Income-expense analysis for a individual or family is quite similar to profit and loss statement analysis of a company. As part of income-expense analysis for individual or family, we build understanding of their total income and total expenses to calculate their total savings using at least past six months of data. It also takes into consideration any upcoming income or expense which will have an impact over next six-to-twelve months. In a way this analysis takes into consideration your past, present and expected future.
Now let us understand what is considered as Income, expense and savings as part of income-expense analysis and simultaneously calculate it.
What is Income?
For a individual or family, “Income is the sum of all the salaries, profits, interest payments, rents, and other forms of earnings received in past twelve months period.” Income is the consumption and saving opportunity gained by an entity within a specified time-frame, which is generally expressed in terms of money.
Further, Income is of two forms – active income and passive income. We can define them further as –
1. Active income is generated by doing something for someone and in return money is payed to you. Most common example of active income is – monthly salary. Common sources of active income are –
a. Salary - Salary is the payment from employer to employee as per the employment contract. In India, salaries are paid monthly. b. Business Income - Business income is any income realized as a result of business activity. Business income is a type of earned income and is classified as ordinary income for tax purposes. c. Commissions - Commissions are a form of variable-pay remuneration for services rendered or products sold. For example, various agents in mutual funds and insurance industry are paid commissions.
2. Passive income is generated or received on a regular basis, with little effort required to maintain it. Most common example of passive income is – interest earned from fixed deposits. Common sources of passive income are –
a. Rental Income - Rental Income is received by letting out your real estate property to someone for living or for business purpose. For example, rent received on home let out. b. Interest Income - Interest income is the interest paid by Banks or NBFC or HFC against deposits by an individual. For example, Monthly interest received on Fixed deposits at a bank. c. Dividend Income - Dividend income is the distribution of earnings to shareholders in the form of cash, stock, or property. For example,Mutual fund dividends are paid out of income, usually on a quarterly basis, from interest generated by a fund's investments. d. Royalty - A royalty is a payment made by one party to another that owns a particular asset, for the right to ongoing use of that asset. For example, Royalty payments to book authors by publishers. e. Income from Capital Gains - Income from capital gains is realized when an asset (investment or real estate) is sold. Capital Gains may be long term or short term and must be claimed on income taxes. For example, income from sale of land or house.
More the merrier, meaning having multiple sources of income is always better than depending on single source. By taking all these incomes sources into account we calculate your total income and average monthly income to do income-expense analysis. As a principle be conservative while calculating your total income for the year.
What are Expenses? For a individual or family, expense is an outflow of money to another person or company to pay for any item or service. For an individual or family, different types of expenses are as –
a. Variable Recurring expenses - Expenses where the amount paid keeps changing every time and is incurred multiple times every month or during the year. For example, purchase of groceries, petrol expense, purchase of clothes. b. Fixed Recurring expenses - Expenses where the amount to be paid is fixed and is incurred once every month. For Example, Monthly EMI, Cable TV Recharge. c. Variable One-time expenses - Expenses where the amount to be paid is keeps changing and you incur them at least one during the year. For example, Annual Vacation. d. Fixed One-time expenses - Expenses where the amount to be paid is fixed and you incur may incur them once every year or so. For example, Annual recharge of internet at home.
Lesser your expenses the better it is for you, meaning you are spending on your needs only. Further, expenses less than your income leads to savings and asset creation over time. As a principle while calculating your expenses do not miss any expense or try to be conservative while identifying them.
What are Savings?
For a individual or family, savings is the difference between your total annual income and expenses. This may be your gross annual savings before taxes if you have multiple income sources. However, for most salaried employees with only one income source, in-hand salary is net salary after deduction of taxes and employee provident fund. In this case your savings is very likely to be your net annual savings.
Now that you have calculated your annual income, expense and savings, you are ready to do Income-Expense analysis. As part of income expense analysis, you look at the following –
a. Ways to make your income more tax efficient - This may vary on a case to case basis, simple restructuring of your business or way that income is collected by you can make a lot of difference in overall tax outgo. b. Ways to optimize your expenses - Each and every expense head identified during expense calculation is reviewed and analysed for possible optimizations. Once the optimization is complete it leads to creation of monthly budgets. Some restructuring of your expenses can also lead to better tax efficiencies. c. Review of your savings and investments - By reviewing your income and expenses, you have an opportunity optimize them for better returns and to make them tax efficient. This leads to greater saving and more investments. Further review of your existing investing process and product selection for investing can also make a huge difference in your overall returns.
By doing income-expense analysis, you reap following advantages –
1. Understand our income and expenses better. 2. We create monthly and annual budget for our expenses. 3. We increase our savings 4. We reduce our Taxes 5. We review our investments to make them more tax efficient. 6. We are able to attain our life goals more effectively with lesser stress in life.
Income-expense analysis is a must do as part of your financial planning exercise, without proper income-expense analysis your financial planning is incomplete as there may be hidden inefficiencies at all stages which are pulling you back.
Hopefully this article will help you build better understanding of income-expense analysis and its importance as part of financial planning. And will help you have a more detailed conversation with your financial planner or investment advisor. For more information please feel free to reach out to us via email at – email@example.com or by phone – 91-9515475381.
Next Article – Budgeting: Planning your monthly or annual expenses
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