Chapter 2 Planning with Personal Financial Statements Copyright

Chapter 2 Planning with Personal Financial Statements Copyright © 2004 Pearson Education, Inc. All rights reserved.

Chapter Objectives • Explain how to create your personal cash flow statement • Identify the factors that affect your cash flows • Show to create a budget based on your forecasted cash flows • Describe how to create your personal balance sheet Copyright © 2004 Pearson Education, Inc. All rights reserved. 2

Chapter Objectives • Explain how your net cash flows are related to your personal balance sheet (and therefore affect your wealth) Copyright © 2004 Pearson Education, Inc. All rights reserved. 3

Personal Cash Flow Statement • Personal cash flow statement: a financial statement that measures a person’s cash inflows and outflows • Cash inflows include salaries, interest, dividends • Cash outflows include all expenses, both large and small Copyright © 2004 Pearson Education, Inc. All rights reserved. 4

Personal Cash Flow Statement • Create a statement by recording your revenues and expenses over a period of time • Net cash flows: cash inflows minus cash outflows Copyright © 2004 Pearson Education, Inc. All rights reserved. 5

Personal Cash Flow Statement Exhibit 2. 1: Personal Cash Flow Statement for Stephanie Spratt Copyright © 2004 Pearson Education, Inc. All rights reserved. 6

Factors That Affect Cash Flow • Factors affecting cash inflows: – Stage in your career path • Closely related to your stage in the life cycle — college, career, retirement – Type of job • Based on skill level and demand for those skills – Number of income earners in your household Copyright © 2004 Pearson Education, Inc. All rights reserved. 7

Factors That Affect Cash Flow • Factors affecting cash outflows: – Size of family – Age – Personal consumption behavior • Some people spend all of their income and more while others spend mainly on necessities and concentrate on saving for the future Copyright © 2004 Pearson Education, Inc. All rights reserved. 8

Creating a Budget • Budget: a cash flow statement that is based on forecasted cash flows for a future time period • Budgets are useful for anticipating either cash surpluses or cash deficiencies Copyright © 2004 Pearson Education, Inc. All rights reserved. 9

Creating a Budget Exhibit 2. 3: Stephanie Spratt’s Revised Personal Cash Flow Statement Copyright © 2004 Pearson Education, Inc. All rights reserved. 10

Creating a Budget • Anticipating cash shortages – Small shortages can usually be made up from your checking account – Budgets provide warning of shortages so that you can prepare for them • Assessing the accuracy of the budget – Compare predicted cash flows to actual cash flows – Adjustment may be necessary Copyright © 2004 Pearson Education, Inc. All rights reserved. 11

Creating a Budget Exhibit 2. 5: Comparison of Stephanie Spratt’s Budgeted and Actual Cash Flow for This Month Copyright © 2004 Pearson Education, Inc. All rights reserved. 12

Creating a Budget • Forecast net cash flows over several months – Use the information for a typical month and adjust it for unusual expenses such as seasonal shopping – Allow for some unexpected expenses like medical care, car and home maintenance • Create an annual budget by extending your budget out for longer periods Copyright © 2004 Pearson Education, Inc. All rights reserved. 13

Creating a Budget Copyright © 2004 Pearson Education, Inc. All rights reserved. 14

Creating a Budget • Improve the budget – Periodically review the budget to see if you are progressing toward your goals – Look for areas that can be changed to improve the budget over time • Focus on ethics – Don’t become overly dependent on others – Create a budget and stay within it Copyright © 2004 Pearson Education, Inc. All rights reserved. 15

Financial Planning Online: Budgeting Tips • Go to: http: //dallasfed. org/htm/wealth/index. html • Click on: Budget to Save • This Web site provides tips on effective budgeting based on your goals. Copyright © 2004 Pearson Education, Inc. All rights reserved. 16

Personal Balance Sheet • Personal balance sheet: a summary of your assets (what you own), your liabilities (what you owe), and your net worth (assets minus liabilities) • A balance sheet reflects your financial position at a specific point in time Copyright © 2004 Pearson Education, Inc. All rights reserved. 17

Personal Balance Sheet • Assets – Liquid assets are financial assets that can be easily sold without a loss in value – Household assets are items normally owned by a household, such as a home, a car, and furniture • You need to establish market values for these assets — the amount you would receive if you sold the asset today Copyright © 2004 Pearson Education, Inc. All rights reserved. 18

Personal Balance Sheet – Investments • Bonds: certificates issued by borrower, usually firms and government agencies, to raise funds • Stocks: certificates representing partial ownership in a firm Copyright © 2004 Pearson Education, Inc. All rights reserved. 19

Personal Balance Sheet • Mutual funds: investment companies that sell shares and invest the proceeds in investment instruments • Real estate: holdings in rental property and land • Rental property: housing or commercial property that is rented out to others Copyright © 2004 Pearson Education, Inc. All rights reserved. 20

Personal Balance Sheet • Liabilities – Current liabilities: debts that will be paid within a year – Long-term liabilities: debts that will be paid over a period longer than one year • Net worth is the difference between the value of your assets and the value of your liabilities Copyright © 2004 Pearson Education, Inc. All rights reserved. 21

Personal Balance Sheet • Creating a personal balance sheet – Allows you to determine your net worth – Update it periodically to monitor changes in your net worth over time Copyright © 2004 Pearson Education, Inc. All rights reserved. 22

Personal Balance Sheet Exhibit 2. 7: Stephanie’s Spratt’s Personal Balance Sheet

Personal Balance Sheet • Changes in the personal balance sheet – Some changes will affect both your personal balance sheet and your net worth – Other changes will affect you personal balance sheet and leave your net worth unchanged • Consider the previous personal balance sheet with the purchase of a new car… Copyright © 2004 Pearson Education, Inc. All rights reserved. 24

Financial Planning Online: The Impact of Reduced Spending • Go to: http: //www. financenter. com/products/ sellingtools/calculators/budget • Click on: “What’s it worth to reduce my spending? ” • This Web site provides an estimate of the savings you can accumulate by reducing spending. Copyright © 2004 Pearson Education, Inc. All rights reserved. 25

Personal Balance Sheet Exhibit 2. 8: Stephanie’s Personal Balance Sheet If She Purchases a New Car Copyright © 2004 Pearson Education, Inc. All rights reserved. 26

Personal Balance Sheet • Analysis of the personal balance sheet – Allows monitoring of liquidity, debt, and ability to save – Liquidity is measured by the liquidity ratio Liquidity ratio = Liquid assets/Current liabilities From personal balance sheet on previous slide 4, 000/2, 000 = 2 Higher result = greater liquidity Copyright © 2004 Pearson Education, Inc. All rights reserved. 27

Personal Balance Sheet – Debt level is measured by debt-to-asset ratio • Debt-to-Asset Ratio = Total liabilities/total assets • From personal balance sheet on previous slide • 2, 000/9, 000 = 22. 22% • Higher ratio = higher debt relative to assets Copyright © 2004 Pearson Education, Inc. All rights reserved. 28

Personal Balance Sheet – Savings rate measures savings over the period in comparison to disposable income over the period Savings rate = Savings during the period Disposable income during the period From personal balance sheet on previous slide $400/$2, 500 = 16% Copyright © 2004 Pearson Education, Inc. All rights reserved. 29

Relationship Between Cash Flows and Wealth • Wealth is built by using net cash flows to invest in assets without increasing liabilities • Net cash flows can be used to decrease liabilities which will increase net worth • Net worth can change even if net cash flows are zero; for example, the value of an asset or investment increases or decreases Copyright © 2004 Pearson Education, Inc. All rights reserved. 30

Financial Planning Online: Budgeting Advice • Go to: http: //www. financenter. com/products/ sellingtools/calculators/budget • Click on “How much am I spending? ” • This Web site provides a means for comparing your actual budget versus your desired budget and shows how you could improve your budget. Copyright © 2004 Pearson Education, Inc. All rights reserved. 31

Relationship Between Cash Flows and Wealth Exhibit 2. 9: How Net Cash Flows Can Be Used to Increase Net Worth Copyright © 2004 Pearson Education, Inc. All rights reserved. 32

How Budgeting Fits within Your Financial Plan • The key budgeting decisions for building your financial plan are: – How can I improve my net cash flows in the near future? – How can I improve my net cash flows in the distant future? Copyright © 2004 Pearson Education, Inc. All rights reserved. 33

Integrating Key Concepts Copyright © 2004 Pearson Education, Inc. All rights reserved. 34

Integrating Key Concepts • Part 1: Financial Planning Tools – In Chapter 2 we learned about personal financial statements – Chapter 3 teaches time value of money – Chapter 4 teaches tax planning • Part 2: Liquidity Management • Part 3: Financing • Part 4: Protecting Your Wealth • Part 5: Investing • Part 6: Retirement and Estate Planning Copyright © 2004 Pearson Education, Inc. All rights reserved. 35