Make a forecast of our income & expenses against the most likely events and circumstances
You must have heard of the word ‘Budget’ several times from your parents, teachers and friends. Let’s define the term for a better understanding: The word budget comes from the French term ‘bougette’ meaning purse, to imply a list of planned expenses and income. It is a plan for saving, borrowing and spending expressed in monetary terms. Through a budget, we aim to:
- Make a forecast of our income & expenses against the most likely events and circumstances.
- Match the actual performance against the forecast to see whether we have earned or lost money.
Budget, as you can see, is critical to financial planning and freedom. Through a good budget, we can effectively plan for our income and expenditure thereby securing our financial freedom. The first step in the process of understanding a budget is to learn about a key financial statement that you can prepare for your own specific needs: Income and Expenditure Statement. We have simplified it to enable your quick understanding, but let’s briefly understand the basic accounting concepts before we turn to the statement.
Principle of debit & credit
Once you understand the principle of debits and credits, you’ll understand the essence of accounting. Every accounting transaction contains both—debit and credit. All debits must equal all credits. Debit and credit are two actions of opposing nature that are relevant to the process accounting. They are as fundamental to accounting as addition (+) and subtraction (-) are two mathematics.
You just need to understand that debit and credit are two actions that are opposite. An element (account) that is effected by an accounting transaction is either debited or credited (with an amount that is reflected in that transaction) depending on the nature of the account and the rule applicable to it.
Let’s understand the meaning of the words ‘transaction’ and ‘accounting’ which is derived from the term ‘account’. Transaction is an event that is expressed in money terms and which changes our financial position - either money goes out or comes in. Account is the summarised record of all transactions according to the established accounting principles.
The total process of accounting is driven by
- The dual entity concept
- The nature of the accounts and
- The rules/principles of debit & credit
All the account heads used in the accounting system of an organisation are classified under three heads Real, Personal and Nominal. Each account type has rules of debit and credit relevant to it, one for debit and another for credit. We will not go into the details of account heads. Just remember the following three simple mantras for change in debit and credit:
- Real Accounts: Debit what comes in. Credit what goes out
- Personal Accounts: Debit the benefit receiver. Credit the benefit giver
- Nominal Accounts: Debit all Expenses and Losses, Credit all Incomes and Gains
Now, let’s learn about a key concept called Net Worth.
Networth = Assets - Liabilities
Assets are ‘things you have’ and liabilities are ‘debts you owe’. Net Worth is the balance between the two variables which shows you exactly where you stand financially. Let’s look at a simple example. In this example, the worth of your home is Rs. 12 lakh and the housing loan is Rs. 5 lakh. Your Net Worth is Rs. 7 lakh as Assets - Liabilities = Net Worth.
So, one can easily deduce that more the liabilities, less the net worth and more the assets, more the net worth. A good net worth is critical to financial security and success.
Cash flow = cash inflows (income) - cash outflows (expenses). It is calculated typically on a monthly basis. Income could be salary, rent, dividend etc. while expenses would be EMI, fuel, entertainment, grocery, food etc. If income exceeds expenses, you have a positive cash flow which is good news. Else, you are in trouble with a negative cash flow.
So if you have a good net worth and bad cash flow, what does it mean? ...That you will have to sell some of your assets and if their market value is poor, you could be in deep trouble …That your home depends on the ability to earn. If you stop earning, there’s no backup even if your liabilities are in check.
For a healthy financial life, you need to look both ways:
- Ways to increase your Net Worth: Eliminating or reducing debt and building assets of good market value.
- Ways to increase your Cash flow: Controlling your expenses and looking for additional streams and sources of income like rent, investment income, additional job, etc.
Good habits to manage your finances
Signs which indicate financial trouble