Simple Formulas for Your Financial Plan
With an alphabet soup of investment options, it's no wonder that many people see financial planning as overwhelming, obscure, and for geniuses only. For most people though, personal financial planning boils down to just a few topline numbers. The two most basic formulas read like this:
- Cash Flow = Income - Expenses
- Net Worth = Assets - Debts
Ideally, your cash flow should be positive at the end of every month and year, thus increasing your net worth incrementally and over time. The concept really is that simple. The execution, however, is where some can get tripped up.
When making your financial plan, you need to know with some certainty the value of each variable in the equation. When these variables are murky or unknown, that’s where the confusion comes in. For example, lack of clarity regarding your monthly expenses or uncertainty about your take-home income will cloud your ability to confidently develop a realistic financial plan for you and your family. In order to make these simple equations work for you, you need to create a spending plan, and build a financial cushion.
Create a Spending Plan
It is amazing how many individuals are unsure about how much money they spend in a given month or year. To clarify that expense variable, you should start by putting a clear spending plan in place. Part of that spending plan should include an automatic transfer of money into a savings or investment account, which will reduce the likelihood that your savings goals fall by the wayside. By putting your spending plan down on paper (or smartphone) and reviewing it often, you can stop the insidious lifestyle creep that catches many by surprise. As with most tasks, there’s an app for budgeting and spending.
Build a Financial Cushion
Some individuals have pretty steady income flows, such as a regular biweekly or monthly paycheck. This makes matching your income to expenses somewhat easier. Others though, have business income that will ebb and flow with the seasons, or incentive pay from their company based on actual sales goals reached. This uncertainty about how much and when, can wreak havoc with the financial planning formulas, and requires a little more forethought and planning for those barren months when income is low but your expenses remain. To accommodate an unsteady income, take the average monthly expenses you calculated in your spending plan, and build a financial cushion that covers these expenses for three to six months. The three to six months is only a guide; you can adjust based on the security of your income and regularity of expenses. Some individuals may need more than that. This financial cushion can be used to smooth out and supplement your income, and can also be used for those one-off expenses like your annual tropical vacation or when your roof needs replacing.
The planning and formulas ultimately add up to this: Spend less than you make each month then save and invest the difference. It really is that simple.