The first step toward understanding your financial situation is your budget. We want to get a grasp of is how much money you have coming in every month and how much money you are paying every month for your expenses. We are doing this before we make a plan to handle debt, invest money or purchase a large new item. We will look at a basic layout for this that includes your sources of income as well as your total expenses.
Your main source of income is most likely going to be what is called “earned income” from your profession. This is going to be your salary that you earn, for our purposes we usually look at this on a monthly basis. However, your income can also be from many other sources including support you receive in the form of government aid, earnings from family or a trust fund or perhaps an investment portfolio. Your salary as well as these other income sources are going to be the starting point for making a budget. This is how much money you are receiving in total every month to use on expenses and build savings. There are additional sources of income you may have but this gives us a good start.
Your expenses are all the costs you have on a monthly basis. The biggest costs most people have are their mortgage or monthly rent, health care costs, car payments, utilities, gas and food. Of course, there are additional expenses that are paid or can be estimated on a monthly basis, but these are usually the big-ticket items that are easiest to put a number on.
Figure 1 below depicts the simplest possible monthly budget in a summarized form. We are only looking at what your monthly salary is less your total monthly costs. While very simple this is the most important aspect of understanding your finances because here you can begin to see if you are saving money on a monthly basis or are you spending more money than you are bringing in. Let’s not make this messy! We can just assume this is the income you receive after your employer withholds taxes on a monthly basis. That way we get a simple quick idea of the money we have from our sources to spend. We can save taxes for later.
In this simple case your total income is more than your total expenses, so you are saving $150 each month. This is money that you can use to build a cash cushion, invest, or perhaps save for a large purchase you would like to make. Below in Figure 2 we have a budget that still just has salary as your sole source of income but shows your expenses broken down into the most common major monthly expenses.
In Figure 2 above we are looking at our biggest expenses. It is helpful to then estimate “other expenses.” These expenses can include all our other miscellaneous estimates. Again, let’s not go overboard here. If we start trying to split nickels the job becomes to big and the precision is just not worth our time. Maybe you bought a book or started a new subscription, perhaps you purchased a gift for someone or went to a music concert. Usually you can get an idea of these cost along with your major costs from your bank statement and credit card statement. The point is these are usually not large costs, but they are costs that come up monthly and can be comprised of different things. The key point here is to not get bogged down in being exact, just get an idea for what those other costs are and lump them together for now. If you pay for many things in cash remember to break that down in your handwritten or Excel version of Figure 2. We will discuss large planned expenses in the future.
Note, there are many expenses that do not occur monthly but can be estimated or known. Perhaps you only pay your car insurance once every six months, but you know the exact cost. This can be dealt with easily if you create a yearly budget that is broken down monthly on a basis with some cost recurring less frequently than monthly or only in certain months.
CAUTION:I see a lot of people start this process and get stuck on one thing. A big pitfall is trying to be too precise or making the process harder than it needs to be. An important concept often stated by Warren Buffet is that we need to look at what is “meaningful,” not just what is “measurable.” So, if we round up to $10 here and there or miss something let’s not worry right now. If you are struggling on getting a number for an item that is less than 5% or so of your expenses just move on. Throughout this process one thing that can really slow you down is making things harder than they need to be. So don’t!
Let’s review. At this point we have created our budget, so give yourself some credit. What have we figured out from this:
- How much we are earning each month from our job.
- A relatively accurate idea of our total expenses each month.
- Whether or not we are saving money each month or spending more than we earn each month.
Knowing these three things we can start to get an idea of our assets and debt and get a further picture of our financial situation. Again, the main point here is to see if we are slowly going more into debt or building up a nest egg. If we are spending too much money, we may need to cut some costs. If we are saving money, we will investigate how we want to invest that money.