In the spectrum of activities that could generate future financial freedom and prosperity, holistic monitoring and analysis ranks in the top three, if not the number one spot. This can seem intimidating at the outset—especially if you’re not already familiar with all your financial ins and outs, if your financial activity flows through many different accounts, or if you don’t have a template or framework with which to monitor.
My goals for this post are:
- Explain the concepts of financial monitoring and analysis
- Document the basic steps needed to complete these activities
- Provide hints on what low-hanging fruit to analyze
Financial monitoring and analysis are two SEPARATE but related activities that are exactly what they sound like. The first step (monitoring) is to compile and understand the relevant data, and the second step (analysis) is to identify trends in the data and use that information to inform better future decision making. In full disclosure, you can make this as simple or as complex as your heart desires—the most important thing is that you take away meaningful, actionable information when you go through this exercise.
Items I recommend you monitor on a regular basis are: cash flow, expenses versus a budget, and balance sheet. Let’s talk a little bit more about each of these.
- Cash flow – This terminology may strike fear into you right away, but it shouldn’t. This step is nothing more than mapping out expected transactions on a sequential basis. We’ll use a simple example. Assume you have one checking account, through which all your financial transactions flow. Let’s assume today is August 1st. You would use your beginning checking account balance as of July 1st as your starting point. From there, you go through your bank statement or online snapshot and map out all the transactions until you get to the July 31st ending balance. Your ending balance at July 31st then becomes your beginning balance for August. Below is what this might look like with a handful of hypothetical transactions. You will notice the beginning balance is $2,500, and the ending balance is $2,500. All the ins and outs leave us with the same balance at the end of the month as we had at the beginning. If this was the case month after month without putting any aside for savings, this would be called “living paycheck to paycheck”, “having too much month left at the end of your money”, etc. As you do this exercise each month, you will become more familiar with the transactions, frequencies, and timing, to the point where you will eventually be able to project your bank balance out into the future—possibly many months—if your spending levels and frequencies are routine and consistent.
- Actual Expenses versus Budgeted Expenses – To build a frame of reference around this one, let’s start with a statistic: according to US Bank, 41% of Americans follow a household budget. That is 4 in 10 people, on average, who monitor their expenses versus a budget. Or to flip that around, 6 in 10 people do not follow a household budget. Think about that! If you don’t know what your targeted level of spending is, how could you possibly hit it? But let’s take this a step beyond the statistic—WHY do only 41% of Americans follow a household budget? Why isn’t that 80% or 95%? I could compile a long list of excuses or reasons, but nearly all my discussions of and reading about why people do not track expenses versus a budget center around time or complexity. The good news is developing a budget and monitoring compliance with that budget does not have to be time-consuming or complex! It can be as simple as taking out a piece of scrap paper at the beginning of the month, determining your major expense categories and how much you intend to spend in each, and then tallying your actual spending at the end of the month compared to the budget. Or if you prefer something that’s more visually appealing that does the calculations of actual versus budget variances, percentage variances, etc., you can develop a spreadsheet to hold the data and do the calculations for you. Once you compile your data, you can start to draw conclusions about your spending that will allow you to improve your habits in the future. Building off the cash flow data above, your actual expenses versus budget might look something like the snapshot below. If you’ll notice, in this month, the grocery spending exceeded the budget by $100 and 50%–maybe this is an area that needs more attention and more diligent spending; or, maybe you really want or need to spend $300 per month on groceries (e.g. dietary considerations or restrictions). This exercise can be one of the most insightful of the bunch as the variances from budget tell you a lot about your spending or your perceptions of your spending. It can also help you uncover “problem spending” areas if you start seeing routinely negative variances versus your budget.
- Balance Sheet – This exercise is largely the long-term culmination in the first two activities. The three main categories of any balance sheet are: assets, liabilities, and equity (commonly referred to as net worth in personal finance). To put a simple, mathematical formula out there, a balance sheet is the detailed representation of the following:
ASSETS = LIABILITIES + EQUITY
Here are a few more details around what resides in each category:
- Assets – For personal finance discussions, this is mostly comprised of:
- Cash in checking account
- Cash in savings account
- Investments in a retirement plan like 401(k) or 403(b)
- Investments in a college 529 savings plan
- Other investments
- Vehicles (fair market value)
- Home and/or land (fair market value)
- Personal property (i.e. other personal assets like a coin or art collection)
- Liabilities – For personal finance discussions, this is mostly comprised of:
- Credit card balance, if not paid in full each month
- Vehicle loan
- Student loan
- Medical debt
- Personal loans
- Payday loans
- Equity – This is simply the difference between your assets and liabilities. If your assets exceed your liabilities, you have a positive net worth, and if your liabilities exceed your assets, you have a negative net worth.
This formula is critical to understanding your long-term financial status. Many people start the journey to financial freedom with negative net worth because they have excessive debt relative to assets. It’s important to know your starting point, but it’s considerably more important to develop goals about where you want to be in the future. Maybe you want to accumulate 6 months of expenses in an emergency fund; perhaps you want to save a certain amount for your children’s college funds; or maybe you want to pay off your student loans. Progress can be tracked and trended to help you reach those goals.
Once you’ve completed the above three exercises, the most important and beneficial step is to analyze and develop takeaways for future improvement. You will notice certain patterns (read “habits”) that you may want to change. As a personal example, after about a year of going over our grocery budget each month (and still tossing spoiled food in the trash), my wife and I concluded we had an opportunity to improve our grocery spending—both the composition and amount. We set about developing strategies to save money and shop smarter at the grocery store, which ultimately led to a 20%+ reduction in spending monthly. As a silver lining, we also threw less spoiled food out each week. Because this is the most important step, I want to provide you with some hints around things to watch:
- Items where your spending significantly deviates from your budget month-after-month – this one can be tough to analyze because it can be a spending problem or a budget problem; in some cases, it can be both. If you set yourself up for budget “failure” by setting an artificially low or unrealistic budget, you may become disheartened about totally reasonable spending levels. Conversely, if you set an artificially high budget for a certain item, you may be giving yourself a pat on the back for coming in under budget with a ridiculously high amount of spending. Like most things, practicing these analyses over time will help you understand the root cause.
- Items that seemingly pop out of nowhere – I call these types of transactions “gotchas”. They are things you don’t expect and can vary widely. Maybe you get a flat on the way to work and have to buy a new tire. Perhaps you have an annual subscription or dues you forgot about (my wife and I are surprised every single year by our Costco membership renewal!). These types of transactions can sometimes make the difference between living paycheck-to-paycheck and being able to sock some money away into savings or put it toward paying down debt. My suggestion for these types of transactions are to either set aside some savings (i.e. emergency savings) or to make a list of gotchas and build them into your future months’ budgets so you know to expect them.
- Items that cause you to overdraft – Sometimes there are certain items that just put you barely over the edge. Maybe it causes you to overdraft your checking account by $100, which then triggers a $25 overdraft fee from the bank, and then you play the next month catching up. Is it possible you could rearrange the timing of some of your expenses so you don’t wind up in an overdraft position? For example, if you get paid on the 15th, maybe you could move some of your expenses closer to your paycheck so you have better visibility late in the month as to how much cushion you have in your cash flows. Some companies will let you pick the date on which your transaction is executed (utility providers, insurance companies, some banks are some that come to mind).
- Items that represent a significant portion of your spending – These are the big fish. Maybe it’s your rent, mortgage payment, or car payment. Challenge yourself on how to save with these biggies. Can you find a cheaper apartment or house to rent (assuming you don’t have to pay a fee to break your lease early…that’s a different story for a different post)? Could you find cheaper homeowners insurance coverage (assuming your homeowners insurance is paid via escrow)? Is it feasible to find a cheaper car to reduce your car loan payment?
- Items that are frequent purchases (but maybe individually insignificant) – These are the little fish. Let’s say you have a long work commute and have to fill your car up with gas twice per week. Each tank of gas costs $30 or $40, but if you aggregate bi-weekly fill-ups that is $320 per month. For fuel, most gas stations offer rewards programs where you can sign up and save $0.03 to $0.05/gallon. Most of these programs have limits of 100 or 200 gallons, but every little bit helps. You could also sign up for one rewards program, fill up at that station until you reach the limit, and then sign up at the next gas station down the street to capitalize on their rewards program. Check your tire pressure and see if your tires are underinflated versus recommendations; this can easily generate 2mpg to 3mpg improvement in fuel economy if your tires are significantly underinflated. There are many other examples covered in other articles.
In summary, the monitoring and analysis activities do take time, but the more you practice the more adept you’ll become at identifying trends and targeting areas for improvement. For those of you who may have studied his work, W. Edwards Deming has an eloquent way of summarizing this cycle in the Deming Circle—Plan (Prepare a budget), Do (Conduct spending), Check (Analyze results), Act (Make changes in behavior). Ultimately, the process itself is simple: compile the data, analyze the data, improve the underlying negative habits (or further improve the good habits)! Happy sowing!