What is Budgeting?

Mehrab Irani 

A budget is planned allocation of available resources and can mean different things for government, business and an individual. The importance of budgeting cannot be underestimated. Budgeting is one of the most important skills that you have. Planning and budgeting are crucial when it comes to preserving and growing your wealth.

Surplus and Deficit Budgets

In accounting terms, budget simply means “income minus expenses”. Therefore, when one is reduced from the other, arithmetically the answer can either be in the positive or negative.

Deficit Budget

Barron’s Finance and Investment Handbook defines a deficit budget as “excess of spending over income, for a government, corporation, or individual”. Pay attention to the words “excess of spending over income”. Today we see that most governments and companies land up in budget deficits. This is simply because they spend more than they earn. A government will finance its deficit budget either by printing notes or taxing more, both of which hurt you as an individual in the form of inflation or higher tax, as the case may be.

A company would try to bridge its budget deficit by either firing some employees, increasing the prices of its products, reducing their quality, or by a combination of these and other factors. Again, all these factors are going to affect you adversely. Individuals who consistently spend more than what they earn accumulate huge debts which result in budget deficits which if not controlled would one day lead them to bankruptcy. Why individuals fall into budget deficits and how to come out of it is the main thrust of this commandment.

Individuals always complain that they don’t have money to save, invest or spend. For this reason, this is a very important commandment for helping you attain financial freedom by converting your budget deficit into surplus.

Surplus Budget

Barron’s says that “A budget surplus is an excess of income over spending for a government, corporation, or individual over a particular period of time.” Give importance to the words “excess of income over spending”. Now a budget surplus does not necessarily mean living below your means — it simply means expanding your means beyond your expenses and having a surplus. This commandment will show how it is possible to do so.

Achieving Budget Surplus

There are two ways of achieving budget surplus — either by increasing your income, or by spending less, or both. I am not telling you to cut down all your expenses and live in a miserly manner in order to achieve budget surplus. Neither am I telling you to keep spending lavishly on unnecessary expenses or bad capital assets. I am simply telling you to expand your income and manage your finances in such a manner that you achieve a budget surplus. This might sound too simple and almost like a fairy tale to you. Wait, let us understand how to do so in practice and achieve financial freedom.

Grow Your Income

The first and foremost thing is income. We all have to learn to increase our incomes. We all have some talent — we have to identify that talent, hone our skills, gain experience, improve our net income and increase our knowledge because that is the key in the current technology and information era. We all have to try to consolidate our strengths and minimise our weaknesses and aim to earn as much as possible because income is the first item of your profit & loss account.

Increase Your Net (After Tax) Income

Earning more is just the beginning and will not in any way solve your financial problems unless you follow the other rules.

The second most important thing is to enhance your net income, i.e. your income after tax. There are lots of financial predators and the biggest amongst them is income tax which legally takes away money from your pocket. There are four different kinds of income:

  • Earned income, such as salary where the person actually works to earn money,

  • Guaranteed income — income from an investment / asset where the return is guaranteed, such as from bank FDs and hence there is negligible risk, and
  • Passive and Portfolio incomes where neither the principal nor the return is guaranteed, e.g. dividend from shares, rent from real estate, capital gains, etc.

Typically, the tax structure is discriminating. As a general rule, there is maximum tax on earned income. It would almost seem as if the government wants to punish you for working hard to earn your income. Equally, there is maximum tax on guaranteed income, perhaps because the government thinks you are not innovative enough with your money! However, there is a lower rate of taxation — or even no taxes in some cases like dividends on equities, long term capital gains on equity shares — on passive and portfolio incomes. Thus, rather than working hard for your money and paying higher taxes, you have to be smart and let your money work for you and thus pay low or no taxes.

Avoid Unnecessary Expenses or Bad Capital Expenditure

Unnecessary expenses include a foreign trip, costly five star dinners, etc. Bad capital expenditure means spending on assets which produce negative income or take away money from your pocket, such as a luxury car, a vacation home, etc. Bad capital expenditure would also include those assets which do not give you any income, such as a self-occupied house. But we all have to live in this world and incur some expenses for food, clothing, medical, etc. for our existence — therefore we have to learn to budget for these expenses and make a judicious use of our finances.

Now, just as you would budget for food, clothing, etc., in the same way you must budget for some fixed amount for savings. Then, too, what is the use of money if we can’t enjoy life? So sometimes everybody has to incur unnecessary expenses or bad capital expenditure as well. But, at least, don’t pay for them — let your assets pay for them. And, remember, treat all money the same way, whether it be the money you get from, say, a lottery ticket or from the estate of some deceased relative or any windfall gain. Treat them all with the same respect as the money you have earned from your hard work. Exercise the same caution in utilizing the money, whatever may be its source — just because it is free money or windfall gain shouldn’t lead you to squander it away.

Liability Side — Good Debt, Bad Debt and the Power of Leverage

You need to distinguish between good debt and bad debt. According to me, bad debt would be that debt which is used for acquiring bad assets, such as a luxury car or a vacation home which take away money from your pocket, or a self-occupied house which does not put any money in your pocket. Good debt, on the other hand, would be that which helps you in creating an asset which then puts money in your pocket (income) as well as scope for future capital appreciation, e.g. rental property which earns rent, shares which earn (tax free) dividends — and both also have the potential for future capital appreciation. Never borrow to incur wasteful expenses, say, on a foreign trip or for buying a bad capital asset like a luxury car or vacation home because they will not only take away money from your pocket in the form of interest payments but also entail recurring expenditure in the form of petrol, repairs, property taxes, etc.

The author is the General Manager – Investments with Tata Investment Corporation Ltd. The excerpts are from Commandment 3 of his just released book “10 Commandments for Financial Freedom”.

Disclaimer: Any content, views, opinions and/or responses on any of the pages of  www.indiainfoline.com, expressed or submitted by the creators, contributors, sponsors or  advertisers, other than the content provided by IIFL, are solely the views, opinions and responsibility of the person submitting them and do not necessarily reflect the opinions of IIFL.  IIFL does not warrant the accuracy, completeness or usefulness of the information. Nothing contained in or provided through this page is intended to constitute advice or solicitation for any investment/financial products or services, neither does it constitute an offer for the purchase or sale of any financial instrument or confirmation of any transaction.

IIFL does not hold any responsibility for the consequences of any action or omission thereof based on any information related to investment/financial products or services that may be available on /through this page. Any reliance you place on such information is strictly at your own risk. We may include links to other web pages, but these links are not an endorsement of those pages, products or services.

IIFL is not responsible for the content of any web site by other operators. Under no circumstances will IIFL be responsible or liable in any way for any content, including but not limited to, any errors or omissions in the content, or for any injury, death, loss or damage of any kind by any person as a result of any content communicated whether by IIFL or a third party. In no event shall IIFL be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits arising out of or in connection with the availability, use or performance of any information communicated on this page.

Please read our other disclaimers and Privacy Policy.

Disclaimer | Disclaimer - Research  | Disclaimer - Discussion Boards | Disclaimer - Chat | Disclaimer - Twitter | Terms & Conditions  | Privacy Policy

Best Viewed in - 1024 x 768 and above resolution, IE7 & above, & other popular browsers
Copyright © 2011 Flame. All rights Reserved