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Chapter 2: Financial Planning
Objectives
• Explain the concept of financial planning, its components, and its benefits.
• Describe financial statements, particularly the balance sheet and the income and expense statement.
• Use financial ratios to evaluate your financial strength and progress.
Objectives
• Identify the purposes and methods of financial recordkeeping.
• Describe the use of computer software in personal financial planning.
• Explain how to choose a professional financial planner.
Financial Planning
The process of developing and
implementing a coordinated series of
financial plans to achieve financial
success.
• No clear goals
• Disorganized records
• Lack of economic understanding
• Flawed decision making
Common Financial Behaviors
BEWARE!
• Specified values
• Explicitly stated goals
• Informed economic projections
• Logical and consistent financial strategies
Components of Successful Financial Planning
Economic Data
LivingExpenses
Earnings
Earnings
Earnings
Managerial Effort
PlanningDecision Making
ImplementingControllingEvaluating
Coping and AdaptingFeedback
Communication
ValuesAttitudesLifestyleWantsNeeds
RelationshipsMoneyWealth
AchievementOf FinancialObjectives
Financial PlansFor Spending/Saving
Financial PlansFor Risk Management
Financial PlansFor Capital Accumulation
Input Throughput Output
• Compilation of financial data
• Communicate information
• Indicate financial condition
• Prepares user to read corporate financial statements
Financial Statements
FUNCTIONS PERFORMED:
The Balance Sheet
• Assets – Items owned• Liabilities- Items owed• Net worth– Difference between what
one owns and owes.
VALUE OF EVERYTHING OWNED MINUS EVERYTHING OWED:
Assets- Liabilities = Net Worth
• Monetary or Liquid assets
• Tangible or Household assets
• Investment assets
Assets
• Short-term liabilities – anything that will be paid off in 12 months or less.
• Long-term liabilities—anything that will still have a balance after 12 months.
Liabilities
•Income – How much you made.
•Expenses – How much you spent.
•Net gain or loss—How much you have left.
•Income – Expenses = Net gain or loss
Income - Expense Statement
SUMMARY OF CASH-FLOW TRANSACTIONS OVER TIME:
Incomes
• Salaries or wages
• Bonuses and commissions
• Child support and alimony
• Public assistance
• Social Security and pensions
Incomes
• Scholarships and grants
• Interest and dividends
• Income from the sale of assets
• Other income (gifts, tax refunds, rent, royalties)
Expenses
• Fixed expenses—items that are the same every month (you don’t have control over these).• e.g. house payment, car payment,
insurance premium
• Variable expenses—expense changes based on the way you live (you have control over these).• e.g. meals, utilities, entertainment
Income Statement
INCOME STATEMENT
INCOMEGross Wages 1,000$ Loan from parents 500
1,500$ EXPENSES
Taxes 250 Room rent 500$ Utilities 25 Laundry 15 Food 120 Car Insurance 125 Car loan 150 Medical Insurance 150 Telephone 40 Clothing 25 Entertainment 45 Other -
1,445$
SURPLUS/(DEFICIT) 55$
Assets Liabilities
Monetary (Liquid) Assets Short-term (Current) LiabilitiesCash 1,200$ Dentist bill 120$ Checking account 250 Credit card balance 1,500
Savings account 350 Total short-term (current) liabilities 1,620
Total monetary (liquid) assets 1,800$ Long-term Liabilities
Tangible (Household) Assets Mortgage -$ Home -$ Car loan 2,000
Car 2,500 Total long-term liabilities 2,000$ Furniture 400
Total tangible (household) assets 2,900 Total Liabilities 3,620
Investment Assets Net Worth 2,580$ Stocks 1,500$
Total investment assets 1,500$
Total Assets 6,200$
Balance Sheet
Financial Ratios
• Basic liquidity ratio
• Debt-to-asset ratio
• Debt-service-to-income ratio
• Investment-assets-to-net-worth ratio
OBJECTIVE ASSESSMENTS OF FINANCIAL STATUS:
Basic Liquidity Ratio
This ratio shows that this person could pay their monthly expenses for 1.25 months using monetary assets.
Using the information from the Balance Sheet earlier in this presentation
Basic Liquidity Ratio = Monetary (Liquid) Assets
Monthly Expenses
= $1,800 $1,445
= 1.25
Liquidity Ratio
This ratio shows that this person has $1.11 liquid assets for every $1 of current liabilities.
Using the information from the Balance Sheet earlier in this presentation
Liquidity Ratio = Liquid Assets
Current Liabilities
= $1,800 $1,620
= 1.11
Debt-to-Asset Ratio
Debt-to-Asset Ratio = Total Debt
Total Assets
= $3,620 $6,200
= .58
If your debt is greater than your assets you are technically insolvent.
Debt Service-to-Income Ratio
Debt Service-to-Income Ratio = AnnualDebt
Repayment
Gross Income
= $1,800 $12,000
= .15 or 15%
1
2
1 The Annual Debt Payment for this calculation includes mortgage
2 Annual debt payment in this example is the car loan monthly payment x 12 months ($150 x 12 = $1,800).
A ratio of 36% or less indicates that gross income is adequate to make debt repayments.
Debt Payment-to-Disposable Income Ratio
Debt Payment-to- Disposable Income Ratio =
Monthly nonmortgage debt payments
Disposable income
Disposable income is the amount of take-home pay remaining after all deductions are withheld for taxes.
A ratio greater than 20% is considered problematic.
Investment Assets-to-Net Worth Ratio
Good Debt vs. Bad Debt
Debt incurred for consumption is bad debt.
Bad Debt
= Debt Danger Ratio
Annual Income
Debt Danger Ratio beyond 25% can spell trouble.
Assessing Financial Progress
• Balance sheet
• Income - expense statement
• Financial ratios
• Am I spending, saving, and investing money where I really want to?
Financial Recordkeeping
• Where you are
• Where you have been
• Where you are going
DETERMINE:
Recordkeeping Issues
• Original source records
• Safeguarding/storage of records
• Use of computer software
Professional Financial Planning
• Commission-only
• Fee-only
• Fee-based
• Designations and credentials
Key Words and Concepts
Financial Planning is the process of developing and implementing a coordinated series of financial plans to achieve financial success.
Values are fundamental beliefs about what is important, desirable, and worthwhile.
Financial Goals are the specific long- and short-term objectives to be attained through financial planning and management efforts.
Financial Strategies are preestablished plans of action to be implemented in specific situations.
Financial Statements are compilations of personal financial data designed to communicate information on money matters.
Balance Sheet (or net worth statement) describes an individual’s or family’s financial condition on a specified date.
Income and Expense (or cash flow) Statement lists and summarizes income and expense transactions that have taken place over a specific period of time.
Assets include everything you own that has monetary value.
Liabilities are your debt.
Net Worth is the dollar amount left when what is owed is subtracted from the dollar value of what is owned. Everything should be calculated at fair market value.
Key Words and Concepts (Cont.)
Fair Market Value is the amount a buyer would pay a willing seller.
Monetary Assets (or liquid assets) include cash and near-cash items that can be readily converted to cash.
Tangible (or use) Assets are physical assets that have fairly long lifespans and could be sold to raise cash but whose primary purpose is to provide maintenance of one’s lifestyle.
Investment assets (also known as capital assets) include tangible and intangible items acquired for the monetary benefits they provide.
Diversification of investments means the investor puts money in a variety of investments.
Short-term (or current) Liability is an obligation that will be paid off within one year.
Long-term Liability is an obligation that will be paid off in more than one year.
Insolvent means net worth is negative.
Fixed Expenses are usually paid in the same amount during each time period.
Variable Expenses are expenditures over which and individual has considerable control.
Net Gain/Loss shows the amount of money left after you subtract expenses from income.
Financial Ratios are objective numerical calculations designed to simplify making judgmental assessments of financial strength over time.
Key Words and Concepts (Concl.)
Liquidity is the speed and ease with which an asset can be converted into cash.
Financial Ratios:Basic Liquidity Ratio: monetary (liquid) assets
monetary expenses
Reveals the number of months a family could continue to meets its expenses from monetary assets after a total loss of income. Families should have a basic liquidity ratio of 3.
Debt-to-Asset Ratio: total debt total assetsMeasures the solvency and ability to pay debt
Debt Service-to-Income Ratio: annual debt repayments gross incomeProvides an incisive view of the total debt burden of an individual. A ratio of .36 or less indicates that gross income is adequate to make debt repayments.
Investment Assets-to-Net Worth Ratio: investment assets net worth
Expresses how well an individual is advancing toward their financial goals for capital accumulation. Experts recommend 50% or higher.