Managing cash flows for those with fluctuating income
I have a friend who lives well when she earns more and gets into a frugal mode when business is bad. An artist, her income fluctuates, so does her lifestyle. Up when there is more and down when there is less. Her mood, though, is quite delinked from her financial status—always up. Last year, she said she wanted to start systematic investment plans (SIPs). Why? Because everybody around her was starting SIPs, and it seemed a cool thing to do—getting financial security is good, no? Yes, sure, but it has taken her the first 40 something years to get to even talk about financial security. Better late and all that. The first thing I asked her to do was to put down a number that she needed each month to live. It’s very difficult to pin down an average monthly expense for a person who matches expenses to earnings every few months. But the budgeting exercise, which is the building block for most plans, takes on much bigger importance for people with fluctuating incomes. Without knowing what you spend each month, there is no financial plan.
Doctors, lawyers, freelancers, small entrepreneurs and other freelance professionals have erratic income flows. Some months are good, the others not that great, but there are living costs that must be met to not default on rent or EMI, credit card payments, insurance premiums, school fees. Money to buy food must be there whether it is a good month or not. One way to think about how much you need is to break down spends into two buckets: ‘survival’ money and ‘living’ money. Into the ‘survival’ bucket will go your rent, EMI, spends on groceries (no, it does not include gourmet meals delivered home), household help costs, travel for work, utility bills, school or college fees and anything else that is essential for your life. ‘Living’ money will have lifestyle spends on eating out, movies, holidays, gadgets, and whatever else is part of your life’s higher needs. A good way would be to analyse your card spends for the past year and see where the money goes to get an idea. To the living cost number, add an average of the lifestyle spend over the year and that is your must-have income level each month, no matter what the income flow looks like.
I like to use a three bank account system in which all your income drops into the ‘Income’ account. From that your average monthly spends get transferred to your ‘Spend It’ account every month and the rest moves to the ‘Invest It’ account. Now figure out how long a bad streak can continue. Has there been a time that no money has come in at all for a month? For 2 months? For 3 months? Whatever that number, add one month to it and keep that much money in a liquid fund—call it the ‘Bad Month’ account. If you’ve been at zero income in the past for 2 months, then keep 3 months of expenses in a liquid fund. In the month that your income falls short of the budgeted expenses, dip into this fund for the amount you need. Remember to refill when the income flows are good. Figure out your periodic lump sum payments and add that number to your Bad Month account.
Budget a bit more for expenses such as car insurance premium or medical and life premiums, for some people this expense can come out of the regular monthly spend. But if your kid is abroad studying or if you have a large insurance-plus-investment premium due (these are plans that you should discard, but there are those who are still funding these wealth destroying insurance plans), you may need to create more pools specific to those payments. You can add it to the Bad Month account or create one more liquid fund for periodic payments.
Next, create a second layer of security with at least 6 months of expenses in an emergency fund. You can use a short-term debt fund for this. If you are single and have dependants to look after, hike this number to 1 year of money in the emergency fund. The first few times you use this system, you will have to be really strict with yourself, especially in a good month. It helps to immediately move the money from your Income account to your Spend It account and then move the rest to your Invest It account. I would keep a buffer of about 10% of your calculated spend as a backup till your Bad Month account builds up. Of course, your basic insurance covers need to be in place—a good medical cover, a life cover if you have dependants, home cover and car cover are the basic must-haves. Your investment process begins once your cash flows have stabilized and your Bad Month fund is created as is your emergency fund. Then you begin to start investing through SIPs, not before.
Before you rush into the new fad of SIPs, remember that financial security comes from a stable money box with neat cells. Unless your cash flows are in order, defer the plan to begin your SIPs. Begin them for sure, but after you know how much you can spare each month for investment, specially if you have uneven income flows.
Monika Halan works in the area of consumer protection in finance. She is consulting editor Mint and on the board of FPSB India. She can be reached at email@example.com