Creating a Comprehensive Budget

Budgets, Financial Statements, and Financial Decisions

Whatever type of budget you create, the budget process is one aspect of personal financial planning and, therefore, a tool to make better financial decisions. Other tools include financial statements, assessments of risk and the time value of money, macroeconomic indicators, and microeconomic or personal factors. These tools' usefulness stems from their ability to provide a clearer view of "what is" and "what is possible." It puts your current situation and your choices into a larger context, giving you a better way to think about where you are, where you would like to be, and how to go from here to there.

Jeff has to decide whether to go ahead with the new roof. Assuming the house needs a new roof, his decision is really only about his choice of financing. An analysis of Jeff's budget variances has shown that he can actually pay for the roof with the savings in his high-interest savings account. 

This means his goal is more attainable (and less costly) than in his original budget. This favorable outcome is due to his efforts to increase income and reduce expenses and to macroeconomic changes that have been to his advantage. So, Jeff can make progress toward his long-term goals of building his asset base; he can continue saving for retirement with deposits to his retirement account, and he can continue improving his property with a new roof on his house.

Because Jeff is financing the roof with the savings from his high interest savings account, he can avoid new debt and thus additional interest expense. He will lose the interest income from his high-interest savings account (which is not that significant), but the increases from his tutoring and sales income will offset the loss. Jeff's income statement will be virtually unaffected by the roof. His cash flow statement will show unchanged operating cash flow, a large capital expenditure, and use of savings.

Jeff can finance this increase in asset value (his new roof) with another asset: his high-interest savings account. His balance sheet will not change substantially – value will just shift from one asset to another – but the high-interest savings account earns a minimal income, which the house does not, although there may be a gain in value when the house is sold in the future.

Moreover, Jeff will move value from a very liquid high-interest savings account to a not-so-liquid house, decreasing his overall liquidity. Looking ahead, this loss of liquidity could create another opportunity cost: it could narrow his options. Jeff's liquidity will be depleted by the roof, so future capital expenditures may have to be financed with debt. If interest rates continue to rise, that will make financing future capital expenditures more expensive, perhaps causing Jeff to delay those expenditures or even cancel them.

However, Jeff also has a very reliable source of liquidity in his earnings – his paycheque, which can offset this loss. If he can continue to generate free cash flow to add to his savings, he can restore his high-interest savings account and his liquidity. Having no dependents makes Jeff more able to assume the risk of depleting his liquidity now and relying on his income to restore it later.

The opportunity cost of losing liquidity and interest income will be less than the cost of new debt and new interest expense. That is because interest rates on loans are always higher than interest rates on savings. Banks always charge more than they pay for liquidity. That spread, or difference between those two rates, is the bank's profit, so the bank's cost of buying money will always be less than the price it sells for.

The added risk and obligation of new debt could also create opportunity costs and make it more difficult to finance future capital expenditures. So financing the capital expenditure with an asset rather than with a liability is less costly, both immediately and in the future, because it creates fewer obligations and more opportunities, less opportunity cost, and less risk.

The budget and the financial statements allow Jeff to project the effects of this financial decision in the larger context of his current financial situation and ultimate financial goals. His understanding of opportunity costs, liquidity, the time value of money, and personal and macroeconomic factors also help him evaluate his choices and their consequences. Jeff can use this decision and its results to inform his next decisions and ultimate horizons.

Financial planning is a continuous process of making financial decisions. Financial statements and budgets summarize the current situation and project the outcomes of choices. Financial statement analysis and budget variance analysis assess the effects of choices. Personal factors, economic factors, and the relationships of time, risk, and value affect choices as their dynamics – how they work and bear on decisions – affect outcomes.