Tuesday, January 18, 2011

How to Financial Plan Step by Step

1.Figure out where you are ?HowMuch are you worth ?

The first thing to do is to prepare a personal balance sheet . Describe your assets - which is what you would call anything you own that is of real value. That means a house is an asset, money in the bank is an asset and stocks/mutual funds are assets. Your TV is not an asset. Your car should not be considered an asset (unless it's less than 3 years old, in which case consider the value declared to insurance).
So add all the values up and you get a list of assets, like so:
Cash in bank: Rs. 50,000,Fixed Deposits: Rs. 200,000,Stocks: Rs. 150,000,Mutual Funds: Rs. 70,000
Gold: Rs. 20,000,Current value of house: Rs. 25,00,000,EPF: Rs. 8,500 ,TOTAL: Rs. 29,98,500
 Underdeclare values of stocks, gold etc. by at least 25% since these are variable commodities. 
Now figure out your liabilities. Meaning, how much do you owe other people?  

Oustanding housing loan: Rs. 20,00,000 ,Personal Loan: Rs. 100,000  ,TOTAL: Rs. 21,00,000 
Don't include things you intend to pay back immediately, like credit card bills, or phone bills etc.
Subtract your LIABILITIES from your ASSETS to find out your NETWORTH: meaning, how much are you worth today. In the example above, NETWORTH = Rs. 8,98,500.
If you find you have a healthy positive balance from the above calculation, pat yourself on the back. You're already well down the path to financial freedom.
And, if you find you're in the red, don't despair. A bit of discipline and you'll soon be in positive territory, after which it's just a matter of time before you're watching your Money  grow before your very eyes! 

Keep an Expense Diary
The best way to work out your expenses is to maintain a log of your spending every day for at least two to three months, ideally a lot longer. If you're married, have a family or are living with a partner, do this at a household level i.e. maintain a diary of all personal as well as common expenses for the entire family.
Basically, at the end of every day write down your expenses in a little notebook. At the very least, the notebook should have columns for date, expense description and amount (ideally also add columns for expense category and person responsible for the expense) and you should add up the amounts spent every week. It takes 5 mins every day and is well worth the effort.

2. What's your "cash flow"? 

Now find out how much you spend. Include all standard expenses (in fact, keep a record of this for about six months, and find out the real average) and also amortize your annual payments (like insurance) into the monthly amount.
Add the total income you earn (minus taxes and any other deductions)  

Apartment Maintenance: Rs. 2,000 ,Phone bills: Rs. 3,000 ,Petrol: Rs. 2,500 ,Credit Cards: Rs. 5,000, Internet connection: Rs. 1,000, Interest payment on housing loan: Rs. 11,000,
Insurance Amortised: Rs. 3,000,House taxes etc. amortised: Rs. 1,000,Cash expenses: Rs. 8,000 
Total: Rs. 36,500  
Salary: Rs. 45,000,Dividend: Rs. 2,500,Total : Rs. 47,000  
Cash Flow: Rs. 10,500 per month.
If your cash flow is not positive, i.e. Expenditure is greater than Income, STOP RIGHT HERE. Go back to the drawing table and figure out how to reduce your expenses or increase your income - there is no other way around. Investments are only for cash flow positive people! 

How Much Can you Save?
Now that you know how much you spend sit down with your family and work out where you could reduce your expenses. There are usually some useless expenses that you can cut without feeling the difference.

A good place to look for saves is in utility bills like electricity and telephone. It might also be possible to reduce in areas like credit card late payments and interest expenses (just pay before the due date, take an instalment loan scheme on the card or transfer your balances to another) and some entertainment expenses (no, I'm not asking you to sacrifice it
all - maybe you could just reduce it by, say 10%?)
Once you have 'cut out the fat', you are now in a position to determine how much you could save every month - your monthly income less your monthly spend. This should, at the very least, be a positive figure otherwise you are definitely living beyond your means. Ideally it should be around perhaps 20% of your income or better. I think that's the average savings rate in India.

Your monthly savings are pretty much all you have to count on when you set your financial goals so the larger the figure you can mange, the better!

3. What and when do you need money? And How Much? What Are your Goals ? 

Find out any longer term requirements to fund a large one time requirement.
The way to do this is:
Ongoing: Liabilities, Rs. 21,00,000
After 5 years: School Donation for Child, Rs. 100,000
After 10 years: House repairs and upgrades, Rs. 10,00,000
After 15 years: College fees for Child, Rs. 10,00,000
After 20 years: Marriage costs, Rs. 10,00,000
After 25 years: Potential medical expenses, Rs. 10,00,000
After 30 years: Retirement, Need to have corpus of Rs. 30,00,000
Discount all these amounts by inflation of 6% a year.  
Insure YourSelf & your Property 
Today's discussion will be on the next important thing to tackle before you start investing - Insurance.
Generally speaking, most of us equate  insurance with savings, treating it as an investment mechanism.
This  midset is reinforced by the tax rebates we get on insurance, encouraging  everyone to invest more
and more in high-premia endowment plans every  year in order to avail of the tax benefit. However, the main  purpose
of insurance is to mitigate risk - risk of death (life  insurance), risk of loss (general insurance), risk of illness (medical  insurnace)
or risk of untoward incidents while travelling (travel  insurance). As an individual, and a responsible householder,
you  should cover all of these risks when you plan your insurance, rather  than rushing off to purchase more life insurance
just because you get a  tax break!

How Much Insurance Do You Need?

This is a fairly straight-forward question to answer:

  • Life Insurance: The conventional approach is to insure yourself for an amount equal to about 10 times your annual income, which is a truly staggering sum! However, I believe this is a better way of looking at it. I also subscribe to the concept of layering your insurance plans so that you can increase your insurance amount over time till a point, after which it starts to reduce because you have saved a good amount by then and might not need so much insurance
  • General Insurance: Insure your house (an option that generally is offered with many home loans nowadays - go for it) and your valuables. Burglaries and other mihaps happen and you'll sleep much better knowing that you have a fallback option. There'n no reason for you to learn this the hard way as general insurance premia are really low and definitely well worth the benefit!
  • Medical Insurance: In general, try to get yourself and your family covered for major illnesses and surgeries. Some banks, such as Andhra Bank, offer a floating cover that can be shared by the entire family, which I think is a very useful facility as it saves the trouble and expense of insuring each family member independently
  • Travel Insurance: This is a must while travelling. If you are abroad and things get stolen, your personal funds will not really help much, I can tell you!
A Bit on Life Insurance
There are two basic kinds of life insurance policies: endowment, wherin it is a risk cover cum saving scheme (this includes money-back policies, unit-linked insurance etc) and term assurance , which is a pure risk cover. The returns on your investment in the former are generally worse than you can do with other comparable investments in the market so I'd always recommend term assurance as the best form of life insurance. It has the added advantage of having very low premia because you need not invest anything in savings. However, due to its nature, the entire premium is an expense. Once you pay it, it is gone and you will not get it back unlike in an endowment policy.

Set Aside Emergency Cash

Now that you have productively used your monthly savings in reducing your debt and purchasing adequate insurance, there is one last thing to take care of before you move on to investments - setting aside emergency cash.

Though the risk of losing your income is low, life is uncertain and any number of things may come up to disrupt the normal course of things and force you to take a break from your job. It is also possible that you may need extra cash to handle an emergency or just to take advantage of an unexpected opportunity.

For such situations, it is important to have a cash buffer. The amount you set aside is up to you, but given the primary purpose of having sufficient liquid funds to tide you over in case you lose your income, I would suggest the minimum you set aside should be enough to cover 6 months of regular expenses, as determined based on your expense analysis earlier.

These funds need to be readily accessible and risk-free, and hence should be kept in a bank account and not as a fixed deposit or in high-risk investments. You may not earn much from this money but that's not an issue.

This concludes the section on things to take care of before you invest. The main purpose of these last three posts was to ensure a fallback plan for you and your family in case of trouble, a conservative approach that will allow you to invest your money secure in the knowledge that you have provided well for the people that depend on you.

4. The Investment Plan Recipe
Now's the time to act. You need to increase your network every single year to reach your goals. Your immediate goals for the next ten years are to build up a corpus for your child's education, and to clear out your loans. Always pay out your first house loan - that is the house you live in, so you must attempt to make that debt free. Further real estate can be financed by loans etc.
To finance the above goals, you have a sum of Rs. 10,500 a month, of which you invest Rs. 3,000 per month (say) in the principal of your housing loan. The remaining Rs. 7,500 must be invested.
What do you need? Here's an illustration:
Grows to
After Inflation
The idea is that:
1) You get 20% on the first 10 years of investment and you increase the quantum of investment per month every five years.
2) After ten years you move money to less risky investments and get lesser return, and this goes on.
3) Every five years you withdraw the amount of money needed to finance your needs.
4) After thirty years you are left with about 3 crores, which will most likely be just enough for your current expenditure for a while.
This is an investment goal. You can see where your goals like and try to achieve them. Update your networth statement once a month, and estimate your free cash flows every three months. That way you are aware of how close you are to your immediate goals and whether you are making it or not.

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