There is no secret for personal budgeting. There are three general rules in all the formulas:
1. In the long term, we do not spend more than we can earn.
2. We might be able to borrow money to cover cash flow shortage.
3. Does not matter how much money we borrow, the debt has to be paid back.
People have different desires when it comes to consuming and investment. So we are not going to spend time discussing how much we should spend. Instead, we focus on the earning capacity and borrowing capacity. In other words, how much can you afford to spend?
For employees, most time the employer withholds the proper amount of tax to forward to ATO. And the borrowing capacity is based on your net income. But for those who work for themselves, understanding your earnings and borrowing capacity can become onerous. Let's explain this with an example.
On 01/07/2016, John started a carpentry business as a sole trader. To make it simple, John does not employ anyone for his business. He receives $5K per week for the service rendered. And the average weekly business outgoings is $3.5K, leaving a $1.5K surplus in his account every week. The business is his sole income. John used that $1.5K to support his living, pay a mortgage and make some share investment.
Sounds like John has reached break even? Not really. There are hidden liabilities that John overlooked, which is the tax. Assuming all sales and supplies associated with John's business triggers GST. The weekly net GST payable is $136. And this equals to $1768 for each BAS circle. This liability is not payable until the BAS lodgement. On top the GST, John has to pay income tax. The 2017 estimate income tax payable is $20K, which is payable by May/2018. As John does not keep the reserve for tax, he will struggle to fund the payment when either of the tax is due. The cash shortage for tax payment comes to $27072 in a year.
So let's go back to the three rules of the budgeting. By not keeping a reserve for tax payment, John is treating his tax account as an overdraft. When ATO start taking actions to recover the outstanding, John would have to pay back the tax in full. John's problem is he over-estimated his earning capacity.
Same as John, a lot of business owners only look at the bank balance when it comes to the question:"how much can I spend." And this practice quit often leave them in cash flow shortage when it comes to the tax time. To avoid this risk, you should take the future tax payment into consideration when budgeting. As a good practice, you can put some money aside each week in a separate reserve account. This practice will help you to ease the cash flow pressure for paying tax. And it also helps you to understand your earning capacity.
If you have a complex budgeting puzzle that needs to be fixed, or you want a solution to ease the cash flow pressure for tax payment, please feel free to contact us for a free consultation.