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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

Chapter 2

Measuring Your Financial Health and Making a Plan


Chapter 2

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

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


Introduction

Introduction

  • 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


Chapter 2

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

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

Figure 2.2 Personal Balance Sheet


Assets what you own

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 own1

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 own2

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

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 owe1

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 measure of your wealth

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 1 how do you compare

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


Figure 2 3 a balance sheet for louise and larry tate december 31 2011 cont

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


Using an income statement to trace your money

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

Figure 2.4 A Simplified Income Statement


Income where your money comes from

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 your money goes

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 2.5 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


Figure 2 6 louise and larry tate s personal income statement cont

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


Using ratios financial thermometers

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

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 emergencies1

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 meet my debt obligations

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 meet my debt obligations1

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

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

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

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

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

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

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

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

  • Mint.com is a free Internet-based personal financial planning site


Figure 2 8 web based financial planning with mint com

Figure 2.8 Web-Based Financial Planning with Mint.com


Figure 2 8 web based financial planning with mint com cont

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


Figure 2 7 budget tracker

Figure 2.7 Budget Tracker


Hiring a professional

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

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 planner1

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


Summary

Summary

  • 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


Summary1

Summary

  • 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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