9 Step method to manage personal finances effectively

Anything related to money is tricky. For most people, a job is the only source of income. It takes a month before we get cash in our accounts but just days to finish it all up. Many of us must have seen our parents keep pushing themselves to save more and more. While saving a part of income is a good practice but that alone doesn’t mean you are managing your finances well. Managing finances effectively means to be in a position to meet the cash requirement irrespective of the situation.

Below is a proven methodology for everyone for managing personal finances.

Step-1. Record Current Status

The first and foremost thing to do before one even starts to manage is to understand current status. Depending on your background and lifestyle you may have various financial advantages and obligations. 

One may already have various kinds of financial advantages like bank balance, inherited properties, durable goods, stocks etc. Such things are considered as assets. Asset is a tangible or intangible item that can be converted into money by selling in the market. Assets are considered positive.

Similarly one may have various obligations like education loans, borrowings, unpaid bills etc. These things are called liabilities. Opposite to an asset, Liability is a tangible or intangible item that requires money to dispose of. Liabilities are considered negative.

Prepare a list of all assets and liabilities you currently have along with their monetary value under their respective columns. Sum up both the columns and difference of these two is your current financial status. The more positive net of asset vs liabilities is, the better.

Step-2. Estimate Basic Expenses

The second step is to understand what your basic expenses are. A person usually spends money on different kinds of things but not all of the expenses are necessary. People do superfluous expenditures on parties, shopping, drinks, entertainment etc. If you are lucky enough to do unnecessary expenses then feel yourself lucky but that’s not how you are meant to manage your finances. Now it is time to separate necessary expenses from unnecessary ones.

The necessary expenses include food, utilities (electricity, internet, water bills), travels, house rent, monthly loan repayments, maintenance. These expenses cannot be skipped and hence are considered basic expenses. Everything else is non-basic expenses. Put a rough number against each item of your basic expenses and sum them up. The total amount thus calculated is your estimate of basic expense per month. 

Step-3. Consider Extraordinary Expenses

Now that our ground understanding of some important aspects of personal finance management is done, let’s move to the next important aspect of finance that is extraordinary expenses. As the name suggests extraordinary expenses are usually unplanned and the amount spent on such cases vary a lot. Extraordinary expenses include money spent on medical bills, unexpected travels, family emergencies, surprise visits by friends, birthday or anniversary celebration etc. Though most of these are listed but it is important to understand that to manage such situations better we need to know the amount we are going to spend on such occasions. But that’s not the case with such expenses. Hence it is better to list down the type of extraordinary expenses you think you can incur over the year. Please keep in mind that there is less likelihood of accidents and emergencies but it is better to keep yourself ready for it so do not forget to include it in the list.

Step-4. Identify Top Priorities

Once the above steps are done, let’s prioritise financial responsibilities. Prioritization should be done such that there is significant improvement in your year-on-year overall financial status that was discussed in Step-1. The goal of this step is to understand which type of spending is more important than others. This will help you make better decisions related to money.

Priority-0 – Survival – Basic Expenses : This is the amount of money a person must spend irrespective of income situation for living. This is priority-0 as you do not rank it. It will always be here.

Priority-1 – Financial Stability – Life & Medical Insurance & Savings : This is the amount of money spent to ensure that any change in current income situation will not affect health and well-being.

Priority-2 – Wealth Creation – Investment : Wealth creation is the process of building assets that would gain monetary value over a period of time. A share of money must be spent on wealth creation. This will lead you to financial independence in medium to long term which basically means having enough income to pay for living expenses for the rest of life without being employed or dependent on others.

Priority-3 – Professional Growth – Skill Development : Money should be spent towards upskilling yourself to become a better professional in the market. This will improve your chances of increasing income in short or medium term.

Priority-4 – Personal Growth – Health & Well-being : Part of expenses must go towards maintaining good physical, mental, social health. Membership and enrollment towards such comes here. This also includes expenses incurred towards anniversaries, birthdays, gifts etc.

Priority-5 – Lifestyle Expenses :  Everything else including extraordinary expenses comes here. These include clothing, shoes, appliances, gadgets etc.

Once you have done this exercise you will have categories of items from all the list of items you made earlier. Also it is easier to remember these category-wise priorities than a memorizing complete list of tens of items.

Step-5. Allocate Budget

Now that we have understood priorities let’s put a target number to each category by allocating budget to it. Budget is an amount of money you are planning to incur towards it. We start from priority-0 category and allocate budget to each category. Budget towards basic expenses should be equal to that of your estimation. We will now divide the remaining amount (income after basic expenses aka IABE) into 5 parts. Allocate a percent of left net income in remaining categories in order of priority. For example – split IABE as 

A. Financial Stability (30%) – 20% Savings, 5% Medical Insurance, 5% Life Insurance

B. Wealth Creation (30%) – 20% mutual fund, 10% stocks

C. Professional Growth (10%) – Vocational Training, Skill Development Courses, Seminars

D. Personal Growth (10%) – Gym, Hobby Classes, Social Groups

E. LifeStyle Expenses (20%) – Clubbing, Dine out, Drinks, Travelling Tours

Convert the percentages to numbers and these are the category-wise monthly expenditure budget.

Step-6. First Things First

After we have understood the priorities and allocated budget it is important to ensure we commit our money on the important things first. Put money aside for basic expenses and spend on financial stability and wealth creation at the beginning of the month itself right after receiving salary. This leads to less chance for you to spend money on low priority items. This also helps in realization of actual disposable cash.

Step-7. Track Expenses

Now you are set to track your financial behaviour. Use a spreadsheet and record each transaction. Mention item detail, category, date and amount for each transaction. You may miss a few transactions here and there but that should not be more than 2-5% of monthly expenses. Keep updating this spreadsheet once a day and sum items category-wise. Update asset liabilities items you prepared earlier based on final sums of latest month. (Note: If you know spreadsheets then you can use formulas to automate this part.)

Step-8. Analyze

At the end of each month look at your spending behaviour and identify areas of where you incurred unexpected expenses. Think and decide whether these expenses were important or not. If yes, then add it to a category as discussed above. Recalibrate your budget allocation.

If you are a beginner use these targets to have a clarity on current situation:

A. Savings: 3-12 times of basic expenses as minimum savings in your account

B. Insurance: 12-36 times of basic expenses as minimum life insurance cover

C. Investment: 36-120 times of basic expenses as minimum investment amount

There will be months when you will end up having excess cash as some expenses in some categories didn’t exhaust allocated budgets. You may keep surplus as a provision for something bigger later. Also you can put that excess cash in savings or investment category.

Step-9. Repeat

Last but not the least. REPEAT. All you need to do now is repeat this process for a year and observe significant improvement in your money handling abilities.

Conclusion

The article covers a step-by-step guide on how to manage personal finance better. We covered how to build a clear understanding of our current financial position and move it forward towards financial independence. This method is effective for all employed professionals who are struggling to figure out how to manage money. Apart from the above method, it would be important to learn about market investments and insurances as they are important in managing personal finances. Hope you like this article. Please feel free to share thoughts in the comments below. Have a nice day.