Designing a cohesive and well-thought-out financial plan is a time-consuming and complex task. In the process, and depending on your financial situation, you’ll likely end up getting burned out glancing at so many numbers on a sheet.
To avoid getting overwhelmed, you should start your financial planning from the ground up. For this purpose, three basic questions must be answered throughout the first stages of the financial plan, to wit:
- What is my net worth?
- Where is my money going (and when)?
- What are my priorities?
Let’s elaborate on these points, one by one:
1. What is my net worth?
Net worth refers to the difference that results from subtracting the value of the liabilities from the global value of all the assets owned by a person or company. It’s essentially the value of the assets minus the debts or obligations.
Assets are resources or goods, both material and immaterial, that carry measurable economic value and that are expected to provide future benefits to their owner. Liabilities, on the other hand, refer to obligations or debts that are prone to deplete resources (accounts payable, loans, mortgages, bills, etc.)
Net worth can be either positive or negative, depending on whether the value of the assets exceeds liabilities (positive) or vice versa, that is, the liabilities surpass the value of your assets (negative).
There are two main types of net worth:
- Corporate Net Worth: A business’s net worth is equated with the “book value” and shareholders’ equity, and it’s reflected in its balance sheet, which is a financial statement that encapsulates a company’s assets, liabilities, and shareholder equity at specific points in time. A company’s net worth is not necessarily linked to the net worth of its owners, though owner’s equity is technically considered an asset within the framework of the owner’s personal finances.
- Personal Net Worth: The net worth of individuals, which is basically the difference between the value of their personal assets (e.g., the value of properties, securities, and commodities) and their liabilities (such as mortgages, student loans, taxes, bills that ought to be paid, rent payments, loan interests, etc.)
With all that said, in order to calculate your net worth, you need to make an exhaustive list of:
- All your assets: Examples of assets you could add to the list are numerous, including the balance reflected in your bank accounts or exchanges, cars, houses, retirement plans, salaries, and pension funds. Small assets could be included, provided that their sum represents a substantial percentage of your global asset value.
- All your liabilities: Insert all your debts, including credit card debt, loans, outstanding mortgage, and bills, among others.
Ascertaining your net worth is a markedly important step in your financial planning, as it allows you to have a clearer picture of your financial health, as well as perform better risk management. Your net worth provides an overview of how much money you could have available to spend, and how much you would be capable of losing in risky trades and investments without severely compromising your solvency ratio.
2. Where is my money going (and when)?
Cash flow should not be confused with net worth. The cash flow does not take into account illiquid assets or liabilities, but only the money transferred in and out of the company in a given period. In short, the cash flow is related exclusively to transactions. If there is a simple way to put it – though there may be occasional overlapping – cash flows are concerned with revenues vs. expenditures, rather than with assets vs. liabilities.
A financial plan is incomplete unless you’re aware of your cash flow. This may be one of the most difficult tasks, as you’d have to copy and paste all your documented transactions into a spreadsheet. This will give you hints about the amount of money you should expect to spend on a monthly basis, as well as the amount that you could probably use for your savings funds or investment opportunities.
There is also the added difficulty of seasonal expenditures. Some individuals and companies are prone to spend more during certain periods throughout the year. For this reason, a good tactic would be to get a monthly average, rather than taking a specific month as a reference. This is done by stacking your yearly expenses and dividing their sum by 12. In doing so, you won’t have to worry about underestimating or overestimating your monthly outlay.
Cash withdrawals can also pose significant challenges, though they might not concern you if you operate mostly via online banking and/or financial instruments like credit/debit cards.
It’s often the case that all the cash withdrawn at an ATM is spent on short notice, but it’s not always the case, especially as you’re sometimes required to withdraw more than you really need. For this reason, it’s good to keep track of all your purchase receipts. In case you’re not capable of doing so, then it’s best to err on the safe side and count your withdrawals as expenses. Another way to salvage the situation is by counting the amount of physical cash you have in your wallet or your “safe spot” and subtracting that from the amount of money you’ve withdrawn in a year.
On a corporate level, cash flow must be treated with utmost seriousness. A cash flow statement is a critical part of a company’s global financial statement – along with the balance sheet and the income statement – and every inflow and outflow must be wholly documented to avoid compliance issues.
Companies may receive income from investments, licensing agreements, interests, royalties, and, of course, sales. Part of these earnings will serve to cover assorted operational and financial costs. All of these operations comprise, as a whole, the cash flow of a company.
Studying a company’s cash flow is key to determining its financial performance, liquidity, and flexibility. When a company’s liquid assets increase, we speak of a “positive cash flow”, in which case the company can cover expenses, reinvest, reimburse shareholders, and mend the fence in the event of future unforeseen challenges and downturns.
The types of cash flow are:
- Cash Flow from Operations (CFO): It relates to the inflows and outflows derived from ordinary operations. This type of cash flow will serve as an indication of whether a company can keep up with operating expenses and bills. It’s obtained by calculating the difference between the received cash from sales and the operating costs in a specific period.
- Cash Flow from investing (CFI): It shows how much revenue or loss was generated from investments. Unrealized losses on long-term investments do not generate negative cash flows, so they’re not always indicative of the overall financial health of the company.
- Cash Flow from Financing (CFF): The amount of money used to fund the company and involves debt issuance, equity, and dividend payments.
3. What are my priorities?
A financial plan will be for naught unless you set out clearly established goals. This is something you must ponder upon mostly on your own. A financial advisor/planner can help push you on the right track, but will not be able to paint the finish line for you.
This is the spinal cord, so to speak, of the plan. It’s what supports the entire endeavor. Failure to set out a defined short-term, midterm, or long-term objective could result in disastrous financial harm and leave you more vulnerable in the event of having to confront a financial crisis or an unexpected bill.
In the case of companies, this is essentially a given. They have, by nature, a delineated objective. But, even then, business owners would also concoct specific plans for territorial expansion or the introduction of additional lines of products and/or services, among other examples.
On the flip side, human beings tend to be very ambiguous as to their ambitions. It’s part of our nature, and it’s something we must cope with during our lifetime, to varying degrees. There are also insecurities derived from prior experience with black swan events and global crises, such as the one that we all recently underwent in the wake of COVID-19.
You won’t be able to foresee every single possible crisis scenario, but you can prepare to at least withstand the worst stages of it. Also, don’t be afraid to fine-tune or shift objectives as you see fit. In this regard, a financial advisor or planner is very handy, such as those you’ll find at JTT Accounting.
How to Set Up Financial Goals
With all that said, these are the basic steps you would want to follow to get started with goal setting:
- Write them down: This may sound a bit too “romantic” or superfluous. Nevertheless, it’s very easy to get swayed from your target. Write your objectives down on a piece of paper, a sticky note, or your smartphone’s note app. Place them somewhere prominently visible so that you’ll be constantly reminded of them.
- Specify them: We all want more money or a better life, but that goes without saying. You ought to make your objectives more specific if you wish to get anywhere. As an example, you may want to be able to pay that college tuition, pay off your mortgage, or do a startup. Those are good examples of specific financial goals you can jot down.
- Measure them: Those goals should be measurable and reasonable. If you want to pay a specific debt, you need to make sure you know the amount. Perhaps you wish to be able to reach a defined amount in a given timeframe, in which case you would have to specify it.
- Set a due date: Sometimes the best way to tackle big financial struggles is to set up small short-term milestones. You could focus on smaller goals in order to accomplish bigger ones. To give just one example, you could commit yourself to pay 30% of a specific debt by year’s end, which, in turn, could entail having to increase your monthly payment. This is a great method to remain motivated as you complete each milestone, and it statistically works better than setting larger goals that could appear unsurmountable.
You may also identify SMART goals as follows:
Finally, businesses and individuals may share many of these goals, while some are specific to each according to their nature. To give an example, a company’s long-term goal is not even remotely close to an individual’s, because companies (particularly medium to large scale ones) normally outlive their founders, while individuals, aware of their inevitable fate, would rather arrange their finances for retirement purposes.
Let’s now focus on the different types of financial goals according to their timeframe:
Short-Term Financial Goals
Short-term financial goals may sometimes be an end in themselves, or stepping stones towards attaining bigger, longer-term goals. They’re also relatively easier to achieve, considering that they’re much narrower in scope.
To illustrate: Being able to allocate a yearly amount of $1,000 into your savings fund somehow rings differently than hitting a 10,000$ savings fund over the course of 10 years, though they’re literally different viewpoints of the same midterm goal.
Some short-term financial goals are not directly related to the procurement of larger ones, but only tangentially so. To give an example, paying off debt may not have a direct connection with paying for college tuition, but it does facilitate, at least in a peripheral sense, the attainability of that latter midterm goal because a person can consequently save more money in the long run.
Some of the most common short-term financial goals consist of the following:
- Setting a budget: The best way to visualize your long-term goals and detect any cracks or seams in your finances is to establish a budget. Details as small as the meals you order on a daily or weekly basis can represent a bigger hole in your pocket than you might realize upon first analysis, and the budgeting process will help bring these issues under the spotlight (and make you reconsider eating healthy home-cooked meals more often).
- Creating an emergency fund: It’s always important to set money aside for a rainy day. An emergency savings fund will back you up during periods of financial turmoil and unemployment. Ideally, an emergency fund should cover from three to six months’ worth of financial obligations and basic needs. Opening up a savings account and enabling recurrent transfers is a great option for those with a faulty memory.
- Pay off credit cards: Credit cards are incredibly costly and a sure means to drag down your net worth and the bulk of your financial goals, mainly owing (no pun intended) to the high APR costs. These APR costs find justification in the ability these instruments grant to access easy credit without having to jump through the usual hoops of applying for a regular loan. Paying off your credit card should be of utmost priority, especially since it’s very easy to get drowned in credit card debt if you’re careless. You will also improve your credit rating in the process.
- Increase sales/revenue and optimize pricing (businesses): This pertains to a business’s day-to-day operations. However, the possibility of selling more products could potentially unlock midterm goals down the line, such as expanding your company’s reach and reducing debt. Pricing optimization is closely related to the increase in sales, and it has to do with outpacing your competition by making your products or services more economically accessible without them losing their true market value.
Midterm Financial Goals
Midterm financial goals, as the name might give out, are a midway between your short-term financial goals and your long-term financial goals, and they serve to bridge those two together. Naturally, you wouldn’t be capable of aiming towards midterm goals if you have not sorted out some of your short-term financial problems first. You could theoretically proceed further without freeing yourself from a hefty credit card debt, but it would not be an advisable way to go about it.
In that vein, accomplishing the short-term milestones will allow for more leeway to target bigger financial burdens or to pursue more ambitious endeavors, such as:
- Paying off student loans: Student loans could potentially entail a lifelong debt, especially for those who were not able to properly jumpstart their careers. These loans leave a massive dent in the debtors’ monthly budgets and could thwart their retirement aspirations if not tackled head-on. Refinancing your federal student loans with a private lender that charges a lower interest rate is a nice strategy, though that would have some associated setbacks related to income-based repayment or forbearance.
- Getting insurance: Not many people like to think about the inevitability of death (or taxes). However, getting both a life and a disability income insurance should be deemed “top priority” within the framework of your midterm financial plan. By acquiring a life insurance policy, you are relieving your spouse or children of the financial distress that may ensue from your departure. Meanwhile, disability insurance policies will protect you whenever you are out of work due to illness or injury by replacing a portion of your income.
- Pursuing your dreams: Other midterm goals include saving for your own home, a vacation home, your wedding, your children’s education, and other similar quality-of-life enhancements. Starting a company or materializing an entrepreneurial/freelance idea could also fit into this category. These are some of the common aspirations that any individual could have, and they bring an immense amount of satisfaction when achieved. Lastly, some of these could also be deemed long-term goals, depending on their attainability relative to your finances.
- Increasing market share (businesses): Market share consists of a percentage of the total sales that a company controls in the context of a given market, and indicates just how dominant a company has become within the scope of an entire industry or a specific product category. However, a higher market share is not necessarily indicative of higher profits. Having a large share in a dying or obsolete market is not something to boast about, but it’s rather indicative of a bigger issue in the company’s management and direction that has to be promptly addressed.
Long-term Financial Goals
There is a thin line that separates midterm goals from long-term goals, and some overlapping is expected. It ultimately comes down to how individuals perceive them from their vantage point.
However, a person’s long-term financial goals are ordinarily linked to retirement plans via RRSP, TFSA, or the traditional IRA. These are basically saving accounts that are unlocked once you’ve reached retirement age. Somewhere along the line, you could also set your sights on having a debt-free retirement and achieving ultimate financial freedom. Mortgage payoff, depending on the person’s financial landscape at the moment, could be set as a long-term objective in addition to retirement.
Most financial advisors would point out that a successful retirement plan would result in replacing, at least, 70% of the income you received prior to retirement. To put things into perspective, if you earned $90,000 a year, you should aim for roughly $63,000 upon retirement. The logic behind this apparent compromise rests in the assumption that retirees spend less money on commodities like gas or electricity, as they’d most likely commute less and end up living in a smaller space.
Now, while 70% is the minimum to aim for, some people could understandably not be satisfied with such low percentages, especially as this generation progressively struggles to make ends meet, in addition to the uncertainty that shrouds the current financial environment. The fear of outliving a retirement plan can quickly set in.
Estimating the percentage that you need to allocate from your paychecks can likewise turn into a complicated subject, particularly since our savings formula is tainted by short-term inflows and outflows. Using our initial short-term budget as a basis for ascertaining future retirement needs could prove to be insufficient as a result, for it’s almost a rule of thumb that people’s spending habits change throughout their lives, sometimes in a drastic fashion.
Moreover, we ought to factor into the equation macroeconomic factors such as inflation and the constant flux in purchasing power over time. Steady inflation rates are assumed into retirement plans for the simple reason that we cannot conceivably forecast what would happen to the economy in 5 years, let alone 20 or 30 years.
Financial advisors at this stage are not only useful but virtually a must. If you require the assistance of a financial planner in Toronto for crafting a safe and effective retirement plan, don’t hesitate to contact our financial professionals at JTT Accounting.
On another topic, a business’s long-term goal is not precisely linked to retirement, but it’s ironically the opposite of that in many instances.
During the establishment of long-term financial goals, managers are free to not take into account the current market atmosphere. In fact, more ambitious business owners or managers would aspire to change that market atmosphere so, in a sense, a company’s long-term financial goal usually transcends the existing conditions. However, this could potentially create a disconnect between short-term and long-term goals.
Companies should always strive to maintain a healthy equilibrium between abstract ambitions and concrete tangible milestones. Focusing only on short-term goals could lead to a loss of perspective and motivation, while “thinking big” all the time could have detrimental consequences in short-term planning.
Some examples of long-term business goals include:
- Developing new lines of products.
- Becoming an innovator in the market.
- Expanding and establishing branches nationwide or worldwide (turn into an “emporium”.)
- Improving overall brand awareness.
- Getting a public listing (IPO).
Final Considerations Related to Financial Planning
To summarize what was said above, writing or crafting a financial plan involves performing the following tasks:
- Calculation of net worth.
- Identification of a person’s spending habits and inflows.
- Once the pertinent documentation has been produced and analyzed, an assessment of short-term, midterm, and long-term financial goals, as well as the means to accomplish them.
Financial plans would ultimately lead to the following resolves (which may be reviewed or reformulated whenever necessary):
- A retirement strategy that’s able to cover customers financially in their most vulnerable years.
- A risk management plan that encompasses all possible negative scenarios.
- A customized long-term investment plan that targets specific investment goals and fits a customer’s risk tolerance profile.
- A tax reduction strategy aimed at reducing a client’s tax liability within legal limits.
- An estate plan to protect heirs
Financial plans are not made out of templates, for the simple reason that we’re not templates ourselves. Each and every human being or legal person requires individualized treatment and attention, and financial advisors/planners need to place special emphasis on conducting thorough financial checkups on a case-by-case basis.