Many thoughts around our goals or investments drive an urge for financial planning. Financial planning is a process of knowing where we stand, deciding on what we want to achieve and making plans to bridge the gap. The analysis of where we stand represents our financial health.
Financial health stands as a reflection of our past financial decisions and mistakes. It also helps in analysing how our past financial decisions would help is in achieving what we want.
To know your financial health, you must understand the following parameters:
The core of our financial health revolves around our savings rate. This savings rate is essentially governed by the spending habits we develop over the years. The irony behind money management is that most of us talk about reducing our spendings and increasing our savings but never act upon it. It is our spending habits which decide our current and future financial well-being, especially when sources of income are fixed and finite.
We must list down all our expenses and categorise them as committed or non-committed spending. Expenses like groceries, medicines, school fee of children, EMI payments and all such expenses which are mandatory account for committed expenses, whereas expenses incurred by dining out, hobbies, vacation and other such non-mandatory expenses account for non-committed expenses. Knowing these areas of high non-committed spending and controlling them helps us in improving the rate in which we save.
Committed vs. non-committed expenses
When it comes to committed expenses, debt management plays an important part. Closing high interest, non-productive loans or refinancing those for a competitive rate can help in improving our savings rate.
Insurance is often perceived as a safe, effective long-term investment and tax-saving tool. In reality, insurance is an expense and is considered a committed expense. Many of us commit our financial mistakes when it comes to insurance. We often fail to analyse our insurance requirement and end up being under insured or over-insured. One should also analyse the choices made wile selecting insurance products. The premiums being paid towards sub-optimal insurance policies have a direct impact on the rate of our savings and, hence, increase the gap between what we have and what we want in terms of our goals.
Apart from life insurance, one should also analyse existing medical insurance policies and the cover provided by them. Being reliant on company-provided medical insurance would leave us without any medical cover in case of an unexpected event of job loss. Similarly, an inadequate medical insurance cover would force us to liquidate our assets in case of a major medical emergency.
Net worth Analysis
Net worth analysis will help you in analysing the efficiency of your debt management skills. It will also help in realising how efficiently you have put money to work towards what you want to achieve. One should differentiate liquid assets and illiquid assets accumulated over years.
Liquid vs. illiquid assets
Assets which can be liquidated or converted to cash with ease can be termed as liquid assets, while assets like real estate, which normally require more effort and time to convert to cash, illiquid assets. One should maintain a healthy ratio of liquid assets to illiquid assets.
One should also strike a balance in maintaining optimal levels of cash reserve. Cash should not sit idle in your bank account and at the same time should not be less than your emergency fund. Analysing your existing assets also reveals how well diversified your investments are. This analysis also helps us in knowing the level of diversification we have employed in our past investments.
This insight should then be analysed along with your outstanding liabilities to know how you can fund your existing liabilities using existing assets in case of a major financial mishap.
Giving your financial health a check can be termed as a reality check from the perspective of finance. It is an efficient way of correcting your past financial mistakes and analysing the financia decision-making process. Until and unless we know where we stand with respect to managing our finances, we cannot lay plans for the future. This allows us in setting realistic expectations from the future rather than setting over optimistic financial goals.
ArthaYantra is an integrated online personal finance company.
Disclaimer: The opinions expressed in this article are the personal opinions of the author. NDTV Profit is not responsible for the accuracy, completeness, suitability, or validity of any information on this article.