Budgeting and Cash Flow

Budgeting and Cash Flow

Longer Term Questions if Things Can Change Voluntarily

The reason why the budget process is set up the way it is in this series is to include various sections on income sources and deductions is to test what would happen if a large change were to occur in your goals, choices, or lifestyle.

If you make a big change in your lifestyle, you can adapt each of the sections to see what a new budget would look like. Common examples of big life decisions are: Large home renovations, buying or selling a car, buying or selling a house, moving to another city or country, expensive vacations, getting a new job or leaving a job, starting or closing a business, investing or divesting a large sum of money in a business, getting married or divorced, buying or selling investment properties, having children or children leaving home, death of a loved one, retirement, large inheritances, large compensation payouts or receipts such as large insurance payouts, large lawsuits won/lost, or a major health issue that impacts lifestyle. The key criterion here is that one of these events will change the nature of your financial situation and by extension your budget. Some examples of how to examine these types of decisions are below.

For each decision like this, look at your present budget and notice what is going to change for a future budget. Then you focus on 5 main areas: revenue, spending, investing or asset building, emergency reserve and debt. Ask yourself for each of these areas: What is going up or down comparing my present situation with my future situation? This will get you a picture of all of the changes that are expected to happen and you can see where the surpluses and shortfalls in cash flow will occur. If you are dealing with something uncertain like future business income, you would have to make an estimate of what that would be and then keep an eye on it to see if your estimate is correct. When in doubt, make the estimates conservative because it is always nice to have additional money than not enough. The estimate would then have to be refined to match reality and a decision would be made further down the road to make the budget more feasible. You would also have to ask yourself: If my estimate is wrong, what are my options? If you can afford to be wrong due to extra money available to you, then this can be your backup plan. If you do not have this luxury, what are the other options? These can be selling an asset to raise the money, cutting expenses somewhere or borrowing money. There may be an option to increase revenue in another area as well.

Example 1) Changing from Employment Income to Starting a Business

If you start a business and shift your income from employment income to an entrepreneurial type of income there will be several implications for your budget. The business income may be uncertain if this is a business that is new to you and there is no established source of revenue, and this new income stream may be lower than employment for the first few years.

The mandatory deductions will change because there will be no pension contributions or life and health insurance deductions from your income, and there may not be EI depending on whether you decide to opt-in. There will however be additional CPP deductions to account for in your budget. On the whole, your mandatory deductions will likely be reduced when going from employment income to business income. Your reserve fund should now be expanded to cover the uncertainty of the cash flows that tends to happen for a business. You may have financing for your business which means additional interest payments each month. The voluntary deductions may change because without an employer you may not have a workplace RRSP or automatic contributions to make to a savings plan or share purchase plan. Discretionary expenses will change because business expenses will rise, but commuting costs, and your lunch budget allocation may be reduced. You may have to allow for higher internet costs and a faster computer to run your business. Once you factor in these changes, you will see a new budget emerge and you can see how well it will work. Many of these inputs are estimates, so you will have to accept the uncertainty, but your budget will be a tool to monitor how things are going. If there are shortfalls in the budget after taking into account all of these changes, the options to balance the budget are to tap further into your reserve, cut expenses, borrow more money, increase revenues, or sell existing assets to generate cash flow. If there is a surplus in the budget after all of these changes, then the same areas can be looked at in reverse. You can add funds to your reserve fund, spend more, purchase more investments, or pay down debt.

Example 2) Purchase a House Versus Renting

If buying a house involves a move to another city and your employment income also changes, be sure to also look at that aspect of your budget, otherwise income sources are not affected by purchasing a home. The fixed expenses would be overhauled as rent is being replaced by mortgage payments, insurance, and property taxes. There would be an increased reserve for home repairs which was not present as a renter, and a change in utilities spending depending on whether your rent included utilities, and if the property is changing (e.g., a detached house will likely have higher utility bills than an apartment). This may result in less money being available each year (or more) depending on the cost of rent versus the group of costs involved in owning a house (property taxes, mortgage payments, home repairs and utilities). Discretionary expenses would also be overhauled. More landscaping costs means a larger allocation in your budget, and some new homeowners take up renovations as a hobby. Depending on your move, you may be driving more which means higher automobile costs and lower transit costs. Other aspects of your lifestyle may change, such as spending more time in your new home, which may save money in the areas of entertainment and dining out.

Example 3) Having Children

Having children is a major life event that can touch on nearly every element of your budget. Parental leave can affect your income, and particularly in the early years you may feel pressure to decrease some voluntary deductions. Life goals will typically shift to focus on your children and on your home, which will affect discretionary expenses. Your hobbies may change to more home-based activities as opposed to eating out often or going to nightclubs. The obvious new expenses are there such as day care, saving for post-secondary education, and the children’s needs – everything from furniture to clothes to diapers and food. There is also a change in hobbies to include more day camps, courses for your child, and entertainment. You may need a different car because you need more space to bring children somewhere or carry more items.

What if Things Change and They are not Voluntary?

If something happens that is not voluntary, like a job loss or relocation, getting divorced, business going bankrupt, investment income dropping or unexpectedly rising, etc. you can use the same techniques as for the voluntary changes, except that you have not chosen the situation. The long term idea behind budgeting is for you to really get to know your financial situation. This would mean where your money comes from, where it is going, what tends to affect your situation acutely and what doesn’t. This is akin to knowing yourself and your habits and your relationship with your money. If something unexpected does happen, you will be best prepared when you understand how you would handle financial changes.

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