budgeting and cash management chapter 15 tools & techniques of financial planning copyright...

Budgeting and Cash Management Chapter 15Tools & Techniques of

Financial Planning

Copyright 2009, The National Underwriter Company 1

Budgeting

“Budgeting can be defined as the ability to estimate the amount of money to be received and spent for various purposes within a given time frame. For purposes of this text, however, budgeting should be thought of as a deliberate plan for spending and investing the resources available to the investor. It ultimately serves as a yardstick against which to measure actual investment results.” – Tools & Techniques of Financial Planning


Financial Planning


How Budgeting Works

• Controlling one’s financial affairs begins with a model of where money should go.

• Track income and spending and saving, and see how actual differs from the model.

• Making comparisons between what ought to be and what actually is the valuable part of budgeting. It is the first step to gaining control of the financial aspects of life.


Financial Planning


Uses for Budgeting

• Measure progress toward goals, particularly when resources are limited.

• When financial affairs are complex.

• To communicate a planning strategy to all family members affected by a budget.

• To provide guidelines for economic performance.

• To provide incentives for economic performance.


Financial Planning


Specific Uses for Budgeting

• Controlling household expenses• Accomplishing desired wealth

accumulation/savings goals, such as– Saving for retirement– Funding the children’s education– Saving for vacation

• Monitoring the performance of a specific investment, such as– A securities portfolio– Rental property– A closely-held business


Financial Planning


Advantages of Budgeting

• For coordination of activity of the client and the planner in developing objectives.

• Revealing inefficient, ineffective, or unusual use of resources.• Making family members understand the need for doing their part.• Financial self-evaluation and a guideline to measure actual

performance.• For recognition and anticipation of problems before they occur and

therefore corrective action or preparation to be taken.• Highlighting the possibility of, and need for, alternative action.• Motivating performance.


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Disadvantages of Budgeting

• Inaccuracy can lead to false conclusions.• Record keeping is a chore and won’t be done.• Depending too much on the budget as a guideline

can cause opportunities to be lost and become stifling.

Note: Some clients (and even a few financial planners) have such an aversion to the term budgeting that they just close down and refuse to participate in a discussion. For these people, not using the word budget, but instead talking about planning priorities for use of their money will sometimes get the discussion going.


Financial Planning


Getting Started in Budgeting

• Remember that the principal purpose of a client budget is to control and evaluate performance, not put a straightjacket on them.

• The basic sources of information needed are the same ones that were used in the first step of financial planning:– personal financial statements, prior years’ tax returns– canceled checks– projections of income and expenditures for the target period

• Once initial estimates have been made, they must be adjusted in light of special circumstances or considerations.


Financial Planning


Practical Tips

• Sometimes people consult a financial planner because they don’t know where their money goes and they know that they should be saving and are not.

• For many people, keeping track of cash transactions is the most difficult part of budgeting. Give each person a small amount of “walking around money” for which they do not have to account.

• Automating the record keeping can make the process less onerous.

• Annualizing the “walking around money” figure will start to build awareness of what small expenditures mean over time. It’s easy to say that one needs $150 per week for spending money, but harder to justify $7,800 per year.


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More Practical Tips

• The blank budget template in the text is an excellent one.

• Give the client a Budget template to fill in with their numbers. Don’t expect them to be able to do it without a template “because everybody knows how” They don’t.

• Microsoft has a free personal budget template for Excel as well as other useful personal finance templates for free download at http://office.microsoft.com/en-us/templates/CT011377171033.aspx

You may want to personalize the template with your business name and telephone number and add a spot for the client’s name.


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Guidelines When Preparing a Budget

• Make the budget flexible • Keep the budget period short, but not too short. (12 months is good

for most families.)• Make the budget simple, short, and understandable.• Follow the form and content of the budget consistently.• Eliminate any extraneous information.• Absolute accuracy is not necessary, especially with insignificant

items.• Tailor the budget to specific goals and objectives.• Analyze unexpected variations, and adjust as necessary.• Try to anticipate events, such as changes in interest rates or family

circumstances that may cause variation.


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Constructing an Income-Expenditure Budget

• Step 1 – Estimate family income.• Step 2 – Develop expenditure estimates broken down

between fixed and discretionary expenses.• Step 3 – Determine the excess or shortfall of income

within the budget period.• Step 4 – Consider available methods of increasing

income or decreasing expenses.• Step 5 – Calculate both income and expenses as a

percentage of the total and determine if there is a better or preferable allocation of resources.


Financial Planning


Step 1 – Estimate Family Income

• salary

• bonus

• self-employment (business)

• real estate

• dividends – close corporations

• dividends – publicly traded corporations

• interest – savings accounts

• interest – taxable bonds

• interest – tax free bonds

• trust income

• other fixed payment income

• variable sources of income


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Step 2 – Develop expenditure estimates• FIXED

– housing (mortgage or rental payments)– utilities– food, groceries, etc.– clothing and cleaning– income taxes– Social Security– property taxes– transportation– medical and dental– debt repayment– household supplies and maintenance– life and disability insurance– property and liability insurance,– current school expenses

• DISCRETIONARY– vacations, travel, etc.– recreation and

entertainment– gifts and contributions– household furnishings– education fund– savings– investments


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Step 3 – Determine the excess or shortfall

• Simply take income minus expenditures.

• If there is positive cash flow – terrific.

• If there is a shortfall, adjustments MUST be made.


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Step 4 – Consider available methods of increasing income or decreasing expenses.• Even if there is positive cash flow, there may be

expenditure leaks that could be plugged or ways to increase income.

• Consider ALL methods of increasing income or decreasing expenses.

• This is a good time to show clients the consequences of habitual small expenditures.


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Step 5 – Calculate both income and expenses as a percentage of the total• Determine if there is a better or preferable allocation of

resources. • Common income problems:

– Too much in low interest accounts– Counting on bonuses that may not materialize

• Common expenditure problems:– Too much unaccounted for spending money– Little indulgences that add up over a year ($6.00 lattes, taxis,

individual water bottle purchases, too much take-out, etc.). None of these are wrong – the client has to decide if it is worth it when the yearly figure is computed.


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Sample Family Budget

Budget shows a positive cash flow, but note that the Samples are counting on Mr. Sample’s bonus of $15,000.


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Sample Family Budget without BonusNote the impact on the Sample Family Budget if Mr. Sample does not receive his expected bonus.


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Blank Budget

• This is typical of a template that you might give to clients or prepare yourself from their documents. Preparing it from their documents, then allowing them to correct it can often be the best tactic.


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Techniques for Families with Irregular Income

• Use scenario analysis – prepare Worst case and Best Case scenario budgets.

• Keep fixed expenses as low as possible. Discretionary expenses can expand in good times and contract in bad times.

• Avoid debt. Pay cash for big ticket items. Set up special savings accounts for desired big ticket items.

• Use visualization. Seeing the best case scenario, if it allows for a desired item, can be motivating to people who have to create their own income.


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Emergency Funds and Reserves

• A standard emergency fund among financial planning professionals is 3 to 6 months expenses.

• Clients with irregular income may need more.

• Cash reserves above and beyond the emergency fund can be invested in short-term CDs, etc., since credit cards can be used to take advantage of a sale on a big-ticket item, or emergency funds can be used and replenished from the short term investment.


Financial Planning


Saving for a Goal in Equal Payments

If this payment toward a budgeted goal (such as saving for retirement) seems to be too much and the period is long, use the increasing payment option shown on the next slide. With raises and inflation, the higher later payments may be affordable.

Note: No provision for inflation!


Financial Planning


Saving for a Goal with Increasing Payments

Using contributions that increase by 5%, the payment required in the initial years is reduced. Note however, that the required contribution in later years is substantially higher.

Still no provision for inflation!

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