A financial plan is a document that defines your current financial situation, your financial goals, and your strategies for getting from here to there. A financial plan is essential to meeting your goals. It’s difficult to hit a target if you don’t know where it is in relationship to your current location. In developing a financial plan, you establish the targets you want to hit—a trip to Ireland, a new car, a down payment on a new home, a child’s college education, early retirement, or some other objective—and when you want/need to hit them. Then you put your plan in writing so that it can be revisited—ideally at least once a year—to determine if changes in your situation mandate modifications to your plan.
Begin at the beginning
The first step in financial planning is to determine your current financial situation. This involves examining two components: your current net worth and your current net cash flow.
Net worth calculation
Your net worth is the total value of your assets minus the total value of your liabilities.
Net Worth = Total Assets – Total Liabilities
Your assets include your bank checking, savings, and money market account balances, bank certificates of deposits, the cash value of any whole life insurance policies you have, the current market value of your home, vehicles, furniture, special equipment (e.g., stereo, video, and camera), jewelry, and collectibles (e.g., coin and stamp collections and fine art), as well as your investment assets, which include stocks, bonds, and mutual funds, whether held in a regular account or a retirement account, such as an Individual Retirement Account (IRA) or a 401k or 403b plan.
Your liabilities are your debt obligations. These include balances owed on revolving credit or credit card accounts, other short-term debt you may have, such as medical expenses, and long-term loans, like a home mortgage or student debt.
The difference between the two numbers is your net worth. It is what you would have left if you sold all your assets and paid off all your creditors.
Cash flow calculation
Your net cash flow is the actual cash you take in (cash inflow) minus the cash you pay out (cash outflow). The cash inflow of most individuals consists primarily of wages or salary income. Some people also have investments that produce dividend and interest income. Others own property that generates rental income. Cash outflows typically include rent or mortgage payments, credit card payments, other loan repayments, and insurance premiums. We may also pay for our food, clothing, utilities and entertainment expenses with cash. Bear in mind, however, that credit card purchases are not included in our cash outflow since cash doesn’t flow out until the credit card bill gets paid. The same applies to the purchase of any other asset, such as a new automobile or refrigerator, on an installment plan. The cash outflow occurs only when the cash is actually paid.
It is a good idea to track your cash flow for several months in order to learn how you are currently spending your money. If your net monthly cash flow is positive, congratulations! You are spending less than what you earn and are well-positioned to apply any excess toward your financial goals. If your net monthly cash flow is negative, your financial plan must include strategies to reverse the situation as quickly as possible.
Once you have a picture of your current situation, the next step is to decide on some goals—short-term, intermediate-term, and long-term. For example, a short-term goal might be to take that trip to Ireland next year; an intermediate-term goal could very well be to have enough money saved to pay for a new car five years down the road when you expect your current vehicle will need replaced; early retirement may be one of your long-term goals, depending on your current age; leaving a legacy is often another long-term goal.
A good goal—financial or otherwise—should incorporate four basic requirements. It must be explicit, realistic, measurable, and time-specific. “I’m going to be crazy rich” is not a good goal. It is not explicit enough, for one thing. “Crazy rich” may mean different things to different people. Therefore, it fails the measurable test, too. It probably isn’t realistic, and there is no time period specified. On the other hand, “I am going to have $8,000 saved at the end of a year in order to take a trip to Ireland” may be a good goal. It is certainly explicit, measurable, and time-specific. And depending on your current situation, it may also be very realistic.
Some goals may not necessarily seem like financial goals on the surface. However, if they require money, they should be part of your financial plan. For example, you may not want to have to deal with the stress of having a high-deductible medical insurance policy. A policy with a lower deductible may cost considerably more, but if you believe having less stress in your life is worth it, then you can set a goal to purchase a lower-deductible policy at the end of the year.
Determine your options for meeting each goal
There may be a number of alternatives that will enable you to hit each of your targeted goals. If you are currently in a negative cash flow position, your immediate goal needs to be to reverse it. You may be able to do this by working extra hours at your current job, finding ways to eliminate some expenses and/or generate additional income elsewhere, or locating a new, higher-paying job. The same is true if you currently have a positive net cash flow, but know it will not grow enough to meet one or more of the goals you have.
Longer-term financial goals are more readily handled by breaking them down into shorter-term goals. For example, “I will begin contributing the maximum annual amount allowed to my employer-matched 401k plan in order to have $1 million accumulated in my account at the end of 20 years, at which point I can retire at age 55 if I wish,” incorporates the short-term goal of contributing the maximum amount allowed each year to a 401k plan in order to achieve the long-term goal of early retirement.
Decide on the specific alternatives you will use
After listing all the alternatives that would work, select the specific ones that will allow you to reach your goals without feeling frustrated and losing your motivation. All alternatives come with opportunity costs, i.e. tradeoffs. Perhaps ensuring you have enough saved at the end of one year for that trip to Ireland means giving up your morning Starbucks each day, leaving you feel like a crazed maniac every day for the next year. That may not be a good exchange. Maybe you could eliminate some other expense or find an additional source of income instead.
You also have to consider the riskiness of each of the strategies you have brainstormed and determine whether the risk is worth the benefit offered. This will vary from individual to individual, based on his or her risk tolerance. For instance, you will likely find that if you direct your 401k monies into an aggressive growth mutual fund, the expected returns will be much higher, perhaps allowing you to retire at the age of 50, or even 45. Then again, the stock market can be pernicious, in which case you may find yourself working until you’re 70 or older. Are you willing to take that risk? Some are; some aren’t.
Put it in writing
Once you have decided on your goals and the specific strategies you will use, prioritize your goals and determine a time frame for each goal. This is now your financial plan. Put it in writing. That way you can revisit it easily to determine if your goals and/or strategies need to be altered. Anytime you have a life event, such as a marriage, divorce, or the birth of a child, some modification is generally required. For example, if you are single, in a well-paying job, with more than enough income to support your lifestyle, you probably don’t need any life insurance since no one is depending on you. But once you marry, you may want to invest in a life insurance policy so that should you die unexpectedly, your spouse and any children you may have will continue to be able to meet their needs in the absence of your income. And even if there is no significant life event, your current investment portfolio may need rebalancing to maintain the risk/return relationship you desire while continuing to target your financial goals.