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Chapter 2

Chapter 2. Measuring Your Financial Health and Making a Plan. Using A Balance Sheet to Measure Your Wealth. Personal balance sheet: the financial Polaroid The financial equation: calculating net worth or equity Assets - Liabilities = Net Worth. Your Assets: What You Own. Monetary

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Chapter 2

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  1. Chapter 2 Measuring Your Financial Health and Making a Plan

  2. Using A Balance Sheet to Measure Your Wealth • Personal balance sheet: the financial Polaroid • The financial equation: calculating net worth or equity Assets - Liabilities = Net Worth

  3. Your Assets: What You Own • Monetary • Investment • Retirement plans • Real estate • Automobiles and other vehicles • Personal property • Other tangible and intangible assets

  4. Monetary Assets: • Cash or other assets that can be easily converted into cash • These assets provide necessary liquidity in case of an emergency. • Examples -- cash, checking accounts, savings accounts

  5. Investment Assets: • Assets that are invested for the future • These assets are used to accumulate wealth to satisfy a goal. • Examples -- stocks, bonds, mutual funds, cash value life insurance

  6. Retirement Plans: • Investments by you or your employer to save for retirement • Long-term investments that often carry a penalty if used before a certain age • Examples -- pensions, IRAs, 401(k), 403(b), Keogh, or SEP-IRA plans

  7. Real Estate: • Tangible asset such as land and a dwelling, reported as fair market value • Represents most of your savings, and normally appreciates in value • Examples -- primary residence, vacation home, and rental property

  8. Automobiles and Other Vehicles: • Tangible assets that normally must be inspected and licensed • Reported as fair market value, but normally depreciate in value • Examples -- cars, trucks, motorcycles, and recreational vehicles

  9. Personal Property: • Tangible assets that represent your lifestyle • Reported as fair market value, but normally depreciate in value • Examples -- boats, furniture, electronics, clothing, jewelry

  10. Other Assets: • Any other tangible or intangible asset that may or may not be of value • Examples -- business ownership, collections, money owed you

  11. Your Liabilities: What You Owe • Current liabilities are liabilities that must be paid-off within the next year. • examples -- credit cards and utility bills • Long-term liabilities are liabilities that extend beyond one year. • examples -- home mortgage and auto loans

  12. Your Net Worth: A Measure of Your Wealth • Insolvency: do you owe more than you own? • How age affects net worth guidelines • Uses of a balance sheet

  13. Using an Income Statement to Trace Your Money • Personal income statement -- the financial motion picture • Cash basis: statement based entirely on actual cash flows

  14. Income: Where Your Money Comes From • Sources of income: wages, tips, royalties, salary, and commissions • Income is amount earned, not necessarily amount received.

  15. Expenditures: Where Your Money Goes • The two major expenditure categories: taxes and living expenses • Fixed expenses: Expenses you don’t directly control -- e.g., mortgage, rent, cable TV • Variable expense: Expenses you can control -- e.g., food, entertainment, clothing

  16. Where Does It Go, On Average? • Taxes, Food, Housing, Medical Care • The more earned, the more spent on education and entertainment.

  17. Using Ratios: A Financial Thermometer • Question 1: Do you have adequate liquidity to meet emergencies? • Question 2: Do you have the ability to meet your debt obligations? • Question 3: Are you saving as much as you think you are?

  18. Question 1: Do You Have Adequate Liquidity • Ratios to determine whether or not you have enough monetary assets (1) to pay for an unexpected large expense or (2) to tide you over during periods of reduced or eliminated earnings. • Current ratio • Month’s living expenses covered ratio

  19. Current Ratio • monetary assets current liabilities • This ratio shows you whether you have enough liquid assets to cover expenses currently due.

  20. Interpretation • Ratio greater than 2 recommended • Track the trend and if going down --make changes

  21. Month’s Living Expenses Covered Ratio • monetary assets month’s living expenses • This ratio tells you how many months living expenses you can cover with your present level of monetary assets.

  22. Interpretation • The rule of thumb: 3 to 6 months of expenses • Factors that affect the rule of thumb: • Available credit cards or home equity loans • Potential for higher earnings on less liquid accounts • Stability of income • Track the trend and if going down--make changes

  23. Question 2: Can You Meet Your Debt Obligations? • Ratios to determine whether or not you can meet current or long-term debt obligations: • Debt ratio • Long-term debt coverage ratio

  24. Debt Ratio • total liabilities total assets • This ratio tells you whether you could payoff all your liabilities if you liquidated all your assets.

  25. Interpretation • Represents percentage of assets financed with borrowing • Track the trend; ratio should go down with age

  26. Long-term Debt Coverage Ratio • total income available for living expenses total long-term debt payment • This ratio tells you how many times you could make your debt payments with your current income.

  27. Interpretation • Ratio of 2.5 or greater recommended • Track the trend and if going down -- make changes • Consider the inverse --the percentage of take-home pay needed to repay debt

  28. Question 3: Are You Saving As Much As You Think? • Ratio to determine whether you are saving as much of your income as you think. • Savings ratio

  29. Savings Ratio • income available for savings income available for living expenses • This ratio tells you what proportion of your after-tax income is being saved.

  30. Interpretation • U.S. rate typically 3% - 8% • Varies with stage of the financial life cycle and goals

  31. Record Keeping • The three reasons for accurate record keeping • Preparing taxes • Tracking expenses • Providing information for others to use in the event of an emergency

  32. Record Keeping (cont’d) • The two steps of record keeping • Tracking your personal financial dealings • Storing your financial records in an accessible manner

  33. Ways to Track Expenditures • Using checks and credit cards: Those expenditures leave a paper trail • Using cash: Record expenditures in a notebook or ledger • Generating a monthly income and expense statement • Using computer programs to track all financial transactions • Learning what and where to keep records

  34. Taxes • Keep all tax-related receipts and records for 6 years. • Always keep accurate tax records in the event of an audit.

  35. Putting It All Together: A Review • Evaluate your financial health: balance sheet, income statement, and ratios • Define your financial goals: must know how much you can save • Develop a plan of action: use the income statement and a cash budget • Implement your plan: Just do it! • Review your progress, reevaluate, and revise your plan: back to the balance sheet, income statement, ratios, and budget

  36. A Cash Budget • A plan for controlling cash inflows and outflows • Purpose: To balance income with expenditures AND savings

  37. Putting It All Together: Budgeting • Evaluate your financial health and your financial plan • Develop a cash budget • Implement a cash budget

  38. Developing a Cash Budget • Examine last year’s total income and adjust for the current year. • Estimate your tax liability. • Identify all fixed expenditures. • Identify all variable expenditures. • Look for ways to reduce your variable expenses. • Consider the effect of credit payments on future income

  39. Calculating the Bottom Line

  40. Implementing a Cash Budget • Try the budget for a month. • Adjust the plan or your expenses as necessary to maintain the plan. • Try the envelope system.

  41. Managing Your Own Affairs Versus Hiring a Professional • The 3 options • Go it alone,make a plan and have it checked by a professional. • Work with a professional and develop a plan. • Let the professional do it all.

  42. Paying Your Financial Planner: • Fee-only planners derive income from charging the client for the service provided or for a financial plan. • Commission-based planners derive income from the sale of financial products. • Some planners charge a combination of fees and commissions.

  43. Choosing a Professional Planner • Pick a competent planner with accreditation(s) from a professional organization(s). • Pick a planner with whom you are comfortable. • Pick a planner with experience.

  44. Choosing a Professional Planner (cont’d) • Before hiring a planner, ask lots of questions about his/her history. • Call professional organizations to get recommendations.

  45. Summary • Balance sheet -- determines net worth based on a comparison of assets and liabilities • Income statement -- summarizes cash inflows and cash outflows • Financial ratios -- diagnose your financial health

  46. Summary (cont’d) • Record keeping -- implement strategies to accurately track expenses and maintain necessary financial records for the future • Cash budget -- provides a plan for achieving your goals by balancing cash inflows and outflows • Financial planners -- can provide many levels of assistance for your planning needs

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