In the previous post we talked about the first step to turning your financial situation around – identifying your free cash flow (or lack there of). Free cash flow is the amount of money you have available at the end of the month after paying for bills and necessities. The first step to improving things is to determine your situation.
The second step is to develop a budget. You have actually done a lot of the work for this in developing your cash flow diagram. The first step in developing a budget is to list your income and expenses, just as you did in determining your free cashflow. In a budget, however, you then adjust your expenses to meet certain debt repayment and saving goals. You start to direct your money where to go so that you can reach your goals.
A budget is also a great communication tool for a couple since we normally spend our money on things that are interests to us. Hobbies, activities, vacations, and luxuries all involve spending, so a budget allows you to discuss plans and agree on how you’ll spend your time and money. Here are the steps:
1. List your income
To start a budget, again list all of your income for the year at the top of a sheet of paper or a spreadsheet and sum.
2. List your non-flexible expenses
Next list all of your non-flexible expenses (those that are fixed, such as rent or mortgage, car payments, credit card minimum payments, car and home insurance, etc….) These are things over which you have little control without a drastic change (like refinancing your home or selling a car).
3. List your required, but flexible expenses
Next, list all of your flexible but required expenses (those which are required but which can be adjusted somewhat, like food, clothing, utilities, and gasoline) and assign a value close to what you are currently paying. Here, use your latest credit card statement or just estimate an amount – it doesn’t need to be exact.
4. Subtract your required expenses from your income
Sum you flexible and non-flexible required spending values together. This is your minimum required spending for the month. Subtract this total from your income – what remains is your free cashflow, which is how much money you have that it not spoken for before the month starts. This is the money you have available to save and invest, or to spend on optional activities and luxuries.
If your required expenses exceed your income such that your free cashflow is negative, you’ve got an issue. Look for ways you can trim back on your flexible expenses, like driving a little less or reducing your food costs by eating in and buying cheaper food. Also try to cut your required expenses, by selling a car and buying a cheaper one for cash to eliminate a car payment, or by paying off a credit card and then cutting it up. The only alternative beyond this is to find extra income through another job or side business. You might be able to work a job temporarily, like delivering newspapers or pizzas, or in retail during the holidays, and use the extra money to pay off a car or a credit card.
Even if you are making more than your required expenses, look for ways to increase your free cashflow by cutting expenses or increasing income since this will give you more money to invest and more flexibility. Look for things that are sustainable and are lifestyle changes, such as eating more lunches from home rather than going out. Avoid things that you cannot keep up like cutting your clothing budget to $10 per month or eating beans and rice at every meal. Like dieting, you’ll do better if you change your lifestyle rather than go on a crash fiscal “diet” you can’t sustain.
5. Allocate money to savings
Allocate some of your free cashflow to savings (including your emergency funds, retirement, kids college accounts, medical savings accounts, and investment accounts). If you can do nothing else, allocate money to get a fully funded emergency fund established quickly (3-6 months worth of your required expenses). Medical savings and retirement are the next most important, followed closely by college. Finally, allocate a healthy portion of the remainder to investing (ideally, at least $3000-$5000 per year). Note that you’ll need to be saving money for replacing cars, major home repairs, and home and vehicle maintenance. You can establish special savings accounts for these, and perhaps put some of the money into investments if these accounts grow large enough to cover the need without an expense occurring (like maybe your air conditioner just keeps chugging along).
6. Allocate money for optional expenses.
Be sure to plan some optional expenses like meals out, vacations, and hobbies. Luxuries like cable and expensive phone plans would also go into this category. You may need to trade off between investments and optional expenses to reach a good balance. Don’t forget things like gifts and kids activities here. Also, allocate a reasonable amount (maybe $40-$150 each month each) to just spend as desired.
When you’re done creating your budget every dollar should be allocated somewhere. All adults int he household should agree to the budget and adjustments should be made until all are satisfied. Once you have the yearly budget, you can start to create a monthly budget where you plan specific income and expenses by month. You can use your yearly budget as a guide for spending goals. For example, if you have $12,000 per year allocated for retirement, you might send in a $1,000 check each month or put in a few thousand during months when you don’t have other big expenses. As another example, if you have $2000 per year allocated to clothing and you allocate $300 in your January budget, you’ll note that you have $1700 left to spend on clothing for the year.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.