As the name suggests, this article runs you through concepts you might have heard of several times in different contexts but may have paid little attention to. Even if you think you know these, it’s always worth one’s time to think about them through the lens of another person. All in all, a worthwhile read for you. Please note that as you read through the article, you may feel that it’s more Accounting and less Finance. Well, you’re right.

Let me explain. Economics is where it all started, with the objective of facilitating household management. Finance took it one step further, to help manage one’s funds, in the most efficient manner. Accounting, on the other hand, concerns itself with the recording of whatever monetary transactions have happened. The sadder bit is; to understand personal financial management, you need to know a little of all three. So here we go!

Four important concepts for you to acquire:

1. Assets: These are things under your control (often because you own them) which help you generate benefits in the future. The future benefits may come in the form of money (think of bank deposits that generate interest income) or mere daily conveniences. Think of items such as computers, furniture, jewellery or may be, a refrigerator. These are articles you may have purchased in the past but continue to benefit from.

However, for you to be able to call something an ‘asset’, you must in a position to control it. Even when you may love (and even envy) your neighbour’s Mercedes, the unfortunate truth is that it’s not YOUR asset, since you cannot decide how and when to use it.

All of us spend all the time on purchases of assets, ranging from small items like laptop bags and electric blenders, to larger and more expensive ones such as cars and houses. Please note that amounts spent on the purchase of assets are referred to as Investments, since the benefits from such spending are expected to be reaped for a long period in the future.

2. Liabilities: These are amounts which are expected to result in the payment of cash in the future. Think of this: you approach a bank for a car loan. The bank looks at your salary slips and grants you the loan, repayable in ten years. This amount (principal plus interest) which must be paid back to the bank after ten years is a liability for you, till the time you have repaid it in full. It is a liability because today (when the loan has been granted), you know for sure that this amount has to be paid in ten years’ time.

So, what does one do, knowing that one has a liability to take care of? Simple, we provide for it through careful financial planning, so that when the amount becomes due, we have enough resources to settle it. Examples of liabilities are bank loans, credit card bills, pending monthly installments for gadgets purchased, etc.

3. Income: This refers to a reasonably regular inflow of cash for an individual. This could come from salary or profession, interest income, rent from property, etc. It is believed that higher the income, the richer the individual. I will discuss with you how wrong this notion is, by the end of this article.

4. Expenses: These are outflows of cash out of income earned. Some people explain it this way – these are outflows of cash for the purpose of earning income. Does it make sense? Think of this. You are a well-paid professional, say an engineer. You bring home a hefty salary each month. Your expenses (largely) will constitute those on food, clothes, rent payments and recreation. Right? But then to be able to maintain your efficiency at work, to be able to bring in money even in the future, you need the basic necessities of life – food, clothing and shelter and of course some recreation to keep you going. Whichever way, one may look at it, expenses involve cash outflows out of income.

But purchase of assets also involve cash outflows, right? Then what’s the difference between expenses and assets?

The difference is in the time period over which the benefits of these outflows is expected to be last. While outflows on expenses result in temporary benefits (no future benefits), assets result in benefits for a considerably long period in the future.

Does it now make sense to you why you think and research so hard before buying a computer, compared to treating yourself to a burger at Mc Donald’s? Because one incorrect investment can make you regret for years altogether, while an expense loses its utility in the same period in which it is made.

Enough definitions for now. Let me bring you where the crux of today’s article lies – the relationship between three extremely crucial variables – income, expenses and savings.

Income – Expenses = Savings
Or, Income = Expenses + Savings
Or even better:
Income – Savings = Expenses

The above equation presents to you, rather simplistically, the relationship between your income, level of expenditure and your savings.

Now think about the following scenarios and assess where you may fall on an average:

a. Income exceeds Expenses

b. Expenses exceed Income

c. Income = Expenses

Now time for some assessment:

If you feel that you are in situation:

(a) You are in the best position possible, given that you generate savings every period, on average. Savings, or the excess of income over expenditure is what makes you rich over time. If you continue to save and invest your funds wisely, you will end up accumulating an even larger pool of wealth overtime (we will talk about the Time Value of Money or the power of compounding) in subsequent articles).

(b) You are in for big trouble because most of your newly earned income is exhausted in settling credit card and other bills, leaving you with fewer funds to spend with, throughout the month. Though this strategy of yours may work for the next couple of years (or may be just months), you will eventually burn all your cash out. (Credit cards allow you to spend first and pay (i.e. earn) later.)

(c) If you’re not the saver types, you are certainly a spendthrift. Though the no-saving strategy may work for you for the next couple of years when you are at your best earning potential, you may find yourself in trouble on a rainy day, i.e. during an unforeseen contingency such as a medical emergency, where large sums of money may be required.

Now it’s time to wrap up. One thing remains: I mentioned to you about the common belief that people who earn more are richer. Well, that’s only half-truth. It is true for individuals, as well as corporations and anyone else, that wealth is generally thought of in the sense of an accumulated pool of money, over time. Accumulation can happen only when some amount of income in the current period is kept aside for future use or in other words, saved.

Savings lead to investments (have you heard of stock markets, bonds and mutual funds?), which in turn result in income (interests and dividends) and add to your existing pool of savings. You keep saving every period (month or year) and it keeps generating more income for you and you keep getting richer and richer, even when you do not think about the performance of your investments on a daily basis. This is where careful and wise financial planning comes in.

Coming to the ‘rich people’ question, I would prefer to call those people rich, who satisfy two conditions at the same time – earn a good amount every month and save an even better amount every month. Remember: the rich would not have been rich had they burnt all their cash. They are rich because they have money working for them, generating income month on month, even when they would choose not to work. Therefore, nothing can underplay the role of savings in the financial management game.

Thanks for reading!