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Chapter 2. Measuring Your Financial Health and Making a Plan. Learning Objectives. Calculate your level of net worth or wealth using a balance sheet Analyze where your money comes from and where it goes using an income statement Use ratios to identify your financial strengths and weaknesses.

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Chapter 2

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Chapter 2

Measuring Your Financial Health and Making a Plan

Learning Objectives

Calculate your level of net worth or wealth using a balance sheet

Analyze where your money comes from and where it goes using an income statement

Use ratios to identify your financial strengths and weaknesses

Learning Objectives

  • Set up a record-keeping system to track your income and expenditures

  • Implement a financial plan or budget that will provide for a level of savings needed to achieve your goals

  • Decide if a professional financial planner will play a role in your financial affairs


  • Where does all your money go?

  • Planning and budgeting require control – it won’t happen without a plan

  • Evaluate your financial health

  • Develop a plan of action

Figure 2.1 The Budgeting and Planning Process: Evaluating Your Financial Health and Developing a Plan of Action

Using a Balance Sheet to Measure Your Wealth

  • A balance sheet is a snapshot of your financial status at a particular time. It will show three things:

    • Assets – what you own

    • Liabilities or debts you owe

    • Your net worth or equity – the difference between assets and liabilities and it is a measurement of your wealth

Figure 2.2 Personal Balance Sheet

Assets: What You Own

  • Assets are your possessions, even if you owe money on them

  • List assets using their fair market value

  • All amounts must be current

Assets: What You Own

  • Monetary assets – these are liquid – cash or can easily be turned into cash

    • Cash, checking & savings accounts, money market funds

  • Investments – stocks, bonds, mutual funds, real estate purchased as an investment

Assets: What You Own

  • Retirement plans – investments made by or for you in preparation for your retirement (more details in Chapter 16)

  • Tangible assets – physical assets

    • House, vehicles, furniture, jewelry, clothing, and all other personal property

  • Other assets – money other people owe you, collectibles, etc.

Liabilities: What You Owe

  • A liability is debt that must be repaid in the future

  • Current liabilities must be paid off within the next year, often the next month

    • Bills: utility bills, insurance premiums, credit card balances

Liabilities: What You Owe

  • Long-term liabilities will take more than a year to pay off

    • Car loans, home loans, student loans, other installment loans, bank loans, insurance policy loans, etc.

  • List only the unpaid balances

Net Worth: A Measureof Your Wealth

  • Net worth = total assets minus total debt

  • If liabilities > assets, there is a negative net worth and you are insolvent (you owe more than you own)

  • If liabilities < assets, there is a positive net worth and you have wealth

  • A good level of net worth depends on your goals and your place in the financial life cycle

Table 2.1How Do You Compare?

Figure 2.3 A Balance Sheet for Louise and Larry Tate, December 31, 2011

Figure 2.3 A Balance Sheet for Louise and Larry Tate, December 31, 2011 (cont.)

Using an Income Statementto Trace Your Money

  • An income statement is like a financial motion picture—tells you where your money has come from and where it has gone over some period of time

  • Shows income and expenditures: money coming in and money going out

  • It is reported on a cash basis—based on actual cash flows

  • The formula is: income minus expenses (over a given time period)

Figure 2.4 A Simplified Income Statement

Income: Where Your MoneyComes From

  • Income or cash inflows:

    • Wages, salary, bonuses, tips, commissions before tax or automatic investments

    • Other sources: family income, government payments (veterans benefits, welfare), investment income

    • All of these added together is called gross income

  • Subtract federal, state, and social security taxes from earnings to calculate your net take-home pay

Expenditures: Where YourMoney Goes

  • Cash transactions may be difficult to track because they do not leave a paper trail

  • Variable expenditures – expenses over which you have some control

    • You may not have to pay them at all

    • Or, they may vary from month to month

  • Fixed expenditures – expenses that are the same from month to month; you cannot control their amounts

Figure 2.5 How Americans Spent Their Money in 2010

Figure 2.6 Louise and Larry Tate’s Personal Income Statement

Figure 2.6 Louise and Larry Tate’s Personal Income Statement (cont.)

Using Ratios: Financial Thermometers

  • Financial ratios allow you analyze raw data in the balance sheet or income statement and then compare it to targets

  • Ratios help you understand how you are managing financial resources

Question 1: Do I Have Enough Liquidity to Meet Emergencies?

  • Current ratio: monetary assets divided by current liabilities

    • Should be greater than 1.0

    • Aim for above 2.0 (you have double the amount of money you need to pay your monthly expenses)

  • For Larry and Louise:

    • $3,590 / $1,500 = 2.39

    • They have 2.39 times more cash than they need to pay their monthly expenses

Question 1: Do I Have Enough Liquidity to Meet Emergencies?

  • Month’s Living Expenses Covered Ratio:

    • Tells how many months of living expenditures you can cover with your present level of cash

    • Formula: monetary assets divided by annual living expenditures divided by 12

    • Should aim for 3 to 6 months of liquid assets, or less if there is enough credit and insurance for emergencies

  • For Larry and Louise:

    • $3,590 / ($52,234/12) = .8925 months

  • This ratio is a better liquidity measure than the current ratio

Question 2: Can I MeetMy Debt Obligations?

  • Debt Ratio: determines if you have the ability to meet your debt obligations

  • Formula: total debt or liabilities divided by total assets (both amounts come from the balance sheet)

    • Should decrease as you get older

  • For the Tates:

    • $175,500 / $300,190 = .5846 or 58.46%

    • 58.46% of their assets are still encumbered by debt

Question 2: Can I MeetMy Debt Obligations?

  • Long-term Debt Coverage Ratio: determines how many times you could make your debt payments with current income

  • Formula: total income available for living expenses divided by total yearly long-term debt payments

    • Less than 2.5 is a red flag warning

  • For the Tates:

    • $56,510 / ($19,656 + $2,588 + $1,600) = 2.37

    • They are at their limit on the amount of debt they can manage

Question 3: Am I Saving as Much as I Think I Am?

  • Savings Ratio: determines how much you are saving

  • Formula: income available for saving and investments (what is left over) divided by income available for living expenses (take home pay). Both from income statement

  • For the Tates:

  • $4,276 / $56,510 = .076 or 7.6%

  • If you are not saving, you are living above your means. Effective saving means setting aside savings before paying bills

Record Keeping

  • Why keep financial records?

    • Without records it is difficult to prepare taxes

    • With records, you can track expenses and know how much and where you are spending

    • It is easier for someone to step in during an emergency and understand your financial situation

Record Keeping Steps

  • Track your financial dealings:

    • Credit card and check expenditures are easy to track because there is a paper trail, but cash expenditures must be tracked as they occur

    • After tracking, record transactions in a ledger, a book or notebook set aside to record expenditures. Computer programs and apps can also be used

  • File and store your financial records so they are readily accessible

Putting It All Together: Budgeting

  • Evaluate your financial health by using the balance sheet and income statement:

    • To set financial goals

    • To achieve financial goals

  • Develop a plan of action and cash budget using the income statement

  • Monitor your progress using the balance sheet and income statement.

Developing a Cash Budget

  • A budget is a plan for controlling cash inflows and outflows

  • Allocate dollar amounts for different spending categories

Preparing a Cash Budget

  • Estimate anticipated after-tax income or take home pay from most recent annual personal income statement

  • Estimate living expenses, both fixed and variable

  • Estimate income available for saving and investing: subtract anticipated living expenditures from anticipated take-home pay

Implementing the Cash Budget

  • Put it in place for a month.

  • Compare actual expenditures in each category with budgeted amounts

  • The difference between budgeted and actual is the variance

  • Evaluate whether you change budget estimates or exert self-control - be flexible

  • is a free Internet-based personal financial planning site

Figure 2.8 Web-Based Financial Planning with

Figure 2.8 Web-Based Financial Planning with (cont.)

Figure 2.7 Budget Tracker

Hiring a Professional

Three options for working with professionals

  • Go it alone and have your plan checked by a professional

  • Work with a professional to develop a plan

  • Leave it all in the hands of a pro

    You still need to know the basics of finance and still bear ultimate responsibility

Choosing a Professional Planner

  • Check accreditations:

    • Personal financial specialist (PFS) – a CPA who has passed certification tests and has three years of financial planning experience

    • Certified financial planner (CFP) – has completed an extensive exam and has three years of experience

    • Chartered financial consultant (ChFC) – has completed course work and ten exams

  • Check experience

  • Get referrals

Choosing a Professional Planner

  • Fee-only planners – generally $75 - $200 per hour

  • Fee-and-commission planners – charge fees and also collect commissions on products they sell

  • Fee offset planners – charge a fee but reduce it by commissions they earn

  • Commission based planners – paid by commission only


  • Use a balance sheet to determine the level of wealth that you or your family has accumulated on a given date

  • Use an income statement to understand where your money comes from and goes to be able to save enough to meet goals

  • Use financial ratios as targets or standards in managing financial resources


  • A sound record-keeping systems makes tax preparation and tracking of spending easier

  • Use a budget to plan and evaluate spending and saving

  • Professional financial planners can help by validating your plan or developing a plan

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