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Chapter 2
Measuring Your Financial Health and Making a Plan
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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
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Your Assets: What You Own
Monetary InvestmentRetirement plansReal estateAutomobiles and other vehiclesPersonal propertyOther tangible and intangible assets
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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
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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
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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
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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
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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
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Personal Property:
Tangible assets that represent your lifestyle
Reported as fair market value, but normally depreciate in value
Examples -- boats, furniture, electronics, clothing, jewelry
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Other Assets:
Any other tangible or intangible asset that may or may not be of value
Examples -- business ownership, collections, money owed you
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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
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Your Net Worth: A Measure of Your Wealth
Insolvency: do you owe more than you own?
How age affects net worth guidelinesUses of a balance sheet
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Using an Income Statement to Trace Your Money
Personal income statement -- the financial motion picture
Cash basis: statement based entirely on actual cash flows
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Income: Where Your Money Comes From
Sources of income: wages, tips, royalties, salary, and commissions
Income is amount earned, not necessarily amount received.
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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
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Where Does It Go, On Average?
Taxes, Food, Housing, Medical Care
The more earned, the more spent on education and entertainment.
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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?
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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
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Current Ratio
monetary assets
current liabilities
This ratio shows you whether you have enough liquid assets to cover expenses currently due.
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Interpretation
Ratio greater than 2 recommended
Track the trend and if going down --make changes
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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.
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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
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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
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Debt Ratio
total liabilities
total assets
This ratio tells you whether you could payoff all your liabilities if you liquidated all your assets.
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Interpretation
Represents percentage of assets financed with borrowing
Track the trend; ratio should go down with age
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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.
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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
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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
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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.
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Interpretation
U.S. rate typically 3% - 8%
Varies with stage of the financial life cycle and goals
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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
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Record Keeping (cont’d)
The two steps of record keeping– Tracking your personal financial dealings– Storing your financial records in an
accessible manner
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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
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Taxes
Keep all tax-related receipts and records for 6 years.
Always keep accurate tax records in the event of an audit.
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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
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A Cash Budget
A plan for controlling cash inflows and outflows
Purpose: To balance income with expenditures AND savings
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Putting It All Together: Budgeting
Evaluate your financial health and your financial plan
Develop a cash budget
Implement a cash budget
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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
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Calculating the Bottom Line
Take Home Pay Living Expenses Money for Savings
GOALS
Spend Less Earn More Downsize
Goals
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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.
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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.
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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.
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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.
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Choosing a Professional Planner (cont’d)
Before hiring a planner, ask lots of questions about his/her history.
Call professional organizations to get recommendations.
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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
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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