At the start of the year many people make New Years resolutions to get a handle on and improve their finances. Unfortunately by now many of those people have given up on those resolutions. The main reasons for abandonment are usually not having enough time to focus on the task or feeling that it is too daunting to put a financial plan together.
If you want to get a better handle on your finances here are five concepts that you should start with to build the foundation of your financial roadmap.
Net Worth
Yes, you have one. This is the sum total of your assets (bank account balances, savings, investments, etc.) minus your debts (loans, mortgage, credit card debt, etc.). Your net worth is the easiest way to get a big-picture perspective on your finances and allows you to see if you are making your progress to your financial goals.
Here is one of many net worth calculators that exist. Take 5 minutes and calculate it.
Cash Flow
I often talk about the importance of getting a handle on Cash Flow (the income you have coming and the money you spend on expenses going out). It is the foundation of getting control of your personal finances.
A lot of people think that budgets are only for people who have too much debt, are tired of never having money, have trouble paying the bills, or are blindsided by unexpected expenses. That couldn’t be further from the truth. Everyone should have a handle on what they are spending. Your living expenses are just one part of the cash flow puzzle. How can you know how much you should be saving for retirement, investing for your child’s education, or have in an emergency fund if you do not have a handle on your cash flow?
Keeping track of all of your expenses can be a tedious process. Do it for a month to understand where you are. Keep track of every dollar you spend for a month and all of your income that you earn. Then figure out what expenses you pay annually, semi-annually, or quarterly, and add their monthly amount to your tracker. Even if you use a pen and paper or a spreadsheet to track everything the exercise will be valuable.
Liquidity
Liquidity is how accessible your money is. Cash is the most liquid your money can be, because you can access it immediately. Your home on the other hand would be on the opposite side of the liquidity spectrum. Even if you sold it today, it would probably be a couple of months before the sale closed and you had the proceeds available to you. Never mind the fact that you would need to find somewhere to live.
You never know when an emergency will arise. You want to have enough money fully liquid but not too much where you have your dollars sitting around not earning anything. Figure out how much time it would take for you to get your hands on $10,000, $25,000, $100,000, and $250,000.
Passive Income
I call passive income the holy grail of personal finance because it gives you the ability to achieve financial independence. If you wanted to you would have the ability to quit your job, yet still pay for all of your expenses.
A valuable exercise is to use the assets in your net worth statement you calculated above and figure out the amount of income those assets could generate if you stopped working today. Then set some goals on how much passive income ($100,000 a year, $250,000, $1,000,000, …) you would like to have and put a plan on the actions needed to achieve that. Here is an article I wrote on how to execute on that topic
Planning for a Catastrophe
One question that is critical to answer is how are your family’s expenses paid for if you and/or your spouse die or become disabled. If you calculate your passive income above and you do not have enough to cover your expenses, or if your assets cannot generate enough income each year until you are slated to stop working it may be wise to look at adding life and disability insurance.
There are different ways to figure out how much life insurance you need. My favorite is to focus on the income that will be lost if something happens to you. Here is a calculator that helps you calculate how much life insurance you should purchase.
The title of this article was inspired by a great blog I came across at http://getyourshittogether.org/ On that website you can get free templates on life and death planning topics like a Will and Power of Attorney. The author started the blog when in 2009 her husband died in an accident. She was shocked by the number of things they had ignored or left disorganized.
Getting a handle on your finances can seem like a daunting task, but if you start off focusing on these 5 areas you’ll create a foundation for your finances. Once you have these in place the next area I would focus on would be with planning for goals like (Ensuring you have enough money to retire, paying for your children’s education, buying a vacation home, …)