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8 Financial Planning Handbook PDPIntroduction to Financial PlanningThe Indian youth never had it so good. On the consumption side, the choice of goods and services available is unprecedented. And, as far as income is concerned, given the booming economy and its ever improving prospects, opportunitie...

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Chapter 1

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Introduction to Financial Planning

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he Indian youth never had it so good. On the consumption side, the choice of goods and services available is unprecedented. And, as far as income is concerned, given the booming economy and its ever improving prospects, opportunities have never been better! So the youth are earning a lot and spending a lot as well. It is definitely a happy situation to be in. In times like these, when everything seems to be going right for so many people, there is a tendency to ignore that one great habit –saving money. The rationale is simple-since the future looks great from here, why set aside money for the future needs and contingencies. But in our view, this is an ideal time to save money as surplus monies are high. Rather than spending this money on a product that you don’t really need, you would do well to invest in the future for some later date critical need. In this book of financial planning, we discuss this and a lot more, including investment avenues available. We also discuss the concept of spending wisely and creating wealth in a systematic way. Happy Investing! Financial decisions are critical decisions, which decide how comfortably we end up monetarily in life. Poorly planned financial decisions can cause, at best, great anxiety and at worst lead to bankruptcy, whereas well thought-out decisions can lead to a prosperous lifestyle. The complexities of our financial circumstances are many and we need to take a careful well thought-out solution to such problems. The concerns could be many. Some of them are: 

How can I grow and protect my financial wealth?

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How can I pay and manage my debt?

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How much should I save to be able to pay for my children’s education?

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How can I maximize the tax benefits which can be availed of?

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How can I save enough to be able to retire comfortably and maintain the current lifestyle?

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How can I maximize what my heirs will inherit?

Definition: Financial Planning is the process of identifying a person’s financial goals, evaluating existing resources and designing the financial strategies that help the person to achieve those goals. The key basic steps toward reaching this end as a financial advisor are: 

Organizing your client’s financial data.

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Assisting your client in goal setting.

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Financial Analysis for the client.

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Developing appropriate strategies.

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Evaluating and choosing the best option amongst the various strategies.

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Coordinating and implementation of the planned decisions.

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What is Financial Planning? Financial planning is the process of meeting your life goals through the proper management of your finances. Life goals can include buying a home, savings for your child’s education, planning for your retirement or estate planning. This process consists of six basic steps. Using these broad six steps, you can work out where you are now, what you may need in the future and what you must do to reach your goal. The process involves gathering relevant financial information, setting life goals, examining your current financial status and coming up with a strategy for a plan on how you can meet with your goals, and map the gap. The Benefits of Financial Planning Financial Planning helps you give direction and meaning to your client’s financial decisions. It allows him to understand how each financial decision affects other areas of finance. For example, buying a particular investment product may help your client to pay off his mortgage faster or may delay his retirement significantly. By viewing each financial decision as a part of a whole, you may help your client consider the long term and the short term effects on his life goals. You will help them feel more secure and more adaptable to life changes, once they can measure that they are moving closer to the realization of their goals. Best Practices When Approaching Financial Planning 

Set measurable goals.

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Understand the effect your financial decisions have on other financial issues.

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Revaluate your financial plan periodically.

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Start now. Do not assume that financial planning is for when you are older.

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Start with what you have got. Do not assume that financial planning is for the wealthy.

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Take charge. You are in control of the financial planning process.

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Look at the bigger picture. Financial planning is more than retirement planning or tax planning.

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Do not confuse financial planning with investing.

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Do not expect unrealistic returns on the investments.

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Do not wait for a money crisis to begin financial planning.

How Do You Make Financial Planning Work For Your Clients. To achieve your goals of making a complete financial plan for your client, you have to be completely in sync with his financial needs and his responsibilities. This can be best achieved by following the processes:  Set measurable goals. Set specific targets of what your client wants to achieve with a specific time line. For example, instead of saying that he wants to be comfortable when he retires, or that he wants to send his children to good schools, he should be able to quantify what “comfortable” and “good” means. He will have to as specific as “I need Rs.100000pm income post retirement for 25 years from the age of 60, considering the anticipated inflation rate at 5%. These plans may have to be changed keeping in view the market scenario or a changed need. 

Understand the effect of each financial decision.

Make the client realize that each financial decision that he takes will affect several other areas of his life. For example, an investment decision may have tax consequences that are harmful to his estate plans or a decision on the retirement plans may affect his retirement goals. If he has invested in real estate and

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would like this investment to provide for his retirement income that he has to realize that real estate investment would invite long term capital gains tax which can reduce the post tax returns and keep margins for this deduction. 

Re-evaluate the financial situation periodically.

Financial planning is a dynamic process. These goals may change over the years due to changes in lifestyle or circumstances such as an inheritance, marriage, birth, house purchase or change in job status. Revisiting these goals periodically is very important to keep track of how much our client is on course, both from a long term perspective and a short term perspective. 

Start planning soon.

Explain to the client consequences of waiting and how any delay in financial planning affects the whole big picture that he has in mind for himself and his family. Developing good habits like saving, budgeting, investing and regularly reviewing one’s finances early in life, makes one better prepared to meet changes and handle emergencies. If one starts investing Rs. 500, one can expect to have Rs.58 Lakhs at age 60. Remember that every Rs.500 that you can save from the age of 21 can get you Rs. 58 Lakhs towards your retirement, but if you start at age 41, you will get only Rs.5 Lakh. 

Be realistic in terms of expectations.

Financial planning is a commonsensical approach to managing one’s finances to reach one’s life goals. It is a life long process. There are certain extraneous factors like inflation, changes in macro economic policies or interest rates that may affect one’s financial results.

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Chapter Review

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Chapter 2

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Assessing your current wealth Taking Stock

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he first step in assessing your current wealth is determining your net worth. It is the starting point for financial planning. It provides an indication of your capacity to achieve your financial goals. Your net worth can be ascertained by drawing up a personal balance sheet, as shown in Worksheet 2. 1. The process consists of three steps: 1.

List the items of value that you own. These are your assets.

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List the amounts that you owe to others. These form your liabilities.

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Subtract your liabilities from your assets; the difference is your net worth.

This relationship is shown below: Items of Value - Amounts Owed = Net Worth Definition: Your assets are the things that you own. You probably own assets that have many different forms, including cash, investments, personal property, real estate etc. Assets possess value. Value can be of different types. The most basic measure of value is cost i.e. the amount of money you spent in acquiring the asset. However, usually cost is not a very accurate meaure of value. This is because, over time, the market value of an asset changes significantly from its original cost. For example, your house may have cost Rs. 10 Lakhs ten years back. But today it is likely to sell for much more. In case of such assets, market value or the amount someone would be reasonably willing to pay for it in today’s marketplace is a much more accurate estimate of the value. However, collector’s items like art pieces and antiques have an emotional value which may be significantly different from their market value or cost. In the Balance Sheet or the Statement of Net Worth, the assets are arranged in order of liquidity. The most liquid assets are listed at the top of the list and include cash, bank accounts, and money market mutual funds. Definition: Liquidity is a measure of the ease with which an asset can be converted into cash or cash equivalents. The easier an asset is to convert into cash, the more liquid it is. Cash is the most liquid asset. The cash surrender values of your whole life insurance policies and annuities can be determined by contacting your insurance company. The value of cars can be obtained from agencies which buy and sell used cars. Household furniture, clothing, and personal effects should be more conservatively valued so as not to overstate their value. It should be remembered that in an actual sale of these items, you are likely to get far less than the estimated values.

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Your home is likely to be your largest asset, so its value should not be over- or under-stated. The figure that you should use is the current market value; that is, the amount that someone would be willing to pay for your house. Do remember that the cost of the property is not an accurate indicator of its value if you have owned your house for a long period of time. The most recent selling prices of houses similar to yours in your area are a good indicator of the likely market value of your house. Real estate brokers can also provide you with an estimate of the value of your house. Note There is another school of thought, which proposes that the value of a self-occupied house should not be considered in the net worth statement because one cannot really sell the house to raise resources. This approach is also worthy because it is the more conservative of the two. Liabilities Definition: Your liabilities are amounts that you currently owe (i.e., your financial obligations). The sum of your liabilities is what you must pay today to overcome debt. Begin by listing your most current debts, such as utility bills, telephone bills, and others. Next, list the balances outstanding on your credit card debts and loans. For most people, a home loan is their largest single debt outstanding. The amount to include is not the original amount of the loan but the current outstanding balance. The current outstanding balance of the loan can be obtained directly from the lender. Add up all the amounts owed to others and to get the total of your liabilities. Net Worth Definition: Your net worth is the difference between the totals of your assets and liabilities. In other words, if you sold all your assets for the values stated and paid off all your debts, the amount left over would be your net worth. The net worth of a person is a measure of a person’s financial position as of the date of the personal balance sheet.

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WORKSHEET 2.1 How to determine your net worth A. Assets

Amount (in Rupees)

Cash Bank Accounts Fixed Deposits Cash surrender value of life insurance Cash surrender value of annuities Market value of investments Mutual funds Stocks Bonds Others Market value of house/real estate Investment property Vehicle(s) Household furniture/appliances Jewelry/precious metals Collectibles Loan receivables Others Total Assets B. Liabilities Credit card balances Bills outstanding Outstanding loan balances Taxes due Others Total liabilities Net worth [assets minus liabilities (A-B)] Steps: 

List all items of value starting with cash, investment assets, the current value of your house, and possessions.

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List and total all liabilities.

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Subtract total liabilities from total assets.

Notes: Assets Determining the value of your stocks, bonds, and mutual funds is easy. The prices can be found in newspapers or on financial websites.

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Why Is Determining Net Worth Important? Determining your net worth is the first step in financial planning and assessing your financial wealth. Net worth is a tool for comparing the changes in your financial position over a period of time. An increase in net worth over a period of time is a favorable trend, and a decrease in net worth is a reduction in wealth. There are a number of ways to increase net worth: 

Appreciation of assets (for example, a rise in the value of stocks, bonds, mutual funds, and real estate).

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Reducing liabilities.

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Increasing income, such as through salary and wage increases as well as growth in investment income.

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Reducing the amount spent on living expenses.

The importance of increasing net worth is obvious. It is important to remember that addition of assets may not always increase your net worth. This is especially true for depreciating assets, such as cars, computers, electronic equipments etc. Investment assets like shares could also lose substantial part of their value. Creating a personal balance sheet will assist you in tracking your personal wealth over time and enable you to see relationships among the balance sheet items. The relationship between liquid current assets and current liabilities indicates the relative ease or difficulty in paying upcoming debts. This evaluation ratio is the current ratio and is determined as follows: Current Ratio = Current Assets ÷ Current Liabilities For example, if a person has Rs. 10 Lakhs in liquid current assets and Rs. 5 Lakhs in current liabilities, the current ratio is 2. This means that for every Rs. 1 in current debts, there is Rs. 2 in liquid assets. Generally, most current debts are repaid from liquid current assets such as cash, savings accounts etc. In the event of unemployment or insufficient liquid current assets to cover current debt, longer-term investment assets would need to be liquidated to pay off the debt. The other significant relationship between balance sheet items is the debt ratio, which is total liabilities divided by net worth: Debt Ratio = Total Liabilities ÷ Net Worth For example, if a person has Rs. 1 Lakh as total liabilities and a net worth of Rs. 2,00,000, the debt ratio is 0.5. We need to make the Cashflow statement and the Income and Expenditure Statement, to assess changes in networth.

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Exercise 1.

Mukesh bought a flat for 12 Lakhs, worth 20 Lakhs today. He has no loan repayments i.e. EMIs due on his flat. He has FDs worth Rs. 2 Lakhs and cash of 30,000 in his account, jointly held with his wife. He has mutual funds worth 1.5 Lakhs and stocks worth 1.5 Lakhs. Ritesh, an old colleague of his, has taken a loan from him for Rs. 50,000, for which he pays him 10,000 every month. His wife, Geeta is fond of diamond jewellery and owns up to 3 Lakhs of diamond jewels. Mukesh bought a car for 4 Lakhs, 3 years ago. He has a tax liability of Rs. 35k per year. He has no other outstanding bills pending, except for telephone and electricity bills to the tune of Rs. 5,000 . A] What is his net worth? B] Can you think of ways of increasing his net worth? C] What is his current ratio and debt ratio?

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Chapter 3

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The Income and Expense Statement and the Cashflow Statement

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our Income and Expense Statement reports income earned and spent during a specified period, while the Cashflow Statement presents a record of all the cash inflows and outflows during a particular time period. The difference between the two is that the cashflow statement records only the actual cash inflows and outflows. It does not include amounts spent or earned on credit. On the other hand the income and expense statement records all types of income and expenses. These statements make it easy to see where your money is being spent. Many people complain that they earn large sums of money, but they never have anything left over. Recording their expenditures is a first step to taking control of their financial affairs. Because earnings and living expenses also influence net worth, these statements also show that change. The income statement shows actual income and expenditures over a period of time, whereas a balance sheet or Statement of Net Worth shows financial position at a single point in time. There are three steps to creating an income statement, as shown in Worksheet 3.1. 

List all income received during the time period.

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List all expenditures made during the time period.

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Determine the surplus/deficit of income over expenditures.

Step 1: List All Sources of Income List all sources of income for the period of the income statement. Income from salary is generally received after deducting tax at source (TDS). The main source of income for most people comes in the form of salaries, wages, self-employment income, and commissions. Other sources of income include bonuses, interest, dividends, rent, gain on the sale of assets, and gifts and inheritances. All sources of income should be included in order to make the income statement complete and accurate. Step 2: List All Expenditures Expenditures show where cash flows have been spent. Major categories of expenditures should be listed. It is not necessary to account for every penny spent. By reviewing cheque-book records and credit card statements and recording the cash payments, you can easily develop categories of expenditures. By adding the payments made in each category, you will have a fairly accurate account of where your money has gone. Certain expenditures are fixed; that is, they remain the same each month or year. Examples of such expenses are rent,...