Managing the Inflow Side of Things
Compared to complex businesses, with much variability on the asset side of things, managing our personal balance sheet is a simpler matter, as our income tends to be more constant and regulated, the amount we earn in salary per year.
This can vary somewhat depending on how we make our money, and in some cases like self-employment it may entirely be based upon circumstances, or may vary considerably if we are on commission or if a large part of our compensation is based upon bonuses, but even in these cases, a fair bit will usually be known about what we may expect to earn.
It’s not that there’s nothing to do on this side of the ledger though, and there may indeed be some real opportunities to increase our income, by doing such things as improving one’s education, looking to develop one’s skills more, seeking higher paying jobs, taking on additional work, seeking out higher bonuses if they are available, and so on.
Some of this at least may be based upon need, as if we’re not making enough money to make ends meet, we may have to increase our income, but increasing income is generally a good thing for us just as it is for a business.
This is all going to be highly dependent on our particular circumstances, and there may be some great opportunities here or this may be extremely limited.
People do pay a fair bit of attention to the income side of things though, and even though many of us can profit from putting more effort into making more money, it is the other side of the ledger, in this case the spending side, that tends to get neglected a lot more.
Managing the Outflow Side of Our Ledger
For most people, there are far more opportunities present in managing what we do with the income that we receive, the liabilities side of our ledger. We do need to realize though that the end goal isn’t to just maximize profit, in our case maximizing what we have left when income is earned and then distributed, as when we spend our money, we do get benefit out of this, or at least that’s the goal.
With a business, the liabilities side represents the costs of doing business, with the profit, the goal of the enterprise, being the difference between what is taken in and what is spent. Things are a little different with a personal finance balance sheet, because what we spend isn’t just a cost, as we ultimately receive benefits from our income from spending it at some point.
Our balance sheet does still tell a story though, which is how much of the income we receive is used now versus kept in reserve for later. We should always be striving to keep a certain amount in reserve, and preferably a good amount, to make up for any shortfalls that arise when our day to day income isn’t enough to cover our day to day expenses.
Our balance sheet also allows us to examine more closely what we are actually spending our money on, and then use that information to decide things such as whether a certain level of spending is sustainable or whether it fits our longer-term goals of supplementing our income when it becomes reduced when we stop working.
The measure of our success here isn’t necessarily measured purely by money, as we do need to make sure that we are focused ultimately on getting the most out of the money we get, in terms of maximizing utility or satisfaction. This is why measures of value are so important when it comes to personal finance, the value of what we get out of spending a certain amount of money on one thing over another, in addition to getting more value out of spending it later instead of now.
We do need to track these things monetarily though, and we ideally will categorize our spending into certain groups to get an idea of what we are spending on these categories, although some purchases will need to be examined separately if the amount spent is significant.
The tendency here is to use capacity as a guideline, meaning that we look to see if we can afford something and if we can we will buy it if we want, but this is not the best way to approach these things because this view is married to the present too much and doesn’t account for the future.
A good example is budgeting for a car, and we might be able to afford a certain payment per month for that with relative comfort, so that would seem to indicate that the purchase is acceptable. Years later though, when we retire, we may not be able to afford a good car anymore and if we had have driven more modest ones when we were working, we may have enough to keep things on a more even keel, not going with an expensive car for years and then having to drive inferior ones or perhaps have to take the bus later.
Putting This All Together
This can be fairly difficult to calculate and we do need a good idea of how things will play out in the future, but if we look to project our income over the rest of our lives and then use an average of this for our income and budget around this, this can be an excellent way to make this changing situation more measurable.
If, for example, we are making $50,000 a year now after tax and expect this to drop to $25,000 after tax in retirement, and we have 20 years to work and plan for 20 years to need to get by on the lower income, then our average will be $37,500 and that’s what we should be using on our balance sheet, not $50,000.
If we can manage this, then this will keep things in line pretty well, without any other adjustments or calculations. The most we will spend is the $37,500 and we will at a minimum set aside $12,500 a year, which works out to saving 25% of our after-tax income, which is a good amount indeed.
Our situations and calculations will of course differ, but if we aren’t using something like this, then we’re going to end up with shortfalls later, and perhaps even some very significant ones.
While we may expect a positive return from this money set aside, and if this is the case, we will actually be a little better off in retirement due to this extra being added in, in our later years there are all sorts of things that can happen which can eat into our savings, and therefore it’s better to err on the side of caution.
There may also be things happen along the way which may require us to spend down some of this, and we need to keep in mind that this calculation is only accounting for typical expenses, and we still need a reserve for both the nearer term and the longer one, such that events that may arise won’t destroy our retirement plans.
We may also find that we can get by on even less if we really want to, especially if our income is on the higher side and our tastes are more modest. Building wealth in itself is desirable and does provide a fair bit of satisfaction, and we can always spend it later, so we should never feel cheated by saving too much.
We can be too frugal though, and the goal here is to strive for what is reasonable, which should have us avoiding unreasonable spending and also unreasonable restraint. If that is our true desire than this is fine, but this should not involve unduly depriving ourselves when we don’t have to because the goal here isn’t just to accumulate wealth, but to ultimately enjoy it and benefit from it.
A great many people, perhaps almost everyone, could benefit from a more analytical approach to their personal finances, and this really doesn’t require that much effort but does require quite a bit of commitment, but no more than we really should be committing to if we are at all serious about helping ourselves by managing things better.