Chapter 2

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

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.

3. 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.

4. Introduction • Where does all your money go? • Planning and budgeting requires control • Evaluate your financial health • Develop a plan of action

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

6. Using a Balance Sheet to Measure Your Wealth • What is a balance sheet? (1st step in creating personal financial plan) • A snapshot of your financial status at a particular time. • Includes assets you own – values must be current (fair market value). List them even if you owe money on them. • Debt or liabilities you’ve incurred- must be re-paid in the future; long term – more than a year; list only unpaid balances • What is net worth or equity? • Assets – Liabilities = Net Worth or Equity

7. Figure 2.2 Personal Balance Sheet

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

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

10. Net Worth: A Measureof Your Wealth • Net worth = total assets - total debt • If liabilities > assets, negative net worth and insolvent. • If liabilities < assets, positive net worth. • What does a positive net worth mean? – if you sell all of your assets and pay off all of your debt, you still would have money left over. • Good level of net worth depends on yours goals and your place in the financial life cycle.

11. Develop Your Skills – Problems and Activities • What is the net worth for Louise and Larry Tate? • Activity 1 on page 58 • Solution to Activity 1 on page 58 • Create your own balance sheet. • What is your net worth? And what does it mean? Are you insolvent?

12. Table 2.1How Do You Compare?

13. Using an Income Statementto Trace Your Money • What is income statement? (2nd step in creating a personal financial plan): • Financial motion picture—tells you where your money has come from and where it has gone over some period of time. • Income (cash flow): Where your money comes from: wages, salary, bonuses, tips, commissions before tax or automatic investments, family income, government payments (veterans benefits, welfare), investment income • Subtract federal, state, social security taxes from earnings to calculate your take-home pay • Expenditures: Where your money goes: Cash transactions may not leave a paper trail; variable or fixed expenditures depending whether you have control over expenditures

14. Income Expenditures

15. Income Expenditures

16. Figure 2.4 A Simplified Income Statement

17. Figure 2.5 How Americans Spent Their Money in 2010

18. Figure 2.6 Louise and Larry Tate’s Personal Income Statement

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

20. Difference between balance sheet and income statement • Balance Sheet • Lets you judge your financial standing by showing your net worth. • If you balance sheet shows you that you are not building your net worth as much or as quickly as you’d like, or if you’re overspending and actually decreasing your net worth….. • Income Statement • Tells you exactly how your spending and saving habits affect that net worth. • Your income statement can help by showing you where your money is going

21. Activity • Prepare your own income statement • Celebrities with biggest money problems: http://money.usnews.com/money/personal-finance/slideshows/celebrities-with-the-biggest-money-problems

22. Using Ratios: Financial Thermometers • Ratios – a tool that “takes temperature” of your finances – identify your financial strengths and weaknesses of your • Financial ratios allow you analyze raw data in the balance sheet or income statement then compare it to targets – raw number do not mean much. • Ratios answer the following questions: • Do I have enough liquidity to meet emergencies? • (current ratio, covered ratio) • Can I meet my debt obligations? • (debt ratio, long term debt coverage ratio) • Am I saving as much as I think I am? • (savings ratio)

23. Question 1: Do I Have Enough Liquidity to Meet Emergencies? • Current Ratio-compares the amount of your cash and other liquid assets with the amount of debt you have currently coming due (look at your balance sheet) • What is the current ratio for Louise and Larry Tate? • What does the number mean? • Should be greater than 1 – ideally above 2 – indicates safe liquidity • If lower than 1 – current liabilities exceed current assets - unable to pay bills • Is it going up or down? Down – identify cause! • What is your current ratio? • Month’s Living Expenses Covered Ratio – tells you how many months of living expenditures you can cover with your present level of monetary assets • Should aim for 3 to 6 months of liquid assets • Less if enough credit and insurance • What is the covered ratio for the Tates? • What does the number mean? • Enough cash and liquid assets to on hand to cover ______ months of expenditures. • What is your covered ratio? Balance sheet Income Statement

24. Question 2: Can I meet my debt obligations?(you saw it, you borrowed money and bought it, can you pay for it?) • Debt ratio = total debt or liabilities/total assets • Tells you what percentage of your assets has been financed by borrowing • Calculate the debt ratio for the Tates • What does this number represent? • It means that half of their assets are financed with borrowing • Long term debt coverage ratio = total income available for living expenses/total long term debt payment • It focuses on long term obligations such as mortgage payments, car loan payments and any other long term debt obligations • The denominator represents your total outstanding long term debt payments (excluding short term borrowing); the numerator represents the funds available to make these payments. • This ratio represents the number of times you could make your debt payments with your current income • What is the coverage ratio for the Tates? • What does this number mean? • A ratio below 2.5 should raise a red flag • Do the reverse to calculate debt to income ratio

25. Question 3: Am I Saving as Much as I Think I Am? (how much of your income are you really saving?) Savings ratio = income available for savings and investment/income available for living expenditures (income after taxes) • What is the savings ratio for the Tates and what does it mean?

26. Activities • Review questions: 1-5, 7, 10, 11 • Activity 2 on page 58 • Activity 3,4, and 5 on page 59 • Discussion Case 1 and Discussion Case 2 on page 60 and 61 • Continuing Case: Cory and Tisha Dumont on page 130

27. Record Keeping • Without records difficult to prepare taxes. • You track expenses and know how much and where you are spending. • Easier for someone to step in during an emergency and understand your financial situation.

28. Record Keeping Steps • Track your financial dealings. • Credit card and check expenditures are easy to track, but cash expenditures must be tracked as they occur. • After tracking, record transactions in a ledger. • File and store your financial records so they are readily accessible.

29. 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.

30. Developing a Cash Budget • Plan for controlling cash inflows and outflows. • Allocate dollar amounts for different spending categories

31. Preparing a Cash Budget • Estimate anticipated after-tax income or take home pay from most recent annual personal income statement. • Estimate living fixed and variable expenses. • Estimate income available for saving and investing: subtract anticipated living expenditures from anticipated take-home pay.

32. Implementing the Cash Budget • Put it in place for a month. • Compare actual expenditures in each category with budget amounts at the end of the month. • Evaluate whether you change budget estimates or exert self-control? • Stick your desired budget for a month with an envelope system.

33. Figure 2.7 Budget Tracker

34. 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.

35. What Planners Do • More unique financial situations need professional help. • They give advice. • You still need to know the basics and still bear ultimate responsibility.

36. Choosing a Professional Planner • Check accreditations: • Personal financial specialist (PFS) • Certified financial planner (CFP) • Chartered financial consultants (ChFC) • Check experience • Referrals

37. Choosing a Professional Planner • Fee-only planners • Fee-and-commission planners • Fee offset planners • Commission based planners

38. 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.

39. 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.

40. Figure 2.8 Web-Based Financial Planning with Mint.com

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