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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