budgeting

Adjusting Budgets for Unexpected Life Events

In the past few months I have been a little frustrated with the progress of my financial situation. Due to a few unexpected life events, I’ve had to deal with a few cash flow issues which took me out of my financial comfort zone. In addition to a temporary loss in revenue, I also had a few large and unexpected bills that I had to pay. This situation had a substantial impact on my day-to-day activities as I wasn’t able to implement my financial plan as I usually do.

Despite my temporary financial situation placing me at unease, I was prepared for it and made it through relatively unscathed. The experience reminded me of a few financial management words of wisdom and three important personal finance concepts.

Being Prepared is Critical

All of us will be affected by changes in our financial situation regardless of location, culture or material wealth. However the impacts of unfortunate life events and their subsequent financial hardships will vary significantly between families. More often than not, the difference between critical and negligible impacts to your finances will be based on your level of preparation.

Being prepared for a financial emergency starts with having an understanding of your financial risks. Taking an inventory of your financial risks will help you avoid them and adequately prepare for them if and when they occur, this is also known as risk management for financial planning. The best way to understand your financial risks is to make a list of life situations that can affect your ability to earn income and all potential large expenses (vehicle maintenance, medical procedure, etc.).

While insurance is a great way to offset the financial impacts of certain life events, your insurance policies will not cover everything. This is why a safety fund is so important. Having 3 to 9 months of your salary saved for a financial emergency will help you deal with a tough situation.

Keep Your Attitude in Check

Mental attitude is an important factor when it comes to dealing with stressful situations. This is especially true when considering the impact of financial constraints on your emotional state and lifestyle. It’s natural to become frustrated and lose hope at times, however don’t let your emotions dictate your financial decisions.

The most important element of savvy financial decision making is keeping your emotions in check. One of the best ways to clear your mind and make logical decisions is to understand everything about your situation.

To bring clarity about your financial situation, begin by determining how long your new financial situation will last. Next attempt to calculate how large the financial impacts will be on your budget. These two pieces of information will help you determine what changes you will need to make to keep your finances under control.

Making Lifestyle Changes

Once you have a checked your emotions and measured the financial impacts of unexpected life events, you can begin to plan how you will get through this tough situation. More often than not you will have to change your lifestyle to reduce your monthly expenses and remain under budget.

Making lifestyle change is difficult, however it's often necessary. The easiest way to remain under budget is to make a list of all of your priorities from most to least important. Next you should assign the cost of each priority (i.e. monthly car payments), then go down the list and scratch the ones that you can’t afford, starting with the lowest priority first.

This is the easiest way to adjust your lifestyle and budget without causing too much turbulence in your daily life.

Adjusting budgets due to unexpected life events is a challenging, yet often necessary, endeavor. When facing an unexpected life event that creates a financially challenging situation remember to check your emotions, understand your situation and strategically reduce your expenses.

Financial Planning Cash Flow Analysis

A pivotal step in the financial planning process is cash flow analysis. As mentioned in my personal financial management post, cash flow is everything. If you have already gathered all of your financial data and created your financial planning statements you have everything that you need to start this portion of your financial plan. By the end of the cash flow analysis you should have a great idea about how your cash flow situation impacts your ability to achieve your goals and objectives, and what you can change in order to change your financial future.

Cash Flow Projections

Projecting your future cash flows illustrates how your long-term financial situation is impacted by your current financial behaviors. What this boils down to is understanding what the future might look like if you stay on your current path. Cash flow projections are a key step in measuring the gap between where you want to be and where you are now.

At this point, if you have your statement of cash flows (budget) in a spreadsheet you are well ahead of the curve. Projecting your baseline cash flows into the future is only a matter of assuming that your income, expenses, savings and investments will continue to increase and decrease based on their historical trends or other financial planning assumptions. So to do this, extend your current budget out to a reasonable time period, a common time period is when you and your spouse are 95-100 years old.

Incorporating Goals and Objectives

Once you have extrapolated your current income, expenses, savings and investments over a relevant time period, its time to incorporate your future goals and objectives. While assessing your cash flow projections begin to adjust your future income and expenses based on your desired lifestyle. You can start by determining your expected retirement age. Once you have that age and year, you should assume that you will no longer receive a paycheck and erase that part of your income.

In addition you can also assume that you will be able to draw from social security at that time thus you will need to account for that new source of income in your cash flow projections. In addition to retirement, your cash flow projections should also incorporate other goals such as when children attend college, major purchases (houses, vehicles, etc.) and job promotions. These changes will have a large impact on your future income and expenses.

Scenario Based Cash Flow Analysis

Once we have calculated our current financial situation and incorporated our financial planning goals and objectives, it's a common occurrence that we find that we do not have enough cash flow to accomplish all of our goals. This is also the point in time when we realize that in order to obtain financial freedom and the lifestyle that we want, we have to make some sacrifices.

The benefit to having your financial projections in a spreadsheet is that you can perform “what if” analyses. In order to do this take some of your current expenses like entertainment, vacations or other discretionary items and reduce the amount you are expected to spend on them. What happens to your savings and investments? Can you accomplish any more of your goals if you reduce your expenses?

Create a few scenarios and measure the impact on your financial plan, this is how you can improve the prospects of your financial future.

Measuring your current and future cash flow situation will help you gain an understanding of what you will need to do to accomplish your goals. When it comes to financial planning, there is nothing more powerful that understanding the gap between where you are and where you want to be.

Financial Planning Statement of Cash Flows

There are two major statements or reports that are included in a financial plan. These reports are used to organize quantitative financial data in the effort to turn it into useful financial planning information. The statement of cash flows is a report that lists all of the income and expenses of individual or family. This report is modeled after the income statement, which is used by corporations to calculate and report revenues, costs of goods sold and income to name a few. Financial plans include this information due to the fact that it provides great insight into the most important part of a financial plan, cash flow.

What is a Statement of Cash Flows

Creating a statement of cash flows is a rather straight forward task. As stated above, this report is used to calculate the cash flows of a client. Cash flows can be thought of as transactional in nature, meaning this report seeks to capture all of the transactions concerning receiving (inflow) or expending (outflow) money in certain categories.

A statement of cash flows can easily be converted into a household budget. In order to accomplish this all that has to be done is to estimate what your future income and expenses will be. This is why the statement of cash flows can be considered the heart of a financial plan.

Organizing Cash Flow Data

To begin organizing your cash flow data create a list of all of your inflows and a separate list for outflows. The following are the most common elements of a statement of cash flows.

  • Salary
  • Dividends
  • Rents, Annuities
  • Food
  • Clothing
  • Automobiles
  • Mortgage
  • Interest
  • Capital Gains
  • Child Support
  • Insurance
  • Utilities
  • Vacation
  • Charity
  • Pension Payments
  • Gifts
  • Alimony
  • Insurance
  • Entertainment
  • Gifts
  • Education

Cash Flow Planning and Analysis

At this point you should have listed all of your monthly income and expenses and their average amounts. Next we will being to analyze this data, but first we need to do some simple calculations. In order to determine what your total monthly income and expense are, total all of your income and expenses.

Next subtract the expense from the income and hopefully it is a positive number. If it is negative this means that you are spending more than you make on a monthly basis. This is usually due to the use of credit cards or other debt instruments. Finally it’s time to estimate how your cash flow will look in the future by forecasting your income and expenses for the year.

I understand that it can be difficult to create a statement of cash flows for the first time based on these instructions alone. For additional free financial planning resources you can go to YouTube and find a bunch of video tutorials.

Elements of a Financial Plan - Part 2

In part one of this series (Elements of a Financial Plan - Part 1) I illustrated the importance of having a comprehensive plan. A good financial plan will attempt to “cover all of the bases” and not leave your financial future to chance or risk. In this post I will go over the importance of tax, retirement and estate planning.

Each and every financial planning element is contingent on one another, however some more than others. In example of how critical these elements are take retirement planning for instance. The success of a retirement plan depends on the right savings levels, portfolio allocation and risk management. Ignoring a element of a comprehensive financial plan could have a severe impact on your ability to reach your goals.

Tax Planning

As I mentioned in part one, tax planning is a fun one! Despite my lack of enthusiasm for tax planning and analysis, if it’s done correctly it can save a client and their family a lot of money. A comprehensive financial plan should consider income, property, transaction and estate taxes.

Due to the complexity of our tax code there is no doubt that many of us miss opportunities to save money every year. A comprehensive financial plan should anticipate when taxes will have to be paid and utilize knowledge of the tax laws to reduce the impact on a client’s bottom line.

Retirement Planning

If there is one part of a financial plan that is most contingent on the other elements is the retirement plan. Retirement plans are affected by your financial situation, savings and investment rate, the performance of the capital markets, the economy and risk management effectiveness to name a few.

If retirement planning recommendations such as, increasing savings, reducing unnecessary spending or creating a portfolio with the proper allocation your desired standard of living during retirement might become unattainable. This is why it is so important to start a retirement plan early and maintain the discipline needed to properly carry it out.

Estate Planning

The last financial planning element, and probably the least known, is estate planning. During life we usually accumulate various assets. These assets can include cash, real estate, investments and art to name a few. Upon passing, the laws of the State will govern the distribution of assets in the absence of the proper estate planning documents. These documents includes wills, trusts, powers of attorney and other legal instruments.

Estate planning seeks to reduce the confusion of distributing assets upon the passing of a loved one. In addition it also aims to minimize any taxes that could be levied on the estate. A comprehensive financial plan should continually revise the estate plan in order to remain relevant.

I hope this article helps you understand the comprehensive financial plan elements; tax, retirement and estate planning. In order to obtain your life’s goals be sure that you cover all of the bases. Overlooking a aspect of the financial process could impact your ability to maintain your desired standard of living.

Elements of a Financial Plan - Part 1

There are many different situations and events that can effect our financial lives. The most common events are the small financial decisions that we make everyday. In addition, these small financial decisions that have the greatest impact on our financial future.

In order to achieve financial freedom or at least financial security many of us should have a comprehensive financial plan. Comprehensive financial plans seek to “cover all of the bases”; meaning a good majority of financial planning factors have been considered. Absent of any special needs or situations a financial plan should include an analysis and recommendations concerning your current financial position, risk management/ insurance, investments, tax planning, retirement and estate planning.

Current Financial Position

The first element of a comprehensive financial plan is the analysis that determines your current financial situation. This step involves gathering a bunch of data consisting of bank account statements, insurance policies, brokerage account statements, estate planning documents, tax returns and any additional financial data you might have available. The information found in these documents will be used to create a income statement and the statement of net worth or statement of financial position.

In addition a Financial Planner should also prepare a “status quo” retirement outlook and conduct a strengths, weaknesses, opportunities and threats analysis or SWOT analysis. This objective of this study is to determine the gaps between your goals and objectives and current financial situation.

Risk Management and Insurance

One of the most common gaps uncovered in the financial planning process is a lack of adequate insurance coverage. This is to be expected due to the fact that nobody likes to pay for insurance. Regardless, insurance is one of the most important elements of an comprehensive financial plan. A rational person could save up a few million dollars and think they have achieved financial freedom, when an event that no one expected occurs.

There are many examples of incidents that could easily wipe out millions of dollars worth of savings. This is why its so important to protect the assets you have and ensure they are protected from life’s negative and unpredictable events.

Investments

Investments are by far everyone’s favorite financial planning element. I personally believe this is due to the fact that investing is much more exciting than insurance and tax planning. A Financial Advisor will review a portfolio’s allocation and assess its theoretical ability to reach a client’s financial planning goals and objectives. This includes determining if there is proper diversification among assets.

In addition the analysis will seek to determine the right investment approach for the client’s financial situation and what levels of future investment is needed in order to fund the desired way of life during retirement.

I hope this article helps you understand the elements of a comprehensive financial plan. In my next post (Elements of a Financial Plan - Part 2) I will provide a quick overview of the last three elements of a financial plan. As you can see the financial planning process can be intense. True Financial Planning seeks to provide a robust financial plan that will enable you to reach your life’s goals and objectives.