Penny Saved is a Penny Earned: Need for Financial Planning

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Financial Planning ensures availability of adequate income and resources to households and individuals in order to meet present and future expenses. Routine expenses and needs are fulfilled through normal income earned through one’s profession or business yet it is essential to plan for time when there will be lower income such as retirement period, a special provision must be made to incur the routine expenses with the reduced income. Similarly, a provision for unexpected expenses such as large medical expenses must be prepared and budgeted. Other than routine expenses, needs requiring a large sum of money, be it buying a house or child’s education also requires adequate funds to be available at the right time. Thus to fulfill the needs mentioned above, an adequate portion of normal income must be saved and invested into assets that will help meet these requirements. Financial Planning is a process wherein the household income, expenses, assets and liabilities are taken into account to make sure those current and future needs of the household is duly met.

Before starting the process of Financial Planning it is essential to prepare a Budget which involves following steps:

  1. Define the normal income of household received in regular intervals.
  2. Deduct the mandatory expenses from given total normal income.
  3. Once disposable income is calculated by deducting the mandatory expenses further deduct essential living expenses and discretionary expenses to arrive at savings.

Financial Planning Process

  1. Understanding Financial Situation: Financial planning ensures that a household has adequate income to meet its present and future needs. Income is derived primarily from following sources: Income from profession, employment or business and income earned on assets such as rent or interest on bank deposits. This income earned is first assigned to the current expenses, surplus income left after deducting these expenses is savings that would lead to fulfilment of future needs. Other than expenses and income it is important to assess the assets (Adds to the income) and liabilities (Deducts from income) too.
  2. Identifying and Defining Financial Goals: Financial Goals represents future needs of an individual or household that requires funding. Identifying Financial Goals helps in planning for the savings and expenditure so that present and future requirements are met. A goal can be described as a financial goal when it can be described in monetary terms (value of goal) and required to meet at a point of time (time of goal) in future. Example of financial goal is, Rs.1 lakh required each month after 10 years to meet household expenses after retirement.
  3. Funding the Goal: Once financial goals have been identified it is important to define how these goals are to be met. Following must be determined to assess the ability to fund goals are:
  • What is the current income available to meet expenses?
  • What is the level of expenses?
  • What is the amount of income that can be saved?
  • What are the assets available that can be used to meet goals?
  • What are the liabilities existing that also have a claim on income?

Relationship between investment, time period and savings to fund a particular goal.

  • Higher the return earned on investments, lower will be the current savings needed since the higher returns earned will lead to savings grow to a larger amount.
  • Longer the period available to accumulate the saving, lower will be the savings needed since the savings have a longer time to earn returns and reach the required value.
  1. Risk Profiling

Financial risk tolerance is measured to determine the risk profile. It is the level of risk an individual is willing to take.

Financial risk tolerance can be divided into two parts:

  • Risk capacity: the ability to take risk i.e. an individual with higher level of income and longer investment term would have higher risk capacity.
  • Risk attitude: the willingness to take risk. Risk attitude connects to individual’s psychology and not on their financial situation.
  1. Portfolio Construction

Portfolio construction is largely based on the level of risk and return associated with a particular financial goal. Financial goals determine various assets to be included in the portfolio so as to fulfil mentioned goals.

INVESTMENT OBJECTIVE SUITABLE INVESTMENT
Appreciation and growth Equity shares, Equity funds, real estate, gold
Regular income Bank deposits and debt funds
Liquidity Cash and bank deposits
Capital preservation Ultra short term funds.

 

Therefore with the growing inflation and expenses, it is necessary to plan your finances and keep a check on one’s expenses and savings. As Warren Buffet said, ” Do not save what is left after spending, but spend what is left after saving.”

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