Chapter 4 Budgets and Balance Sheets Your Personal

Learning Objectives • Explain the steps involved in creating a budget • Explain the steps involved in creating a personal balance sheet • Analyze the importance of budgeting in your financial plan © 2010 Pearson Education, Inc. All rights reserved 0 -2

Creating a Budget • A budget is a forecast of future cash inflows and outflows • Creating a budget is a key part of your financial plan • A budget provides guidance for reaching your personal goals • It gives you a detailed roadmap to your financial future © 2010 Pearson Education, Inc. All rights reserved 0 -3

Step 1: Create a Personal Cash Flow Statement • Identify your current cash inflows and cash outflows • Many cash inflows include salary, hourly wages, or allowance • Cash outflows include car payment, rent, or phone bill • See Figure 4. 1 for an example of a Personal Cash Flow Statement © 2010 Pearson Education, Inc. All rights reserved 0 -4

Figure 4. 1 © 2010 Pearson Education, Inc. All rights reserved 0 -5

Step 2: Turning Your Cash Flow Statement into a Budget • Forecast your net cash flows for a period a time into the future • Think of how the cash flows might change from month to month • Be sure to include expected, yet irregular expenses, such as school activity fees or vacation © 2010 Pearson Education, Inc. All rights reserved 0 -6

Step 2: Turning Your Cash Flow Statement into a Budget • A good budget should include unexpected expenses • Adjust the budget as necessary as you get more information • An annual budget helps identify times where you can save money and times when you will be spending more money • See Figure 4. 2 for an example of an annual budget © 2010 Pearson Education, Inc. All rights reserved 0 -7

Figure 4. 2 © 2010 Pearson Education, Inc. All rights reserved 0 -8

Working with and Improving Your Budget • A budget will help you save money for: – major purchases – unexpected expenses – unexpected opportunities • A budget will help you anticipate future cash shortfalls • A budget is a great planning tool © 2010 Pearson Education, Inc. All rights reserved 0 -9

Assessing the Accuracy of the Budget • A forecast error is the difference between what you forecast to happen and what actually happened • Evaluate your forecasts and compare those with the actual cash flows • Keep an expense journal to track your spending • After looking at your forecast error, you may need to adjust your spending • Look at Figure 4. 3 for an example forecast errors © 2010 Pearson Education, Inc. All rights reserved 0 -10

Figure 4. 3 © 2010 Pearson Education, Inc. All rights reserved 0 -11

Check Your Financial IQ • What are the steps involved in creating a budget?

Check Your Financial IQ • Step 1: Creating a personal cash flow statement • Step 2: Turning a cash flow statement into a budget • Step 3: Working with and improving your budget © 2010 Pearson Education, Inc. All rights reserved 0 -13

Personal Balance Sheet • Personal balance sheet tells you what your financial position is at a point in time. • A personal balance sheet helps you make decisions on how to use extra money • Knowing where you are financially will help guide in deciding how to manage: – your liquidity – your use of credit and borrowing, – your investments – and more © 2010 Pearson Education, Inc. All rights reserved 0 -14

Assets • Assets on a balance sheet can be classified in several ways: –

Liquid Assets • Liquid assets are financial assets that are either cash or can be easily converted to cash without significant loss of value • Liquid assets include money in checking and savings accounts • They are necessary for covering unexpected emergency expenses • It is important that they have quick availability, • It is also important for them to be making money © 2010 Pearson Education, Inc. All rights reserved 0 -16

Math for Personal Finance • Jeff has $1, 000 in a savings account, $340 in his checking account, and $2, 100 in stock that his grandmother gave him. He also owns his car, which is worth about 43, 200 • How much does Jeff have in liquid assets? © 2010 Pearson Education, Inc. All rights reserved 0 -17

Math for Personal Finance • Solution: Jeff’s liquid assets consist of the money in his savings and checking accounts, which is $1, 000 + $340 = $1, 340. © 2010 Pearson Education, Inc. All rights reserved 0 -18

Household Assets • Household assets include those assets owned by a household – cars, houses, furniture • The market value of something is what it would be worth if you sold it today • Another type of asset is household assets • While creating your personal balance sheet, evaluate the true market value of these assets • Kelley Blue Book (for cars), EBay, and other internet sites are good resources for determining the value of these assets © 2010 Pearson Education, Inc. All rights reserved 0 -19

Investments • An investment is something you acquire with the ultimate goal of making money • Investments are third major category of assets • Investments are something you buy that you believe will increase in value over time • Some common investment assets are: – Stocks – Bonds – Real estate © 2010 Pearson Education, Inc. All rights reserved 0 -20

Investments • Bonds are basically certificates that function like IOUs— promises to repay a certain amount of money at some future time • When you buy a bond, you are essentially loaning the issuer money • The issuer pays you interest until the maturity date • People buy bonds expecting to receive interest income while they hold the bond and getting their money back when the bond matures • Investing in bonds involves some risks © 2010 Pearson Education, Inc. All rights reserved 0 -21

$Investments • Stocks are certificates that represent fractional ownership of a firm • People$

Investments • Stocks are certificates that represent fractional ownership of a firm • People buy stocks expecting that the company will do well and the value will increase • Each share of ownership represents a percentage of the business and is called a share of stock • Stocks can be risky • It is possible that the value will decline or disappear altogether © 2010 Pearson Education, Inc. All rights reserved 0 -22

Math for Personal Finance • Emily owns 50 shares of Company Y’s stock that is currently selling for $170 a share. She also owns 65 shares of Company Z’s stock worth about $47 a share. • What is the total value of her stock holdings? © 2010 Pearson Education, Inc. All rights reserved 0 -23

Math for Personal Finance • Solution: Company Y 50 x $170 = $8, 500

Investments • Mutual funds are created so investors can pool their money in order to invest in a larger variety of financial assets, such as stocks and bonds from many different companies • Mutual funds are managed by professionals who decide which stocks/bonds to purchase • Individual investors who buy shares in the fund do not have to be experts in stock or bond selection • The risk of loss is usually spread across many different investments © 2010 Pearson Education, Inc. All rights reserved 0 -25

Investments • Real estate includes homes, rental property, farms, and other land • Real estate is another type of investment • People invest in this hoping it will generate revenue over time and increase in value © 2010 Pearson Education, Inc. All rights reserved 0 -26

Liabilities • Liabilities represent the amount of debt a person owes • These debts can be put into 2 categories: – Current liabilities – Long-term liabilities © 2010 Pearson Education, Inc. All rights reserved 0 -27

Liabilities • Current liabilities are debts that must be paid off within 1 year • Credit card balances are the most common form of current liabilities for people • A credit card acts like a short term loan that “should” be paid of every month • When you pay the credit card bill, you are eliminating the current liability © 2010 Pearson Education, Inc. All rights reserved 0 -28

Liabilities • Long-term liabilities are debt that will take longer than 1 year to pay off • Examples of long-term liabilities include student loans, car loans, and home mortgages • Each payment includes an interest component and some amount that will reduce the initial liability (principal) • Note that many people use credit cards this way • This leads to paying more money than originally intended © 2010 Pearson Education, Inc. All rights reserved 0 -29

Net Worth • Net worth is the difference between your assets and your liabilities • Figuring your net worth is an easy way to measure your wealth • You can figure your net worth with a personal balance sheet • Refer to Figure 4. 4 for an example of figuring out your net worth © 2010 Pearson Education, Inc. All rights reserved 0 -30

Figure 4. 4 © 2010 Pearson Education, Inc. All rights reserved 0 -31

Math for Personal Finance • Lakisha’s car is worth about $6, 000 and she still owes $1, 200 on it. She has an outstanding credit card balance of $450. • What is her net worth? © 2010 Pearson Education, Inc. All rights reserved 0 -32

Math for Personal Finance • Solution: Lakisha’s net worth is $6, 000 $1, 200

Changes in the Personal Balance Sheet • Your Personal Balance Sheet changes as you acquire new assets or liabilities • This will affect your net worth • There are 2 ways to increase your net worth 1. The value of your assets needs to increase by more than your liabilities 2. To pay down debt on your liabilities © 2010 Pearson Education, Inc. All rights reserved 0 -34

Analysis of Your Personal Balance Sheet • Lenders look at your personal balance sheet to determine if you can pay the loan • Loan officers use a debt-to-asset ratio to determine if you have borrowed too much money • Keep your personal balance sheet in good shape • It can influence the options you have for making financial decisions and having a good financial plan © 2010 Pearson Education, Inc. All rights reserved 0 -35

Check Your Financial IQ • What are the steps in creating a personal balance

Check Your Financial IQ • To see your net worth, you need to identify all your assets, identify all your liabilities, and then subtract your liabilities from you assets. © 2010 Pearson Education, Inc. All rights reserved 0 -37

Budgeting and Your Financial Plan • Your cash flows feed into your balance sheet • If cash flows exceeds cash outflows, you will either increase assets or reduce liability • Take a look at figure 4. 5 to see how this will show up on your balance sheet in the form of increased net worth © 2010 Pearson Education, Inc. All rights reserved 0 -38

Figure 4. 5 © 2010 Pearson Education, Inc. All rights reserved 0 -39

Budgeting and Your Financial Plan • Budgeting helps in financial planning because it makes you answer the following questions: – How can I improve my net cash flows in the near term? – How can I improve my net cash flows in the long term? – What decisions should I make about using credit, borrowing, and investing? © 2010 Pearson Education, Inc. All rights reserved 0 -40

Check Your Financial IQ • What is the importance of budgeting to your financial

Check Your Financial IQ • Budgeting helps you evaluate your current financial condition and determine how to improve net cash flows and make wise credit, borrowing, and investment decisions. © 2010 Pearson Education, Inc. All rights reserved 0 -42

Summary • The budgeting process allows you to monitor and control cash inflows and outflows • Examine the difference between your forecast and actual cash inflows and outflows • You can anticipate future problems and make necessary adjustments © 2010 Pearson Education, Inc. All rights reserved 0 -43

Summary • Your personal balance sheet tells your financial position at a point in time • It is a summary of your assets, your liabilities, and your net worth • Assets can be listed as liquid assets, household assets, and investments • Liabilities represent the amount of debt you owe • Liabilities can be split into two categories: – Current liabilities – Long-term liabilities © 2010 Pearson Education, Inc. All rights reserved 0 -44

Summary • Budgeting can help you manage your cash flows to increase your net

Vocabulary • • Bond Budget Current liability Forecast error Household asset Investment Liability © 2010 Pearson Education, Inc. All rights reserved • • Liquid asset Long-term liability Market value Mutual fund Net worth Personal balance sheet Real estate Stock 0 -46