Creating a budget that works for you

Budgeting that actually works

Everyone knows that successful businesses always stick to their budgets. In an entrepreneurial setting, where a company has raised money through investors and banks, every dollar needs to be carefully deployed to resources that give the business additional value. Making frivolous decisions with investor money is a recipe for disaster and the CEO is accountable for how money is invested. A business, from a financial perspective, is a set of assets and liabilities, which produce income and require expenses. The financial foundation for growing a business’ shareholder value is no different than growing personal wealth, so why do so many people treat their own net worth so poorly?

For better or worse, psychological factors for personal finance make behaviour different for an individual managing their own wealth versus a CEO of a business. There are no investors in your personal net worth – you are the only investor. You get to enjoy all the gains but you also have to suffer all the losses. This lack of accountability, in my opinion, gives people the “excuse” that they can make poor financial decisions and not have to answer to anyone of suffer any consequences. Of course, there are consequences – significant ones. A poorly managed budget and financial strategy will leave you with far less wealth and therefore personal freedom down the road. Therefore, more people need to think of themselves as the CEO of their personal net worth. Let’s say your net worth is $50,000 from all of your diligent retirement savings, mortgage payments and investments over the year. Imagine you are not you – you are an investor that has invested in you and as an investor, you’ve put all of your eggs into the “you” basket.

If this were the case, the investor would be really critical of you to make sure that the $50,000 investment is being managed so that it grows. Since you the investor have all of your money invested into a single investment you’d probably want to check in with the CEO regularly, review performance, understand the strategy of how the $50,000 is being deployed for growth and so forth. This, in my opinion, is the correct attitude to take when it comes to your money – take control of it, use prudent planning and budgeting strategies, manage risk and then execute the plan.

You are the CEO of your own net worth. Be accountable to yourself and take control of your own financial destiny!

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How to make a budget work

In an ideal world, everyone sits down for a few hours at the beginning of each year and prepares a detailed budget in Microsoft Excel. The budget includes all of the components of the financial picture. What does this mean? It means not only is the budget looking at income coming in and expenses going out, it is looking at the capital allocation for assets and liabilities to understand what the expectation is for asset appreciation, liability changes and investment performance. I will overview the approach for each category below:

Income Sources

All outlays of cash have to come from somewhere, and so understanding all of your sources of income is important as a starting point to know what you are working with for your expense and investment budgets. For most people the main source of income in their early years is their salary. You should look at the income number after having factored in all of the deductions and taxes on your pay slip, such that your income from your salary is your post-tax, post-deduction amount.

Other sources of income will be anything you earn from “side hustles”, investments, rental properties or otherwise. Note that if you earn income outside of your salary, chances are it does not have income taxes withheld at its source, so you’ll need to associate a tax cost with these sources of income so that you don’t find yourself at the end of the year with an income tax bill that you don’t have the cash to pay.

Once your post-tax income total is totalled up, you’re ready to understand what to do with it.

The Budget       
Income Sources      
Salary (post-tax and deductions)  $   3,000.00 $   3,000.00 $   3,000.00 $   3,000.00 $   3,000.00
Tutoring  $      250.00 $      250.00 $      250.00 $      250.00 $      250.00
eBay Sales  $      100.00 $      100.00 $      100.00 $      100.00 $      100.00
Uber Driving  $      200.00 $      200.00 $      200.00 $      200.00 $      200.00
Total Income Sources  $ 3,550.00 $ 3,550.00 $ 3,550.00 $ 3,550.00 $ 3,550.00
So far, your budget should look something like this.

Cash Outlays

I always say that before you look at any expenses for your life, the first thing to start with is a cost line for “paying yourself first”. This means taking money from your income and re-investing it into assets that grow your wealth over the long term. Focus on any matching programs available to you as well as tax advantaged accounts. If your employer matches a contribution to a retirement plan, use it in full – free money. If you have contribution room in an account like an IRA/401k/459 (USA) or TFSA/RRSP/RESP (Canada), use that first to get your money growing in a tax advantaged way whether from tax deductions for contributions or tax free growth. Try to get to at least 15% of your post-tax income as your “paying yourself first” line item. This is critical to your long term financial success – do NOT leave your investment budget to the end.

The next section of cash outlays are your “fixed” expenses. By fixed, I mean the expense is the same every month and doesn’t have any opportunity for change. The main one is housing, so you can slot in your rent or mortgage payment here. Other fixed expenses would be things like utilities on your home, transportation (bus pass / car payment), loan payments for student loans or other debts that have fixed monthly payments.

Fixed payments      
Pay myself first investing -$     532.50-$     532.50-$     532.50-$     532.50-$     532.50
Rent -$   1,200.00-$   1,200.00-$   1,200.00-$   1,200.00-$   1,200.00
Utilities -$     200.00-$     200.00-$     200.00-$     200.00-$     200.00
Transit pass -$     200.00-$     200.00-$     200.00-$     200.00-$     200.00
Student loan payment -$     300.00-$     300.00-$     300.00-$     300.00-$     300.00
Total Fixed Payments -$2,432.50-$2,432.50-$2,432.50-$2,432.50-$2,432.50
Start with fixed payments. These happen regardless of what you do, and they need to be treated as such.

After paying yourself first and paying your fixed expenses each month, the next bucket of spending is your needs. These are expenses which you need every month to be successful in your personal and professional life that you can’t live without. Before you can budget for anything which is not absolutely necessary you need to put money aside for what IS absolutely necessary.

First is food. Your food budget is one of the areas where most young people falter. This budget line includes both groceries and eating out. Eating out is 300% more expensive than cooking for yourself, so if you need a way to cut your spending, this is one of the lowest hanging fruit areas you have. Take a look back at what you spent on food over the past year. How much was on groceries versus eating out? Could you improve and set a better goal for yourself this year?

Next is communications. In 2021, it is basically a requirement that you have good home wifi and a mobile phone that you can use to stay in touch with coworkers, friends and family.

Food -$     500.00-$     500.00-$     500.00-$     500.00-$     500.00
Internet / Phone -$     100.00-$     100.00-$     100.00-$     100.00-$     100.00
Other -$       50.00-$       50.00-$       50.00-$       50.00-$       50.00
Total Needs -$   650.00-$   650.00-$   650.00-$   650.00-$   650.00
Budget for your needs first. You never want to be in a place where you don’t have enough cash to pay for these items due to spending on discretionary items.

Finally comes elective spending decisions. This is the bucket of money you have to spend once you have taken care of your long term investing needs, your current housing, food and utilities requirements and your basic necessities.

While your income and spending to date should be categorized on a monthly basis, which is the frequency that those cash flows generally occur, I tend to think that your elective spending decisions should be an annual “pot” which you may decide to spend slowly over the year, or in larger chunks. As a few examples, you likely need to budget for Christmas gifts or personal travel. These things happen at a single time, but you likely need multiple months of discretionary income to afford them. In the example above, $3,550 of monthly income, less fixed payments of $2,432 and Needs payments of $650 produce about $450 per month of discretionary income. Over 12 months, that gives you $5,610 in cash to spend on discretionary items.

Available for “Wants”  $ 5,610.00
Put your discretionary fund into a single annual pot of money. It looks like a bigger number and gets you excited about your year.

Moving back to the business analogy, any good CEO is going to want to see a comparison of the company’s budget to its actual performance to make sure their team is sticking to the plan and not being wasteful of company resources. It also allows the CEO to pivot if changes are required mid-year. Often times we budget for certain income and expense items which turn out to be materially different from reality. We need to own those adjustments and make changes to our budget as a result. For example, in this case, our subject is doing some Uber driving on the side. If they are too busy to get out on the road after work and only make $100 a month over the first few months of the year, that’s potentially a $1,000 annual hit to the discretionary fund and means that something planned like a trip might have to get cancelled.

This regular cadence of revisiting the budget and looking at actuals is also a forcing function for you to own your financial reality and acknowledge where you’ve had successes and where you’ve had missteps. We all have them – its how you adjust that matters.

Process Approach – How do I actually do this?

In an ideal world, you set up an excel spreadsheet with as much detail as you can and try to plan out your year. You have a column for each month and a row for each income and expense item. Then, there is a blank column to the right of each month’s budget where you can fill in the actuals after they occur for your comparison process. This probably takes you an hour or two each month to stay in the weeds of your money and pivot where neccesary in real time. This is a reasonable amount of time to spend on a process which over long periods of time can have a 6 or even 7 figure impact on your wealth at retirement.

For those of us who just can’t force themselves to sit in front of a spreadsheet and punch in numbers, the next best way is to use technology. Sign up for Mint allows you to link your mint account to your banking and credit card automatically so that in real time your Mint App can tell you whether you have exceeded your budget, have a trend in a wrong direction etc. It is a fantastic tool and its free, so I highly recommend it.

photo of person holding mobile phone

This is where it ends for most people. But time to take your budgeting process to the next level.

Your annual budget is very important, however it only covers the income and expense components of your financial situation. You also need to visit your balance sheet regularly. This means you need to look at what assets you own, what liabilities you have and understand how the net of the two, your equity, is on track to grow.

Every year you put money aside for investments. In the case above, its about $6,500 per year. That money goes into some sort of investment vehicle, whether its stocks, ETFs, bonds, money market instruments, real estate etc. Over time it grows and compounds into a significant number. Another thing a CEO of a company is responsible for is monitoring the allocation of their capital. Think about the CEO of Disney for a minute. They have to decide how much of their company’s equity is invested into content production, theme parks, cruise ships, retail and so forth. They also need to decide on how much leverage their company should take on to boost returns and acquire more assets. (By Leverage I mean taking on debt).

Illustrated below, here is a balance sheet budget for someone who owns their home, a stock portfolio and a rental property. The Home and Rental have mortgages, so we need to incorporate the anticipated cost of interest, as well as the reduction in loan principal through mortgage payments.

     A  B  C  D  E = A + B + C – D + E 
  Asset Liability Beginning of Year EquityAdditions during the year Asset Growth/Income  Liability Cost  Liability Reduction  End of Year Equity  Equity Growth 
House $500,000$400,000$100,000 $15,000$8,000$2,000$109,0009%
Stock/ETF Portfolio $75,000$0$75,000$6,500$6,000$0 $81,0008%
Rental Property $250,000$200,000$50,000 $21,900$4,000$1,000$68,90038%
Total $825,000$600,000$225,000$6,500$42,900$12,000$3,000$258,90015%
What is your balance sheet budget?

This is a crystal ball budget, no doubt. Noone can predict how the stock market, real estate market will perform. However, I think going through this process is a mental encouragement exercise. By viewing how your wealth will grow each year from your investments, it will encourage you to save more from your “operating budget” and put it towards investing.


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