Chapter Notes

INTRODUCTION to Financial Management and Planning

As individuals transition into adulthood, they enter what is often called the "real world," a phase of life involving higher education, work, marriage, and starting a family. With these new roles come significantly increased responsibilities, especially in managing personal and family finances.

Financial management, in the context of a family, is the process of managing all forms of income to achieve the greatest possible satisfaction. It involves three key stages:

• Planning: Deciding how to use income.
• Controlling: Monitoring spending to stick to the plan.
• Evaluating: Assessing whether the financial plan is helping the family meet its goals.

Financial planning is the first step in this process. A common tool for financial planning is a budget, which helps a family use its income to meet current needs while also saving for long-term goals. Effective planning helps minimize wastage and encourages saving for the future.

This entire process relies on managing family resources, which are everything available to a family to help them reach their goals. These include:

• Human Resources: Knowledge, skills, health, time, and energy.
• Material Resources: Money, housing, and investments.
• Community Resources: Public facilities like libraries, parks, and hospitals.

Money is a crucial family resource, and learning to manage it effectively is a skill essential for a comfortable and secure life.

Family Income

Family income is the total income received by all members of a family from all sources over a specific period (daily, weekly, monthly, or annually). For official purposes, it is typically calculated for a financial year, which runs from April 1st to March 31st of the next year.

Income can come in many forms, such as:

• Wages and Salary
• Profits from a business
• Rent from properties
• Interest and Dividends
• Pensions and Bonuses
• Gifts, Royalties, and Tips

Money and its Importance

Money is defined by what it does. Its two most important functions are:

• Serving as a medium of exchange: It eliminates the difficulty of bartering by providing a universally accepted way to trade for goods and services.
• Measurement of value: It acts as a common standard to express the value of different commodities.

Money is also important because it can be used for deferred payments (facilitating savings and investments) and can be stored for long periods, allowing for the accumulation of wealth.

Types of Family Income

There are three main types of family income:

Money Income

This is the actual purchasing power in rupees and paisa that a family receives in a given time. It includes salaries, wages, rent, interest, bonuses, and any other monetary payments. This income is used to buy goods and services for daily living or is set aside as savings.

Real Income

Defined as the flow of goods and services available to satisfy a family's needs and wants over time. Real income is not just about money; it includes things that money may not be needed for. It is divided into two types:

• Direct Income: These are goods and services available to the family without using money.

  • Examples: Services provided by family members like cooking, cleaning, or stitching; produce from a kitchen garden; use of community facilities like parks and libraries; living in a house that is fully paid for.

• Indirect Income: These are goods and services that are available only after an exchange, usually involving money.

  • Example: Using your skill and money to select and purchase high-quality vegetables from the market is a form of indirect income.

Psychic Income

This is the satisfaction and sense of well-being that comes from using goods and services. It is the enjoyment derived from real income. Psychic income is intangible, subjective, and cannot be easily measured in money, but it is a critical component of a family's quality of life.

Income Management

Income management is the process of planning, controlling, and evaluating the use of all types of income to get the most satisfaction from available resources. Because no two families have the same needs or goals, each family must create its own unique financial plan.

Budget

A budget is a detailed plan for future income and expenditure. It is the most common tool for financial planning and represents the first step in managing money effectively.

The success of a budget depends on it being:

• Realistic and flexible: It should be practical for the family's situation and adaptable to unexpected changes.
• Suitable for the group: It must be designed to meet the specific needs of the family for which it is made.
• Well-controlled and evaluated: The family must actively monitor and review the budget for it to work.

Steps in Making a Budget

There are five main steps to creating a family budget:

1. List all needed commodities and services: Identify everything the family will need during the budget period and group related items together (e.g., food, housing, education, clothing, transportation, savings).
2. Estimate the cost of each item: Research the prices of the listed items and calculate the total expected expenditure. It's wise to account for potential price increases, especially if market trends show an upward swing.
3. Estimate total expected income: List all sources of income, separating them into assured income (like a salary) and possible income (like a potential bonus). Necessities should be covered by assured income.
4. Balance income and expenditure: Compare your total estimated expenses with your total expected income. If expenses are higher, you must either find ways to increase income (like taking on extra work) or cut expenditures (like reducing spending on non-essentials).
5. Check the plan for success: Review the budget to ensure it:
   • Meets the family's essential needs.
   • Includes a provision for emergencies.
   • Ensures solvency (the ability to pay bills on time).
   • Recognizes the family's long-term goals.
   • Considers broader economic conditions (e.g., a recession).

Advantages of Planning Family Budgets

• It provides a clear overview of how the family's income is being used.
• It helps prioritize spending on the most important goals.
• It prevents wastage of money on non-essential items.
• It encourages rational decision-making that aligns with long-term goals.

Control in Money Management

After planning, the next step is controlling, which involves checking the plan's progress and making adjustments as needed.

Checking the Plan

There are two main ways to check your spending:

• Mental and Mechanical Checks:

  • A mental check involves visualizing what a specific amount of money needs to cover. For example, realizing that ₹1,000 must pay for shoes, a festival outfit, and books helps you be more careful with your spending.
  • A mechanical check involves physically setting aside cash for a particular purpose. A common example is keeping a separate "food purse" with the monthly food budget inside.

• Records and Accounts:

  • Keeping records of expenditures shows where money has been spent and allows for comparison with the budgeted amounts. This can be as simple as a daily written log or as formal as detailed accounts.
  • Advantages of record-keeping: It helps identify overspending, informs future budgets, and provides proof of payment if you need to complain about a faulty product or service.

Adjusting and Evaluation

A financial plan may need adjustments if the initial planning was poor, an emergency occurs, or the family overspends. Regularly adjusting the plan keeps it on track.

Evaluation is the final step. It involves assessing the satisfaction gained from the money spent. A budget is successful if the family feels it's getting fair value for its money, can pay its bills on time, is providing for the future, and is improving its economic status.

Savings

Savings means setting aside a part of your income for future use. It is crucial for a family's future security and for the national economy, as savings lead to capital formation when invested productively.

A family's ability to save depends on two factors:

• Ability to save: This is linked to income. Higher-income families generally have a greater capacity to save.
• Willingness to save: This depends on the family's long-term goals and their readiness to sacrifice some present wants for future security.

Investment

Investment is the act of using savings for further production to generate more money. Simply hiding money away is not an investment; it must be put to productive use.

Investments can be made in two types of assets:

• Financial Assets: Putting money into bank accounts, post office schemes, shares, insurance policies, etc. These are considered productive in economic terms as they help in capital formation.
• Physical Assets: Using savings to buy land, property, gold, or household goods. While these investments often have positive long-term returns, they are not considered productive in the economic sense as they do not directly contribute to capital formation.

Principles Underlying Sound Investments

To ensure that hard-earned savings grow and are secure, investments should be guided by the following principles:

• Safety of the Principal Amount: The original amount invested must be safe. This can be ensured by diversifying investments across government and private sectors, different companies, and various types of securities (stocks, bonds, real estate).
• Reasonable Rate of Return: Generally, higher returns come with higher risks. It's important to balance the desire for a high return with the need for safety and regularity of income.
• Liquidity: This is the ease with which an investment can be converted back into cash without losing value. One must balance the need for liquidity with the potential for higher returns from less liquid assets.
• Recognition of World Conditions: Economic trends and business cycles can affect investments. Understanding these conditions helps in making wise investment choices.
• Easy Accessibility and Convenience: Choose investments that you understand and can manage without unforeseen problems.
• Investing in Needed Commodities: Match the maturity date of an investment to a known future need. For example, if you need funds for a child's higher education in ten years, choose an investment that matures around that time.
• Tax Efficiency: Select investment instruments that offer tax benefits, such as Public Provident Fund (PPF) or insurance policies.
• After-Investment Service: Choose companies that provide good customer service, including timely communication, easy encashment, and support.
• Time Period: Consider the "lock-in" period. Longer investment periods often yield higher returns. The choice depends on when the family will need the money.
• Capacity: Do not invest beyond your means. It's important to balance present needs with future financial security.

Savings and Investment Avenues

In India, consumers have a wide range of options for saving and investing, including:

• Post Office schemes
• Banks (Fixed Deposits, etc.)
• Unit Trust of India (UTI)
• National Savings Certificates (NSCs)
• Shares and Debentures
• Bonds and Mutual Funds
• Provident Fund (PF) and Public Provident Fund (PPF)
• Chit Funds
• Life and Medical Insurance
• Pension Schemes
• Gold, Housing, and Land

Credit

Credit means obtaining money, goods, or services now with a promise to pay for them in the future. It is a form of postponed payment that increases a family's purchasing power in the present.

Need for Credit

Families use credit for various reasons:

• To purchase high-cost items like land or a house, spreading the cost over time.
• To meet emergencies, such as a sudden illness.
• To fulfill social obligations, like a child's marriage.

The 4 Cs of Credit

Lenders, such as banks, use the "4 Cs" to decide whether to grant a loan:

1. Character: The borrower's willingness and determination to repay the loan as agreed.
2. Capacity: The borrower's ability to make payments, which depends on their income relative to their expenses.
3. Capital: The borrower's net worth (the difference between what they own and what they owe). This provides a safety margin for the lender.
4. Collateral: A specific asset (like property or gold) that is pledged as security for the loan. If the borrower fails to repay, the lender can sell the collateral to recover the money.