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Personal Finance: An Integrated Planning Approach. Winger and Frasca Chapter 3 Financial Statements and Budgets: Where Are You Now and Where Are You Going?. Introduction. This chapter explains the use of financial statements for evaluating financial performance.

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Personal finance an integrated planning approach

Personal Finance:An Integrated Planning Approach

Winger and Frasca

Chapter 3

Financial Statements and Budgets:

Where Are You Now and Where Are You Going?



  • This chapter explains the use of financial statements for evaluating financial performance.

  • The balance sheet is used to measure wealth. It can then be compared yearly to evaluate progress.

  • An income statement is used to record cash flows. Both inflows and outflows are shown to summarize the financial activity of a household.

  • Two types of budgets are presented as a way to manage finances on an ongoing basis.

  • Finally, methods for evaluating and controlling expenses are reviewed.

Chapter objectives

Chapter Objectives

  • To understand the importance of the balance sheet as a tool for measuring personal wealth

  • To prepare a balance sheet by identifying and valuing assets and liabilities

  • To prepare an income statement and to recognize its role in measuring financial performance

  • To evaluate financial performance by using appropriate financial ratios

Chapter objectives continued

Chapter Objectives (Continued)

  • To prepare an annual budget by constructing a master budget worksheet and a monthly income and expense plan

  • To monitor monthly activities by creating a system for recording actual income and expenses and then comparing them with budgeted amounts

  • To evaluate and control expenses during the year through a monthly review process

Topic outline

Topic Outline

  • The Balance Sheet

  • The Income Statement

  • Evaluating Past Financial Performance

  • Achieving Goals through Budgeting

The balance sheet


  • A personal balance sheet is a report that measures wealth; also called net worth.

  • A balance sheet has three components:

    • Assets: items that are owned; measured at fair market value

    • Liabilities: bills and obligations owed to creditors that must be paid in the future

    • Net worth: the difference between assets and liabilities.

  • A personal balance sheet is used to measure financial progress and success over time.

Balance sheet equation

Balance Sheet Equation

  • Balance sheet equation:

    Assets (A) = Liabilities (L) + Net Worth (NW)

  • Example:

    • A family has a current balance sheet equation as follows:

      A = $10,000; L = $6,000; therefore, NW = $4,000.

    • The family works hard at saving and is able to save $5,000. It uses $2,000 to acquire more assets and uses the remaining $3,000 to pay off some debt. Its new balance sheet equation is: A = $12,000; L = $3,000; NW = $9,000

    • Increased savings increased net worth

Another balance sheet example

Another Balance Sheet Example

  • Beginning balance sheet equation (A = L + NW):

  • $10,000 = $6,000 + $4,000

  • Another family spends all of its income and does not save anything. At the same time, one of its assets depreciates in value by $3,000. Its new balance sheet equation: $7,000 = $6,000 + $1,000

  • Its net worth has decreased due to asset depreciation

  • Remember that net worth (or wealth) is what is left after liabilities are subtracted from assets

Balance sheet for the steele family 12 31 2005

Balance Sheet for the Steele Family: 12/31/2005

  • Assets $325,540

    • Liquid $ 16,240

    • Lifestyle 261,500

    • Investment 47,800

  • Liabilities $168,149

    • Current $ 8,354

    • Noncurrent 159,795

  • Net Worth $157,391



  • Remember that assets are items that are owned.

  • To identify these assets requires two steps:

    • First, you must identify and count all items owned.

    • Second, you must determine the value that should be used.

  • Assets are grouped for easy evaluation as follows:

    • Liquid assets can be easily converted into cash with no loss in market value.

    • Lifestyle assets help us to achieve our desired standard of living.

    • Investment assets provide income or increase our net worth over time.

Steeles liquid assets

Steeles’ Liquid Assets

  • Cash$ 240

  • Checking Account 2,400

  • Savings Account 5,600

  • 42-Month CD 5,000

  • Series EE Bonds 3,000

  • Total$16,240

Steeles lifestyle assets

Steeles’ Lifestyle Assets

  • Residence$205,000

  • Household Furnishings 20,000

  • Automobiles and Camper 29,100

  • Jewelry, Clothing, Stamp Coll. 5,800

  • Sporting Equipment 600

  • Riding Mower 1,000

  • Total$261,500

Steeles investment assets

Steeles’ Investment Assets

  • Common Stocks$ 16,000

  • Mutual Funds 6,800

  • Cash Value: Life Insurance 4,000

  • Cash Value: Retirement Fund 21,000

  • Total$ 47,800



  • Remember that liabilities represent amount owed to companies or creditors.

  • Liabilities are grouped as follows:

    • Current liabilities are obligations that must be paid within a year. There are two sources of current liabilities.

      • The first is unpaid bills such as credit card bills, electric, cable, etc.

      • The second is installment loans that are due in the coming year such as the car payments that are due in the next year.

    • Noncurrent liabilities are obligations that must be paid beyond one year. This is the balance that is owed on installment loans not including the current year payments.

Steeles current liabilities

Steeles’ Current Liabilities

  • Unpaid Bills$ 460

  • Credit Card Balances Due 1,720

  • Estimated Taxes Due 1,750

  • Installment Pmts Due in 1 Year 4,424

  • Total$ 8,354

Steeles noncurrent liabilities

Steeles’ Noncurrent Liabilities

  • Mortgage Loan$ 152,829

  • Installment Pmts after 1 Year 4,966

  • Loan on Life Insurance Policy 2,000

  • Total$ 159,795

Net worth

Net Worth

  • Net worth is defined as the difference between assets and liabilities.

  • It is a useful measure of wealth.

  • Net worth can be increased in several ways: positive contributions to savings (spending less than you earn) and increases in market value of assets on the balance sheet.

  • The Steeles’ Net Worth is:

  • NW = $325,540 – $168,149 = $157,391

The income statement


  • The income statement shows a detailed breakdown between cash income and expenses for a certain period of time (generally a year).

    • It can therefore provide information about the amount saved or the amount “dissaved”.

  • Income usually consists of cash inflows.

  • Expenses are cash outflows that sustain our standard of living.

  • Both the income statement and balance sheet help to measure our success in meeting financial goals.

Steeles income statement year ended 12 31 2005

Steeles’ Income Statement: Year Ended 12/31/2005

  • Salaries $75,600 97.4%

  • Other Income 2,027 2.6%

  • Total Income $77,627 100.0%

  • Total Expenses 75,033 96.7%

  • Savings 2,594 3.3%



  • Income usually consists of cash inflows.

  • For most people, the largest portion of income comes from salaries and wages.

    • Most people use take home pay for their income figure.

    • From a tax planning perspective, it would be useful to use gross wages as income and show taxes as an expense.

    • This creates greater awareness of the amount of tax paid and may provide an incentive to do more careful tax planning.

  • Other income may be interest income and dividends.



  • Expenses are cash flows that sustain our scale of living. Thus, it does not include all cash outflows.

  • Payments on installment and mortgage loans as well as credit card payments are also considered expenses.

  • Expenses are distinguished between flexible and inflexible expenses.

    • Inflexible expenses (fixed expenses) are expenses that remain constant and cannot be controlled in the short run.

    • Flexible expenses (variable expenses) are those expenses over which you have some control.

Steeles major expenses as a of total income

Steeles’ Major Expenses as a % of Total Income

  • Housing 28.0%

  • Taxes 23.3

  • Food 10.6

  • Transport. 10.3

  • Others 7.2

  • Leisure 6.5%

  • Utilities 4.8

  • Insurance 3.3

  • Clothing 2.7

Steeles major expenses total 75 033

Steeles’ Major ExpensesTotal = $75,033

  • Housing$21,785

  • Taxes 18,070

  • Food 8,230

  • Transportation 7,998

  • Others 5,550

  • Leisure$ 5,010

  • Utilities 3,750

  • Insurance 2,520

  • Clothing 2,120

Expenses flexible 49 133 and inflexible 25 920

Expenses: Flexible ($49,133) and Inflexible ($25,920)

  • Mortgage$18,285

  • Auto loans 5,668

  • Car Licenses 210

  • Utilities 3,750

  • Taxes 18,070

  • Insurance 2,520

  • Dues 200

  • Tuition, books 390

  • Allowances$ 1,300

  • Leisure 5,010

  • Home furn. 3,500

  • Gas, oil, etc. 2,100

  • Food, cons. 8,230

  • Clothing 2,120

  • Gifts, contrib. 2,080

  • Others 1,580

Evaluating past financial performance

Evaluating Past Financial Performance

  • In evaluating financial performance, one of the ways to measure success is to evaluate financial goals.

    • Example: If an individual had a goal of saving a certain amount per year, he would define success when he attained that level of saving.

  • There are also financial ratios that are used to evaluate financial performance.

  • Another good financial criteria is to compare the annual inflation rate with the annual changes in your net worth and income.

Matching or beating the inflation rate

Matching or Beating the Inflation Rate

  • Nominal income is the amount actually received.

  • Real income is the nominal income adjusted for inflation.

  • A measure used is (% change in nominal income) =

    this year’s nominal income

    last year’s nominal income

  • Then compare this % with the actual annual inflation rate. If the number calculated is equal to or greater than the actual rate, good. If less, this says that your income is not keeping pace with inflation.

– 1

Financial ratios

Financial Ratios

  • Measure financial strengths and weaknesses.

  • Ratios must be used with care.

  • You should look at a number of ratios, rather than only one.

  • Also, look at a ratio’s trend. Is the ratio improving from year to year?

  • Also, your ratios can be compared to those of other families. With some ratios such as the debt service ratio, creditors have established acceptable levels.

Steeles liquidity ratios

Steeles’ Liquidity Ratios

  • Liquid Assets to Take-Home Pay Ratio:*

    * Take-Home Pay = Salaries of $75,600 - Payroll Taxes of $14,570

    Liquid Assets/ Take-Home Pay =

    $16,240/$61,030 = 0.266 (Fair)

    They have 3.2 months. The recommendation is 3–6 months

  • Liquidity Ratio:

    Liquid Assets/Current Liabilities =

    $16,240/$8,354 = 1.94 (Good; > 1)

Steeles debt capacity

Steeles’ Debt Capacity

  • Debt Ratio:

    Total Liabilities/Total Assets =

    $168,149/$325,540 = 0.517 (fair)

    This ratio should be less than .50

  • Debt Service Coverage Ratio:

    Take-Home Pay/Debt Service Charges =

    $61,030/$24,133 = 2.53 (some weakness)

    Ideally, this ratio should be 3.0 or more

Achieving goals through budgeting


  • Set realistic budget goals.

    • The budget is a device to help in achieving goals.

  • Stick to simple procedures.

    • Set a system that can be maintained consistently.

  • Use the budget to control and direct expenses.

    • Be realistic and realize that the budget is your way to achieve your financial goals.

Preparing the annual budget

Preparing the Annual Budget

  • Set Spending/Savings Goals.

  • Prepare Master Budget Worksheet.

  • Prepare Monthly Income and Expense Plan.

  • Evaluate and Control Activities:

    • Monthly

    • At Year End

The master budget worksheet

The Master Budget Worksheet

  • It has the same format as the annual income statement.

  • The allocated amounts should reflect historical experience plus inflation adjustment. Last year’s income statement can be used as a starting point for forecasting income and expenses.

  • It should focus on planned savings.

  • It should be realistic and achievable. Can you really live with this plan?

The monthly income and expense plan

The Monthly Income and Expense Plan

  • It shows income and expenses by month.

  • It shows months with positive and negative cash flow.

  • Positive cash flow says that income exceeds expenses and may be an opportunity to increase savings.

  • Negative cash flows require management by

    • Using cash reserves or savings from positive cash flow months

    • Borrowing to meet this cash flow deficit.

Monitoring and controlling activities

Monitoring and Controlling Activities

  • Don’t use cash—paying with a check provides a written record. If you use your debit card, keep the receipt.

  • Create a “personal voucher” to record any necessary cash outlays.

  • Code income and expense accounts for easy summing.

  • See if your bank has a recording system (at a reasonable cost to you).

  • Use a personal computer.

Updating income expense accounts

Updating Income & Expense Accounts

  • Each month compare actual income or expense with budgeted amount.

  • The difference is an account variance.

  • Unfavorable expense variances need attention.

    • Reduce spending in future periods to eliminate variance.

    • Ideally by year end, cumulative variance = 0.

  • To stay within a budget, you need to continuously adjust your expenses during the year.

  • At year end, evaluate the reasonableness of budget.

Controlling expenses meals eaten out

Controlling Expenses: Meals Eaten Out

Monthly Cumulative

Month Budget Actual Variance Variance

January $80$ 88.00($8.00) ($8.00)

February $80 102.00(22.00) (30.00)

March $80 91.00(11.00) (41.00)

April $80 39.00 41.00 -0-

Spending was adjusted in April to eliminate variance

Discussion questions

Discussion Questions

  • How can someone measure their financial worth?

  • On a balance sheet, how are the liability amounts calculated?

  • Ratios are a useful tool when used properly. List some guidelines for using ratios effectively.

  • What are some of the methods for measuring financial performance?

  • How is an income statement different from a budget?

  • What are some reasons that people create budgets and then fail to use them to manage their finances?

Next chapter 4 taxes

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