The Essential Guide to Budgeting - Part 1: The Basics You Need to Know
- Davina Jackson
- Feb 13, 2024
- 14 min read
Updated: Mar 8, 2024
Welcome to The Woman CFO – a space crafted just for you, where we embark on a journey of financial empowerment.
This post is part 1 of a 2-part series on budgeting.
Budgeting is like the superhero cape of personal finance – it empowers you to make informed decisions about your money, prioritize your financial goals, and achieve the life you want.
But let's face it, budgeting can feel overwhelming at times, especially if you're just starting out or have struggled with it in the past.
That's why we're here to break it down into manageable steps and equip you with the knowledge and tools you need to succeed.
In today's post, part 1 of our 2-part Essential Guide to Budgeting series, we’re going to lay the groundwork for effective budgeting by covering the basics. We'll explore what budgeting is all about, why it's important, and the different methods you can use to build a budget that works for you.
So let's roll up our sleeves and get down to business. Are you ready? Let’s go.
Instant Gratification Zone: Skip to the Good Stuff
Budget Essential #1: Assess Your Financial Situation
Budget Essential #2: Set Financial Goals
The Basics: Understanding Budgeting
At its core, a budget is a strategic financial plan that outlines your income, expenses, savings and debt repayment goals over a specific period, usually monthly or annually.
Think of it as a roadmap for your finances, guiding you on how to allocate your money effectively to achieve your financial objectives.
The Importance of Budgeting
Budgeting isn't just about crunching numbers and restricting yourself from splurging on your favorite guilty pleasures.
It's about empowerment, freedom, and setting yourself up for success. Sounds great, right? But it doesn't really tell us why budgeting is so important.
Let's break it down into something more tangible:
Financial Clarity
Budgeting gives you a crystal-clear picture of where your money is coming from and where it's going.
It's like shining a spotlight on your finances, illuminating areas of excess spending, and identifying opportunities for savings and investment.
With a budget in hand, you'll have a better understanding of your financial situation and can make informed decisions about your money.
Goal Achievement
Whether it's saving for a dream vacation, buying a home, or building an emergency fund, budgeting helps you turn your financial dreams into reality.
By setting specific financial goals and creating a budget to support them, you'll stay motivated and focused on achieving those goals.
Budgeting keeps you accountable and ensures that your hard-earned money is working towards your dreams and aspirations.
Debt Management
Let's face it – debt sucks. Whether it's student loans, credit card debt, or a hefty mortgage, debt can weigh you down and hinder your financial progress.
Budgeting helps you tackle debt head-on by allocating funds towards debt repayment and prioritizing high-interest debt.
With a solid budgeting plan in place, you'll be well on your way to becoming debt-free and reclaiming your financial freedom.
Emergency Preparedness
Life is unpredictable, and unexpected expenses can throw a wrench in even the most carefully crafted financial plans.
Budgeting helps you prepare for the unexpected by building up an emergency fund to cover those rainy days.
With an emergency fund in place, you'll have peace of mind knowing that you can handle whatever life throws your way without derailing your financial goals.
Empowerment and Independence
Perhaps most importantly, budgeting empowers you to take control of your financial destiny and live life on your own terms.
Instead of feeling stressed and overwhelmed by money matters, budgeting gives you the confidence and independence to make informed decisions about your finances.
Whether you're single, married, or somewhere in between, budgeting is the key to unlocking financial freedom and living your best life.
Components of a Budget
Now that we understand why budgeting is important, let's take a closer look at the components that make up a budget:
Income: The first component of a budget is your income – the money you earn from sources like your job, side hustle, investments, or any other sources of revenue. Your income is the starting point for your budget and determines how much money you have available to allocate towards expenses and savings.
Expenses: Expenses are the money you spend on various necessities and discretionary items. They can be categorized into fixed expenses (like rent/mortgage, utilities, and insurance) and variable expenses (like groceries, entertainment, and dining out). Tracking your expenses is crucial for understanding where your money is going and identifying areas where you can cut back or reallocate funds.
Savings and Investments: Saving and investing are essential components of any budget. Setting aside money for emergency savings, retirement accounts, and other financial goals ensures that you're building a secure financial future. Make sure to prioritize savings and investments in your budget to achieve long-term financial stability.
Debt Payments: If you have debt, such as student loans, credit card debt, or a mortgage, it's important to include debt payments in your budget. Allocating funds towards debt repayment helps you pay off debt faster and save money on interest charges. Make sure to budget enough to cover minimum payments and consider increasing payments to accelerate your debt payoff.
Emergency Fund: An emergency fund is a crucial component of a budget and serves as a financial safety net for unexpected expenses or income disruptions. Aim to build an emergency fund with enough savings to cover three to six months' worth of living expenses. Having an emergency fund in place can provide peace of mind and protect you from financial stress during challenging times.
Goals and Priorities: Finally, a budget should reflect your financial goals and priorities. Whether you're saving for a down payment on a house, planning a vacation, or funding your child's education, make sure to allocate funds towards your goals in your budget. Setting specific, measurable goals and incorporating them into your budget keeps you motivated and focused on achieving your financial aspirations.
It's important to remember that budgeting is not one-size-fits-all approach. It's about finding a strategy that works for you and your unique financial situation.
Whether you're just starting out on your budgeting journey or looking to refine your budgeting skills, the key is to be consistent, flexible, and proactive in managing your money.
Budget Essential #1: Assess Your Financial Situation
Assessing your financial situation is like taking a snapshot of your current financial health.
It gives you a clear picture of where you stand financially, what your strengths and weaknesses are, and where you need to focus your efforts to improve.
Here are a few reasons why it's essential:
It Identifies Strengths and Weaknesses
By assessing your financial situation, you can identify areas where you're doing well and areas where you need to improve.
Maybe you're great at sticking to a budget but need to work on building your emergency savings.
Or perhaps you're doing well in your career but struggling to pay off debt.
Understanding your strengths and weaknesses allows you to prioritize your efforts and focus on areas that need attention.
It Helps You Set Realistic Goals
Assessing your financial situation helps you set realistic goals based on your current circumstances.
Whether you're saving for a down payment on a house, planning for retirement, or paying off debt, knowing where you stand financially allows you to set goals that are achievable and tailored to your needs.
You Can Create a Plan of Action
Once you've assessed your financial situation and set your goals, you can create a plan of action to achieve them.
Whether it's creating a budget, increasing your savings rate, or paying down debt, having a clear plan in place helps you stay focused and motivated on your financial journey.
You Can Track Progress Effectively
Assessing your financial situation isn't a one-time event – it's an ongoing process.
Regularly monitoring your finances allows you to track your progress towards your goals, make adjustments as needed, and celebrate your successes along the way.
It's like having a GPS for your financial journey – helping you stay on course and navigate any detours or roadblocks that come your way.
How to Assess Your Financial Situation
Now that we've covered why assessing your financial situation is important, let's talk about how to do it.
Step 1: Build your Personal Income Statement
Your personal income statement is like a report card for your finances.
It shows how much money you earn and how much you spend over a specific period, usually monthly or yearly.
It’s composed of 3 items:
Income: This is the money you earn from sources like your job, freelance work, or investments. It includes your salary, wages, bonuses, and any other income you receive.
Expenses: These are the things you spend your money on, such as rent or mortgage, groceries, utilities, transportation, entertainment, and more. Expenses are typically categorized into fixed expenses (like rent or mortgage) and variable expenses (like groceries or dining out).
Net Income (or Profit): This is your actual disposable income after accounting for all financial obligations.
First: Evaluate Your Current Income
To accurately assess your income, gather all relevant financial documents, including pay stubs, bank statements, investment statements, and any other sources of income documentation.
Add up the total income from each source to get a clear picture of your monthly or annual income.
Next: Calculate Your Expenses
To calculate your expenses, review your bank statements, credit card statements, and receipts to track your spending over the past few months.
Then, categorize your spending into 2 categories - fixed expenses and variable expenses.
This will help you understand your spending patterns better.
Fixed Expenses: Recurring expenses that remain relatively stable each month, such as rent or mortgage payments, utilities, insurance premiums, loan payments, and subscription services.
Variable Expenses: Expenses that can fluctuate from month to month, such as groceries, dining out, entertainment, transportation, clothing, and miscellaneous purchases.
Finally: Calculate Your Net Income (or Profit)
To calculate your net income, subtract your total expenses from your total income.
If net income is higher than expenses, you have a positive net income - which means you're earning more than you're spending.
If expenses are higher than income, you have a negative net income - meaning you're spending more than you’re earning.
Step 2: Assess Assets and Liabilities to Calculate Net Worth
Your assets and liabilities, or personal balance sheet, show you what you own (assets) and what you owe (liabilities).
It's like taking a financial selfie – giving you a clear picture of where you stand financially at a specific point in time.
It has 3 items:
Assets: Think of assets as everything you own that has value. This includes
Cash: Money in your checking and savings accounts, and any cash you have on hand.
Investments: Stocks, bonds, mutual funds, retirement accounts (like 401(k) or IRA), and any other investment accounts.
Real Estate: The value of your home, rental properties, land, or any other real estate you own.
Vehicles: The current market value of your cars, motorcycles, boats, or any other vehicles you own.
Personal Property: The value of valuable items such as jewelry, artwork, furniture, electronics, or collectibles.
Liabilities: Liabilities are your debts and financial obligations i.e. what you owe to others. This includes your:
Mortgage: The outstanding balance on your mortgage or any other loans secured by real estate.
Consumer Debt: Credit card balances, personal loans, student loans, and any other debts you owe.
Other Liabilities: Any other financial obligations, such as medical bills or outstanding taxes.
Net Worth: Represents your overall financial health and the value of your assets after accounting for your debts.
How to Calculate Your Net Worth
Once you have the total value of your assets and liabilities, subtract the total value of your liabilities from the total value of your assets.
The result is your net worth.
Net Worth = Total Assets - Total Liabilities
Ideally, you want your net worth to be positive, indicating that you have more assets than liabilities.
If your net worth is lower than expected, don’t panic. It's natural to feel concerned, but use this exercise as a learning opportunity and motivation to make positive changes in your finances.
Money Tip: Calculating your net worth is just the first step. Regularly reviewing and updating your net worth statement can help you stay on top of your financial goals and make adjustments as needed.
Step 3: Track Your Spending
Tracking your spending is an essential aspect of assessing your financial situation.
It allows you to identify areas where you may be overspending or where you can cut back to free up funds for savings or debt repayment.
There are several tools and methods you can use to track your spending, including:
Budgeting Apps: Utilize budgeting apps like Mint, YNAB (You Need a Budget), or Personal Capital to automatically track your transactions and categorize your spending.
Spreadsheets: Create a simple spreadsheet to manually track your income and expenses. List all sources of income and expenses in separate columns and update them regularly.
Receipts and Notes: Keep track of your spending by saving receipts or jotting down purchases in a notebook or smartphone app.
Budget Essential #2: Set Financial Goals
Setting clear and achievable financial goals is essential for building a strong foundation for your financial future.
Let’s explore the importance of setting financial goals and how they can shape your budgeting strategy.
Importance of Setting Financial Goals
Financial goals serve as a roadmap for your financial journey, providing direction, motivation, and a sense of purpose to your budgeting efforts.
Whether you're saving for a down payment on a home, paying off debt, building an emergency fund, or planning for retirement, having clear financial goals allows you to prioritize your spending and make informed decisions about your money.
Types of Financial Goals
There are various types of financial goals that you may consider setting, depending on your life stage, priorities, and aspirations.
Some common financial goals for women include:
Emergency Fund: Setting aside funds to cover unexpected expenses or emergencies, such as medical bills, car repairs, or job loss.
Debt Repayment: Paying off high-interest debt, such as credit card debt, student loans, or personal loans, to reduce financial stress and improve your credit score.
Saving for Short-Term Needs: Saving for short-term goals, such as vacations, home renovations, or purchasing a car, to avoid relying on credit or dipping into savings.
Saving for Retirement: Contributing to retirement accounts, such as 401(k) plans or IRAs, to build long-term wealth and secure your financial future.
Investing: Building wealth through investments, such as stocks, bonds, mutual funds, or real estate, to achieve financial independence and achieve long-term growth.
How To Set Financial Goals
When it comes to managing your money and achieving financial success, having clear, actionable goals is key.
But here's the thing – setting goals can sometimes feel overwhelming, especially when you're not sure where to start or how to make them stick.
That's where goal-setting methods come in handy. They help you with clarity and focus; motivation and inspiration; accountability and tracking; and flexibility and adaptability.
Choose the Best Goal Setting Method that Supports your Financial Goals
In our previous post, The Power of Goal Setting, we discussed the process of setting goals in detail. You can read it here for help finding the best goal setting method that works for you.
There are 3 proven goal setting methods. Choose the one that best suits your financial goal:
SMART Goal Setting: Specific, Measurable, Achievable, Relevant, and Time-bound
Values-Based Goal Setting: Aligns your financial goals with your core values and aspirations.
Incremental Goal Setting: Encourages you to break goals down into smaller, more manageable tasks. It shifts focus to celebrating every small victory along the way, building momentum, and staying motivated for the long haul.
Or, you can choose a method based on life stage - as certain approaches resonate with specific age ranges more than others:
SMART Goals for Young Women: Can be beneficial for young women who are just starting their journey into adulthood, particularly women ages teens to early 20s.
Values-Based Goal Setting for Women in Their Mid-20s to 30s: Allows a more introspective approach to goal setting that aligns with core values and life priorities.
Incremental Goal Setting for Women in Their 40s and Beyond: Can be particularly effective in helping this age group manage and adapt to life changes.
Combination Approach for All Ages: While certain goal-setting methods may be more commonly associated with specific age ranges, it's essential to recognize that individuals may benefit from a combination of approaches throughout their lives.
Align Goals with Your Budget
Once you've established your financial goals, the next step is to align them with your budget because your budget serves as a tool for allocating your resources towards your goals, ensuring that you're making progress towards achieving them.
Budget Essential #3: Build the Best Budget for You
Whether you're new to budgeting or looking to refine your existing budgeting approach, these 6 budget building methods will help you take control of your finances and achieve your financial goals.
1. Zero-Based Budgeting
Zero-based budgeting is a budgeting method where every dollar of income is assigned a specific purpose, leaving no money unallocated.
This means that your total income minus your total expenses equals zero. In other words, you're actively deciding where every dollar goes, ensuring that you're maximizing the use of your income.
To use a zero-based budget: Start by listing all your sources of income and then allocate funds to different expense categories, such as housing, utilities, groceries, transportation, savings, and debt repayment. Be sure to account for every dollar of income, leaving no money unassigned.
2. Envelope System (or Cash Stuffing)
The envelope system is a cash-based budgeting method that involves dividing your cash into different envelopes, each designated for a specific expense category.
This method is particularly effective for managing variable expenses, such as groceries, dining out, entertainment, and discretionary spending.
To use the envelope system: Determine your budget for each expense category and withdraw cash from your bank account accordingly. Label each envelope with the expense category and allocate the appropriate amount of cash to each envelope.
When you make a purchase in a particular category, use the cash from the corresponding envelope. Once the envelope is empty, you're done spending in that category for the month.
3. 50-30-20 Budget
The 50-30-20 budgeting method is a simple and flexible approach to budgeting that allocates your income into three broad categories:
50% for needs: Including essential expenses like housing, utilities, groceries, transportation, and healthcare.
30% for wants: Including discretionary expenses like dining out, entertainment, travel, and personal indulgences.
20% for savings and debt repayment: This category is reserved for savings goals, emergency funds, retirement contributions, and debt repayment.
To use a 50/30/20 budget: calculate your total monthly income and allocate funds to each category based on the specified percentages. Adjust the percentages as needed to align with your financial goals and priorities.
4. Percentage-Based Budgeting
Percentage-based budgeting is a flexible budgeting method that allocates a specific percentage of your income to different expense categories.
This method allows you to adjust your budget based on your income level and financial priorities.
To use percentage-based budgeting: Determine the percentage of your income that you want to allocate to each expense category, such as housing, transportation, groceries, savings, and debt repayment.
For example, you might allocate 30% of your income to housing, 15% to transportation, 20% to savings, and 15% to debt repayment. Adjust the percentages as needed to reflect your unique financial situation and goals.
5. Pay Yourself First
The pay yourself first method prioritizes savings by setting aside a portion of your income for savings goals before allocating funds to other expenses.
This ensures that you're consistently saving towards your financial goals and building a strong financial foundation.
To implement the pay yourself first method: automate your savings by setting up automatic transfers from your checking account to your savings or investment accounts. Treat your savings contributions like any other bill or expense, prioritizing them before discretionary spending.
Remember to start with a small percentage of your income and gradually increase your savings rate over time as your financial situation improves.
6. Automated Budgeting
Automated budgeting leverages technology to streamline the budgeting process and make it easier to manage your finances.
With automated budgeting tools and apps, you can track your income and expenses, set spending limits, categorize transactions, and monitor your progress towards your financial goals.
To automate your budgeting process: explore budgeting apps like Mint, YNAB (You Need a Budget), or Personal Capital, which offer features like transaction categorization, spending insights, bill reminders, and goal tracking.
Set up automatic transfers for savings goals, bill payments, and debt repayment to ensure that your budget stays on track without requiring constant manual intervention.
The Essential Guide to Budgeting Recap
In this post, we covered everything from understanding the basics of budgeting to assessing your financial situation and ended with six tried and true ways to build a budget.
But our budgeting adventure is far from over! In part 2 of The Essential Guide to Budgeting series, we'll dive deeper into practical tips for sticking to your budget and celebrating your wins along the way.
Get ready to discover strategies for staying disciplined, treating yourself responsibly, and sharing your successes with others. See you soon!
Ready to embrace your inner CFO? Join our community. Share your financial goals, budgeting tips, and success stories in the comments.