06 December, 2010

Don't ignore Expenses...

Unless watched, rising expenses could undermine your wealth creation

Income should not be confused with wealth. Whatever an individual’s income, if his expenses take up all or a larger portion of his income, there will be no surpluses left and as a result, no wealth creation. It is only when our surpluses are invested that wealth is generated.

Expenses are, hence, also critical. Two people, despite earning the same income can end up looking very different in a few years - the difference would be as a result of their expenses and their investment. Hence, having a laser-like focus on just the amount of income is misplaced.

Financial planners use various ratios to ascertain the health of their client's wealth. They consider the savings to income ratio, liquidity ratio and the debt to asset ratio of a person. However, intriguingly, even financial planners will leave expenses out of the calculus.

Savings to expenses ratio
This is a very important indicator of financial health. Let us say, Ram earns Rs 50,000 per month.He spends Rs 30,000 out of his earnings each month and saves the rest. His friend, Bharat, earns Rs 75,000 each month. His expenses add up to Rs 50,000 at the end of the month and he manages to save Rs 25,000 per month. Ideally on the face of it, Bharat saves Rs 5,000 more each month. This should add up to a good amount at the end of the year and so he is considered to be better off than Ram.

However, look closer. Ram's expenses are Rs 30,000 per month and he saves Rs 20,000 every month. His savings to expenses ratio is calculated at 0.66 (20,000/30,000). In practical terms, with the savings he manages every month, he will actually be able to pay for 20 days of his monthly expenses. Lets compare, the same ratio in Bharat’s case. His ratio works out to 0.5 (25,000/50,000). This means Bharat will be able to take care of only 15 days' expenses.

But the above observations could be debated by some who may conclude that Bharat may have a better standard of living than Ram, considering his expenses. Even that may not be true if Bharat is supporting a lavish or better lifestyle depending on loans. Servicing more loans does not mean a better lifestyle. One could be servicing more loans to support unwanted expenses.In any case, even if it were a better lifestyle that Bharat enjoys, he needs to save much more to enjoy the same staying power as Ram. With respect to this ratio, keeping the expenses within desirable limits is important, rather than focusing on income alone.

Debt servicing to total expenses
Even while considering one’s expenses, looking at the break-up of how much is being spent on which item will be significant. For instance, if out of your total expenses in a month, 40 per cent is spent on paying the equated monthly instalments (EMIs) for a home loan, it is fine. Spending another 20 per cent more to service other loans would also be fine. Assuming that the balance 40 per cent of your expenses gives sufficient leeway for all other expenses. And includes some savings too.

However, say the debt servicing to total expenses ratio is 0.6. In this case, if the instalment component of any loan goes beyond 60 per cent, it would be dangerous as EMIs are non-discretionary. You might end up paying a penalty if you miss paying those.

An ideal debt servicing to total expenses ratio would be 0.5 or lower. However, this works well for those in the higher income brackets (Rs 50,000 per month or more). For lower income brackets, the amount of loan that can be taken would be dictated by monthly or annual expenses, as loans' servicing can be done only after meeting the basic expenses.

For instance, for a person who is earning Rs 30,000 per month, if the monthly expenses are about Rs 20,000, then he can use a maximum of Rs 10,000 every month for servicing his loans. Here, the debt servicing to total expenses ratio is 0.33. The general logic of having a ratio of 0.5 atleast will not apply here. Similarly, for double income families with a high combined income, this ratio can go up, to even 0.7, as the balance available may still be big enough in absolute terms to meet the basic expenses and saving needs.

Expenses play an important role at the time of retirement and beyond. A muted spending style can stretch the corpus a long way. A flamboyant spender may see the same corpus deplete in no time. Expenses, hence, play a pivotal role through out life. Merely focusing on income and investments can be a mistake, a costly one.

The Delta factor
While calculating our future expense requirements, we merely consider our current expenses and inflation. However, another factor that would determine your future expenses is the aspiration factor-which we shall call the Delta factor. A hatchback might make one look self-assured today. But aspirations also keep galloping. In future, the same person may be aspiring for a car that is considered up-market.Once vacations meant going to hometown and back. Now, vacations take one to exotic locations in India and abroad.

The Delta factor is seldom considered while planning finances. It is true that this is difficult to estimate. Considering, it depends on societal and peer pressures, the future contours of which are difficult to define. It also depends on the strata of society they belong to. What may be "arrived" in one strata may be "passe" in another. How many people would have predicted that they would be sending their children abroad for education, if asked 15 years back? But then, that is what many are doing today.

Building a cushion to accommodate this delta factor, would be a capital idea. It may not be accurate. But then, estimating it and making at least a rough provision would solve the problem to an extent, instead of completely ignoring it.

Published in Business Standard on 28/11/2010

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